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The Case for Indexing
The author of A Random Walk Down Wall Street discusses the merits of indexing -- and why low-cost index funds should be the core of your stock investments.
By Steven Goldberg, Contributing Columnist, Kiplinger.com
September 27, 2005
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Whenever beginning investors ask me for a good book, I recommend Burton Malkiel's A Random Walk Down Wall Street. First published in 1973, Malkiel last year came out with the eighth edition of this classic -- which is the one to buy because it's the most up to date.
In his first version, Malkiel argued that individual investors would do best by buying index funds. But he complained that there weren't any. Three years later, Jack Bogle started Vanguard -- which offered the first index funds to individual investors. (Big institutional investors had been using them for some time.)
Malkiel recently retired from Vanguard's board of directors. But he's still teaching at Princeton, and he still has one of the liveliest investment minds in academe. So I was pleased when he dropped by our offices the other day.
A portfolio with a stock portion consisting of 75% Vanguard Total Stock Market Index (VTSMX) and 25% Vanguard Total International Index (VGTSX) will serve most investors far better than chasing after better returns with active fund managers, much less trying to pick stocks on their own.
If you work hard at it, which we do at Kiplinger's, I still believe you can find managers who will beat the indexes. But finding such mangers is, as Malkiel puts it, "like finding needles in a haystack." And even then you have to monitor their funds closely.
Nowadays, Malkiel argues for a so-called core and satellite approach to constructing a portfolio. Indeed, this is the approach many of the best financial planners employ.
The core, say 80% of a portfolio, is index funds. For the satellites, you look mainly for funds whose results are largely uncorrelated with the market as a whole. So when the market is going down, at least some of these funds may do well.
The satellite funds may be quite volatile individually. But added to a portfolio, they can actually reduce overall risk -- so long as they zig when the market zags.
What satellites does Malkiel like? He's a long-time fan of emerging markets, particularly China. After a torrid run, though, he warns to expect volatility. Still, 5% in an emerging-markets fund may be a good move. Excelsior Emerging Markets (UMEMX) is one of the best.
Malkiel is bullish on Vanguard Health Care (VGHCX). Pharmaceuticals have been laggards for years now, and manager Ed Owens is as good as they come.
He also likes Vanguard Primecap Core (VPCCX). It's a relatively new fund, but Vanguard Primecap, run by the same team, has been a longtime top performer. This fund acts more like the market than the others, but it's still a winner.
Malkiel warns investors to be leery of hedge funds. Not only are fees sky high, but he says that returns aren't nearly as good as the industry boasts, partly because bad funds fold, often without reporting results.
For the core of your investments, though, Malkiel makes the same case he first made more than 30 years ago: Stick to low-cost, widely diversified index funds.