“For the individual investor, investing in low-cost, tax efficient, broad-based, capitalization-weighted index funds is still the best way to build an investment portfolio.” ~ Burton G. Malkiel, author “A Random Walk Down Wall Street”
Index funds serve investors far better than expensive, tax inefficient, actively managed funds, argues Burton G. Malkiel, author ” A Random Walk Down Wall Street”. By holding a portfolio of all stocks on the market, in the proportion to their relative size or capitalization, the investor would be guaranteed to realize market return.
Index funds generally provide higher net returns for investors than actively managed funds that try to beat the market. “You are much better off not buying individual stocks, but buying an index fund,” Malkiel wrote. When investors talk about “beating the market,” they mean getting returns — over time — that are higher than what the broader market achieves.
Malkiel believes investors are generally better off to buy-and-hold rather than trying to chase particular strategies or make short-term moves. One of the best ways to cut down on both trading costs and capital gains taxes is simply to invest for the long-term. Do your research and buy into stocks slowly so you get comfortable with them. Hold them for decades.
But, if you’re inclined to invest in individual stocks, what follows are Malkiel’s Rules for picking quality stocks
1. Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years.
Malkiel says although it is a difficult job to do, picking stocks whose earnings grow should be the main objective of investors.
“Consistent growth not only increases the earnings and dividends of the company but may also increase the multiple that the market is willing to pay for those earnings. Thus, the purchaser of a stock whose earnings begin to grow rapidly has a potential double benefit—both the earnings and the multiple may increase,” he says.
2. Never pay more for a stock than can reasonably be justified by a firm foundation of value.
Malkiel says investors can roughly gauge when a stock seems to be reasonably priced so they can look at the market price-earnings multiple before making an investment decision.
“Buy stocks selling at multiples in line with, or not very much above, this ratio. Look for growth situations that the market has not already recognized by bidding the stock’s multiple to a large premium. If the growth actually takes place, you will often get a double bonus—both the earnings and the price-earnings multiple can rise,” he says.
Malkiel says investors should be cautious of stocks with very high multiples as many years of growth is already discounted in their prices.
“If earnings decline rather than grow, you can get double trouble—the multiple will drop along with the earnings. Buy stocks whose P/Es are low relative to their growth prospects. If you can be even reasonably accurate in picking companies that do indeed enjoy above-average growth, you will be rewarded with above average returns,” he said.
3. It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air.
Malkiel says investors are emotional human beings driven by greed, gambling instinct, hope, and fear in their stock market decisions. This is why successful investing demands both intellectual and psychological sharpness.
“The key to success is being where other investors will be, several months before they get there. So ask yourself whether the story about your stock is one that is likely to catch the fancy of the crowd. Can the story generate contagious dreams? Is it a story on which investors can build castles in the air—but castles in the air that really rest on a firm foundation?,” he says.
4. Trade as little as possible.
Malkiel says frequent switching accomplishes nothing but subsidizing the broker and increasing tax burden when investors do realize gains.
“I do not say, “Never sell a stock on which you have a gain.” The circumstances that led you to buy the stock may change, and, especially when it gets to tulip time in the market, many of your successful growth stocks may become overweight in your portfolio,” he says.
Hence, Malkiel says picking individual stocks is a fascinating game and investors should tilt the odds in their favor while protecting themselves from the excessive risk involved in high-multiple stocks.
The odds of anyone consistently beating the markets are very low. Therefore, the recommended strategy includes index funds as the core of your portfolio follow by picking stocks with the money you can afford to put at somewhat greater risk.
While “beating the market” is a pursuit that can lead you to substantially grow your wealth, it’s not healthy to make it the cornerstone of your life. Investing should serve a bigger purpose in your life — like achieving financial independence, helping to send your kids to college, or whatever else matters to you. When you have a nest egg to do that, it’s entirely possible that it’s time to stop focusing on “beating the market” and turn your attention elsewhere.
References:
- Burton G. Malkiel, A Random Walk Down Wall Street, W. W. Norton & Company, New York, 2015, pp. 261-262.
- https://economictimes.indiatimes.com/markets/stocks/news/burton-malkiels-rules-to-pick-quality-stocks-avoid-irrational-decisions/articleshow/91850408.cms