Burton Malkiel author of "A Random Walk Down Wall Street" defends buy and hold.

"A Random Walk Down Wall Street" has been a huge influence on my investment approach. It is one of my top recommended books on investing. In this op-ed in todays WSJ, Burton Malkiel defends a diversified buy and hold strategy.

This is a great lesson for all investors to learn.

By Burton G. Malkiel

In the wake of the recent financial crisis, many investors believe that the traditional methods of portfolio management don't work anymore. They think that "buying and holding" is outdated, and that success depends on skillful timing. Diversification no longer works, they argue, because all asset classes move up and down together, especially when stock markets fall. In other words, diversification fails us just when we need it most. And they suggest that low-cost, passively managed portfolios are no longer useful, that today's difficult investment environment requires active management.

I don't agree with any of these arguments. The timeless investment maxims of the past remain valid. Indeed, their benefits may be even greater today than ever before.

Many obituaries have been written for the investment strategy of buy and hold. Of course, investors would be better off if they could avoid being in the stock market during periods when it declines. But no one—either professional or amateur—has ever been able to time the market consistently. And when they try, the evidence shows that both individual and institutional investors buy at market tops and sell at market bottoms.

Money poured into the stock market at the peak of the Internet bubble during the first quarter of 2000. Stocks and mutual funds were liquidated in unprecedented amounts at market bottoms in 2002 and 2008. Professional investors had large cash holdings at market bottoms but tended to be fully invested during market tops. Buy and hold investors in the U.S. stock market made an average annual return of 8% during the 15 years from 1995 through 2009. But if they had missed the 30 best days in the market over that period, their return would have been negative. Market strategists called for a sharp market decline in late August 2010 as technical indicators were uniformly bearish. The market responded with its best September in decades.

While no one can time the market, two timeless techniques can help. "Dollar-cost averaging," putting the same amount of money into the market at regular intervals, implies investing some money when stocks are high, but also ensures some buying at market bottoms. More shares are bought when prices are low, thus lowering average costs.

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Associated Press

While no one can time the market, two timeless techniques can help.

The other useful technique is "rebalancing," keeping the portfolio asset allocation consistent with the investor's risk tolerance. For example, suppose an investor was most comfortable choosing an initial allocation of 60% equities, 40% bonds. As stock and bond prices change, these proportions will change as well. Rebalancing involves selling some of the asset class whose share is above the desired allocation and putting the money into the other asset class. From 1996 through 1999, annually rebalancing such a portfolio improved its return by 1 and 1/3 percentage points per year versus a strategy of making no changes.

Diversification has not lost its effectiveness. Over the past several years, when stocks went down, bonds went up, preserving the value of the portfolio. And while stock markets around the world have tended to rise and fall together, there were huge differences in regional returns. Even though portfolios in the U.S. market actually lost money in the first decade of the 21st century, emerging-market stocks enjoyed returns of more than 10% per year. Every portfolio should have substantial holdings in the fast-growing emerging economies of the world.

Low-cost passive (index-fund) investing remains an excellent strategy for at least the core of every portfolio. Even if markets may not always be efficiently priced, index funds must produce above-average returns after costs. All the stocks in the market must be held by someone. Therefore, if one active portfolio manager is holding the better-performing stocks, then some other active manager must be holding those with below-average returns. But active managers charge substantial investment fees, and their buying and selling of securities in their attempt to beat the market generates significant transaction costs (and possibly greater taxes). Index mutual funds and their exchange-traded-fund (ETF) cousins do not trade from security to security, and they charge rock-bottom expenses (usually well below one-tenth of 1%).

The one investment principle about which I am absolutely sure is that the less I pay to the purveyor of an investment service, the more there will be for me. As Jack Bogle, founder of the Vanguard Group, says: "In the investment fund business, you get what you don't pay for."

The evidence is clear. Low-cost index funds regularly outperform two-thirds of actively managed funds, and the one-third of actively managed funds that outperform changes from period to period. Even the very few professional investors who have beaten the market over long periods of time—Berkshire Hathaway's Warren Buffett and Yale University's David Swensen, for instance—are quick to advise that investors are likely to be much better off with simple low-cost index funds than with expensive actively managed funds.

The chart nearby illustrates how someone who invested $100,000 at the start of 2000 and, following my advice, used index funds, stayed the course and rebalanced once a year, would have seen that investment grow to $191,859 by the end of 2009. At the same time, someone buying only U.S. stocks would have seen that same investment decline to $93,717.

