In the opening chapter to Burton Malkiel’s book A Random Walk Down Wallstreet, a book well known in both the finance and economic sectors, Malkiel famously notes that an initial investment of $10,000 in the stock market in 1969 would have grown to $327,000 by 2002 while an investment in the average active fund would have only grown to $213,000 – a difference of $114,000. Roughly 40 years after the initial publishing of his book, Malkiel stands by his statement that over time, passive investing will outperform active investing.
If you haven’t heard of Malkiel’s book, maybe you have heard of the million dollar bet between Warren Buffett and a partner at a hedge fund. The story, which has been featured in several business articles over the years, begins with the hedge fund partner and Buffett agreeing to donate $1 million dollars to the winner's charity based on the success of their chosen investments after ten years. The hedge fund partner chose 5 funds of funds, while Buffett invested in the S&P 500. A recent Forbes article, published in February, noted that seven years in, Buffett is well on track to win with his fund up 63.5% and the hedge fund partner's investments only up 10.6%.
The point to both Malkiel’s book and Buffett’s wager is that it is incredibly difficult to consistently beat the market. The remainder of Malkiel’s book makes the claim that the reason why it is so difficult is because stocks follow what is known in the investing world as a random walk, which is another way of saying the future is unpredictable. This has several implications for the average investor. First, it should tell us that predicting when the market is at the top or at the bottom is difficult and while there may be indicators of which direction the market is headed, more often than not, major downturns and recoveries are most clearly observed in hindsight. Secondly, in an ideal world, you should buy the S&P 500 and then do nothing. Many individuals, however, don’t live in an ideal world. At some point or another they need the money they invested, which is where the concepts of diversification and risk analysis come in. Over the long term, the market reigns, but people live life in the day to day and the day to day can’t handle the volatility of the market. Consider a situation where your kid is heading to college or you’re preparing to retire in 4 years. Let’s say you are feeling pretty aggressive and put 100% of your college/retirement savings into the S&P 500. Four years later, your kid has begun his schooling at the college of his choice or you have just signed the papers for your retirement and settled into the perfect game of golf when unexpectedly, the market plunges. Unfortunately for you, your kid is still in college or you are still retired and you need money so you begin to pull money while the market is at rock bottom leaving less and less of a base for your portfolio to recover from. Suddenly, buying and holding the market is no longer the best strategy.
Now imagine that four years earlier, instead of investing 100% in the market, you had diversified your portfolio and adjusted the risk based on your imminent need. You’re still exposed to the S&P 500, but you’re also exposed to other parts of the world as well as other parts of the market such that when the S&P 500 tanks, a significantly smaller portion of your portfolio tanks and other parts tank less or even possibly go up. By diversifying your portfolio and adjusting your exposure based on your cash needs, you are now in a much better place. You are still able to draw without significantly reducing your principal in addition to remaining exposed to the S&P 500 when the recovery begins.
To learn more about how stocks take a random walk, why Buffett is beating a hedge fund partner, and why diversification works, or to create a customized plan that will guide you through the ups and downs of the market safely toward your goals, we invite you to contact one of our advisors today.
Loomis, Carol J. (February 3, 2015). “Warren Buffett Adds to His Lead in $1 Million Hedge Fund Bet.” Fortune. http://fortune.com/2015/02/03/berkshires-buffett-adds-to-his-lead-in-1-million-bet-with-hedge-fund/.
Malkiel, Burton G. (2003). “A Random Walk Down Wall Street.” W.W. Norton & Company: New York.