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Fund Watch

Burton Malkiel Explains Why Investors Should Stick With Index Funds

After 40 years of studying the stock market, the Princeton economist still finds that a low-cost indexing strategy beats active management.

Burton Malkiel is professor of economics emeritus at Princeton University. The 11th edition of his book, A Random Walk Down Wall Street, has just hit shelves. Here are excerpts from our recent interview with him.

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KIPLINGER: You advocate index investing, a strategy outlined in the first edition of your book in 1973. Forty years on, what’s new?

MALKIEL: Every time I update a new edition, typically every four years, I get the same results: A low-cost index outperforms two-thirds or more of active managers over time. And the one-third that outperform are never the same from one period to the next. In 2014, it was amazing how few people did better than the index: 86% of large-company fund managers lagged the market. Meanwhile, competition among exchange-traded funds has driven fees close to zero. Some have expense ratios of 0.04%.

Can you improve your odds by investing in active funds with low fees? No question. If you want an actively managed fund that does better than average, buy one that charges lower-than-average expenses. We need to be modest about what we know and don’t know. But one thing I absolutely know is that the lower the fee, the more money is left for me.

Burton Malkiel just released the 11th edition of A Random Walk Down Wall Street. Photo by: Gina Levay

Do index funds perform well in down or sideways markets? Indexing works in both up markets and down markets. But the advantage of indexing is a little bit smaller in down markets. That’s because active portfolios generally hold 5% to 10% of assets in cash, which may be set aside to meet redemptions. Those managers can put that money to work in down markets, buying stocks when prices are cheaper. But an index fund is always 100% invested. So the advantages of indexing in a down market are slightly lower.

What about the “lost decade” of the ’00s? Standard & Poor’s 500-stock index ended up not far from where it started. It’s true that if you put all your money in the market in January 2000 and added no more, your investments would have been pretty flat by January 2009. But I’m a big believer in dollar-cost averaging, or investing fixed amounts at regular intervals. That way, you buy more shares when prices are low rather than high. So the 2000s weren’t a great decade, but the dollar-cost-average investor made money.

A lot of people get a kick out of picking stocks. What about them? You don’t have to index everything. Investing in individual stocks is fun. Go and do it. It’s a great hobby. I buy individual stocks myself. I bought shares in Alibaba (symbol BABA), the Chinese e-commerce company, after it went public last year.