The recommended index-fund portfolios contain bonds, U.S. stocks, foreign stocks (including those from emerging markets) and real-estate securities. The diversified portfolio, annually rebalanced, produced a satisfactory return even during one of the worst decades investors have ever experienced. And if the investor also used dollar-cost averaging to add small amounts to the portfolio consistently over time, the results would have been even better.

If you ignore the pundits who say that old maxims don't work and you follow the time-tested techniques espoused here, you are likely to do just fine, even during the toughest of times.

Mr. Malkiel is a professor of economics at Princeton University. This op-ed was adapted from the upcoming 10th edition of his book "A Random Walk Down Wall Street," out in December by W.W. Norton.

Bogle: On Equity Styles

Chapter 6 of "Common Sense on Mutual Funds" is a discussion of investment style, returns, and relative index fund performance.

Over the last 30 years, academic research into the US stock market has shown that the whole US stock (equity) market can be dissected into various sectors that have there own risk and return characteristics. Below is a short excerpt from www.Investopedia.com that explains the most common style box:

The domestic equity style box, designed to assist in the evaluation of securities, is the best-known and most popular type of style box. Morningstar's domestic equity style box, shown below, provides a simple equity classification system.
The vertical axis of the style box is divided into three categories, which are based on market cap. For mutual fund evaluations, Morningstar's proprietary market cap evaluation methodology is used to rank the underlying stocks in each mutual fund in order to determine the fund's market cap. Of the 5,000 stocks in Morningstar's domestic equity database, the top 5% are categorized as large cap. The next 15% are classified as medium cap and the remaining stocks are classified as small cap.

The horizontal axis is also divided into three categories, based on valuation. Once again, the underlying stocks in each mutual fund portfolio are reviewed. The price-to-earnings (P/E) andprice-to-book (P/B) ratios are used as the basis of a mathematical calculation that results in the classification of each stock as growth, blend or value. "Blend" is used to describe stocks that exhibit both growth and value characteristics.

Analysis of the style boxes will show an investor that the smaller the sector the higher the return. Likewise, value funds outperform growth funds. In addition, as style drifts towards smaller and value, risk increases.

Understanding this breakdown is important for a couple of reasons;

1. It allows an investor to understand why and how their mutual fund performance is behaving in a certain manner. For example, over time, a small value fund should outperform a large growth fund - because it is riskier.

2. It helps explain manager performance. For many years, a mutual fund (or portfolio manager) was evaluated on pure returns. Now funds are reviewed through the risk and style box lens. A fund manager who focuses on small value and outperforms the total market will be evaluated against other small value measures not the whole market. So managers can no longer outperform by taking higher risks.and be perceived as being smarter than the market.

Next post I will explore how index funds compare against active managers in each style box.

Indexing: The Triumph of Experience over Hope

Warren Buffet in 1996:

"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

In chapter 5 of John Bogles's Common Sense on Mutual Funds, he makes his case for index funds.

What is an index fund? It is simply a mutual fund that holds a basket of stocks that meet a specific definition. They are not chosen by a single person, or by an investment committee, or by some formula.

The Dow Jones, S&P 500, and NASDAQ are index's. The Dow is 30 large US stocks, the S&P 500 is the largest 500 stocks in the US, and the NASDAQ is the market of technology stocks. An index fund is a mutual fund that replicates a particular index.

If you own the S&P 500 index fund, you own the 500 largest stocks in the US. Nobody picked those stocks in that fund, they are there because they meet the definition of 1 of the 500 largest stocks in US.

There are now hundreds of index funds available to investors. Including everything from a total US market fund to small cap value funds to international funds to specific industry funds, ie health care.

What studies have shown is that over time index funds perform better than funds that are managed by investment professionals.

Bogle shows that over the last 40 years the S&P 500 index earned 9% while the average actively managed equity fund earned 7.6%

To clarify:

The S&P is a good index to represent the total US market. By definition it is the average of all the investors investing in the market. And therefore, by definition, roughly half the investors will be better and half will be worse. Then, when you factor in expenses, it is nearly impossible to consistently outperform an index net of fees. A look at the above numbers demonstrates this. The average fund fees for mutual funds are approximately 1.3% to 1.5%. So if the average mutual fund earns the market average (since all equity mutual funds are essentially the market) of 9% then subtract the fees., the net return is the 7.6% . A mutual fund would have to earn better than 10% to beat the index net of fees.

It is primarily due to the fee issue that index funds outperform over time. This exists over all types of index funds. It mathematically has to: actively managed funds have higher expenses and if the index in every category is the average, the net active return has to be lower than the average (net of fees). This last argument is not mine it is William Sharpe's - 1990 Nobel prize winner in Economics.

