Burton G. Malkiel: Index Funds and Bond Substitutes

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Burton Gordon Malkiel, the Chemical Bank Chairman’s Professor of Economics, has been responsible for a revolution in the field of investing and money management. And he’s also author of the widely influential investment book, A Random Walk Down Wall Street.

His book, A Random Walk Down Wall Street, first published in 1973, used research on asset returns and the performance of asset managers to recommend that all investors would be wise to use passively managed total market “index” funds as the core of their investment portfolios. An index fund simply buys and holds the securities available in a particular investment market.

There were no publicly available index funds when Malkiel in a Random Walk first advanced this recommendation, and investment professionals loudly decried the idea. Today, indexing has been adopted around the world.

Additionally, Malkiel believes that investors “probably needs to take a bit more risk on that stable part of the portfolio”. One asset class that he recommends, instead of low yielding bonds, is preferred stocks. There are good-quality preferred stocks, which are basically fixed-income investments. They’re not as safe as bonds. Bonds have a prior claim on corporate earnings.

According to Malkiel, investors need some part of the portfolio to be in safe, bond like assets–such as preferred stocks, or what he calls bond substitutes, for at least some part of their portfolio.

He suggest a preferred stock of like JPMorgan Chase. He doesn’t think you’re taking an enormous amount of risk. The banks now have much more capital. They are constrained by the Federal Reserve in terms of what they can do and buying back stock and increasing their dividends. And with a portfolio of diversified, high-quality preferred stocks, one can earn a 5% yield.

And if one wants to take on even a bit more risk, there are high-quality common stocks that also yield 5% or more: a stock like IBM, which has a very well-covered dividend, yields over 5%; AT&T– you can think of basically blue chips and they might play a role.

Regarding diversification, investors do need some income-producing assets in their portfolio. But his recommendation is that you think in the diversification of not simply bonds, but maybe some bond substitutes. However, there is a trade-off; there is going to be a little more risk in the portfolio. And one needs to recognize that there is not a perfect solution.

But part of the solution for an investor, especially a retired investor, must be to revisit their spending rule. If one is worried about outliving one’s money, then the spending rate has to be less. In part, it means maybe a bit more belt-tightening.

There’s no easy answer to this. Malkiel wished there were an easy answer that there’s a riskless way to solve the problem. But there isn’t. In terms of wanting more safety, one ought to be saving more before retirement, and maybe the answer is to be spending less in retirement. Thus, on a relative-value basis, things like preferred stocks, and some of the blue chips that have good dividends, and dividends that have been rising over time, ought to play at least some role in the portfolio.

In this age of “financial repression”, where safe bonds yield next to nothing, an asset allocation of 40% bonds is too high, states Malkiel. Now, of course, there’s not just one figure that fits all. For some people it might be 60-40 would be OK. But, in general, the asset allocations that Malkiel recommended have a much larger equity allocation and a much smaller bond allocation. And if you look at the 12th edition of Random Walk book, you’ll find that he has generally reduced the fixed-income allocation and increased the equity allocation–different amounts for different age groups,

References:

  1. https://dof.princeton.edu/about/clerk-faculty/emeritus/burton-gordon-malkiel
  2. https://www.morningstar.com/articles/995453/burton-malkiel-i-am-not-a-big-fan-of-esg-investing
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