Customer Review

18 of 29 people found the following review helpful
4.0 out of 5 stars Good book, except for one problem, March 6, 2004
This review is from: The Random Walk Guide to Investing: Ten Rules for Financial Success (Hardcover)
I just had a few comments to make.
Malkiel is famous for his position that no-one can beat the stock market over the long term. The evidence for this is so sobering that I won't repeat much of it here, since it's now so well known--such as 90% of the mutual fund managers failing to beat the indexes year after year. Also, managed funds vs. index funds have higher expense ratios, which further lessons their performance since those costs are passed on to the customer. This is certainly a potent argument in favor of investing in index funds that track various things, such as growth stocks, high tech, or the broad market.
However, there is one major problem with Burton's argument which he doesn't discuss in the book that I could recall. Burton's data refers to mutual funds, which typically buy many stocks. At its height, for example, the big Magellan fund owned 1400 stocks. The average mutual fund owns about 100 stocks, and many own more. The turnover can be as high as 75% a year or more, which further increases costs because of all the commissions.
The problem with needing to own that many stocks is that mutual funds often run out of top-quality picks, and then are forced to buy second or even third-tier stocks, which degrades their performance. This almost guarantees that there will be a regression to the mean in terms of overall performance of the sort Malkiel talks about. However, the small investor has no such limitation. He can cherry pick and create a top-quality portfolio without having to buy the less steller (or worse) stocks that would make your typical mutual fund manager green with envy.
The problem here, of course, is being able to ferret out the top quality stocks. Malkiel would point out that this approach isn't without its risks, either, since such a portfolio with a small number of stocks could lack diversification. However, there's a way to deal with that. If you had, say, $100,000 to devote to a portfolio of stocks, you would be adequately diversified if you bought 15-20 stocks and picked the best stock in different sectors, ranging from high-tech to low-tech such as retail. Some people find that this is too many stocks to track, and that 10-12 in different sectors is a good compromise that still offers good diversification without having to track so many stocks. This has been proven to be almost as effective a way to diversify as buying the overall market (the economist who developed this asset allocation theory won the Nobel Prize in econ some years back), but has the major advantage of not diluting the strength and quality of the portfolio with poorer stocks.
Since Burton is a financial economist I'm surprised he doesn't seem to be aware of this. If you didn't want to devote all your money to this strategy, you could still put half of it in index funds and then use the other half for this. Whichever way you decide to go, good luck and happy investing!
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