Stock market value and the economy

A recent blog by Larry Swedroe - who is always worth the time.

He gives a brief but excellent explanation of stock market value relative to the overall economy.

http://moneywatch.bnet.com/investing/blog/wise-investing/the-economy-isnt-the-same-as-the-market/1732/

On Asset Allocation - The average investors most important decision

In Chapter 3 of Common Sense on Mutual Funds, John Bogle emphasizes the importance of getting your personal asset allocation correct.

Asset allocation means your stock to bond mix. Bogle emphasizes that bonds should be used as a moderator to your risky stocks. Not as another risky investment alternative. He says this because there are bonds that are very risky such as low grade and junk bonds. So by mix he means stable investments (short term high grade bonds) relative to risky, volatile investments (stocks).

He sites the famous 1986 study in the Financial Analysis Journal by Brinson, Hood, and Beebower that over 90% of the variation in pension plan returns studied were due to the stock bond mix. Not the particular stocks or bonds chosen.

Bogle clarifies the meaning behind the study's outcome: "Long-term fund investors might profit by concentrating more on the allocation of investments between stock and bond funds, and less on the question of what particular stock or bond fund to hold"

He goes on to emphasize that an investor needs to understand their time horizon, ability to stomach volatility, and whether the savings is for accumulating wealth or the distribution of wealth. Longer time horizons and investors in the savings stage can invest in a greater percentage of stocks. Versus an investor who is in the distribution phase of their investment cycle who should have a lower percentage of stocks. All investors should work with a trusted, competent advisor in order to develop the allocation mix that is best for them.

Bogle goes on to demonstrate that once the allocation mix is defined. The second most important thing an investor should do is fill the portfolio with low cost, preferably index, funds. Study after study show that when comparing similar funds, low cost is the best determinant of long term performance (see blog post 8/27/10).

The advice is straight forward: Determine the percentage of stocks you should own, then fund your portfolio with low cost index funds.

In future posts we will discuss what makes up the stock and bond portions. But you cant get to this question until you have determined the allocation.

SIMPLE 401K investing. Spend 5 minutes and potentially improve your wealth.

Most people get little advice an how to invest in their 401K plan. This is a SIMPLE approach. Spend 5 minutes reading the link below - simple investing advice on how you could invest in your 401K.

Remember that the more you allocate to stocks in your portfolio the greater the downs you will experience.

http://online.wsj.com/article/SB10001424052748704407804575425851977494576.html?mod=ITP_thejournalreport_0

Combine the above with this golden nugget of wisdom from John Bogle, summarizing a recent Morningstar study in the August 26, 2010 Wall Street Journal:

"A mutual fund's past returns are no guarantee of its future. Even the most sophisticated rating systems are erratic at best in forecasting a fund's performance in the years ahead. But for decades, academic experts and analysts have proven that fund costs are a powerful predictor of relative performance. Returns come and go, as it were, but costs go on forever.

A recent study by the Morningstar fund evaluation service came to this very same conclusion. In an admirable report that was the opposite of self-serving, Morningstar found that using fund-expenses ratios as a factor in choosing mutual funds was even more helpful than relying on its own carefully constructed "star ratings." Specifically, focusing on funds with the lowest expense ratio was more helpful in fully 58% of the time periods studied.

"In every asset class (U.S. stock funds, international stock funds, balanced funds, taxable bonds, and municipal bonds) over every time period," Morningstar wrote, "the cheapest quintile produced higher net returns than the most expensive quintile." Among domestic equity funds, the returns of the lower-cost funds outpaced the returns of the higher-cost funds by about 1.3 percentage points annually. That proves to be a compelling edge. Over a 50-year investment lifetime, for example, a return at the 8.1% historical average for stocks would produce nearly 50% more capital than a return of 6.8%.

These calculations actually understate the success of low-cost funds. "Survivor bias"—only the more successful funds survive to make it into the database—permeates the equity-fund data. According to Morningstar, in the highest-cost quintile only 57% of equity funds survived over the past five years. Even in the lowest-cost quintile, only 81% survived. So much for relying on most mutual funds as long-term investments.

The idea that costs matter is not new. In a 1966 article in the Journal of Management, economist William F. Sharpe concluded, "all other things being equal, the smaller a fund's expense ratio, the better results obtained by its stock holders."

Bogle on fees in todays Wall Street Journal

http://online.wsj.com/article/SB10001424052748703846604575447531979322798.html?mod=ITP_opinion_0