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The KISS mantra for financial planning

The KISS mantra for financial planning

The sequel from A Random Walk Down Wall Street is a primer for investment with a message: ‘keep it simple, stupid’.

THE RANDOM WALK GUIDE TO INVESTING
BY BURTON G. MALKIEL PRICE: RS 495 PAGES: 202 W.W. NORTON


MONEY TODAY reviews a book that is both an investment classic and an everyday-use primer
In 1973, Professor Malkiel wrote A Random Walk down Wall Street, where he expounded Eugene Fama’s Efficient Market Theory (EMT). The book was a successful attempt to take an academic hypothesis out of the ivory tower of academia and apply it to the chaotic realities of equity markets. It sold millions and is one of the most influential books ever. It midwifed the birth of index funds and changed the workings of the investment industry.

EMT itself remains hotly debated—it is often referred to as the EM Hypothesis (EMH) because it has not yet been accepted as “true”. An efficient market is one which offers a level playing field in trading platforms and news gathering. In an efficient market, everybody hears the news at almost the same time and anybody can trade with ease.

EMT suggests that in these circumstances, it is very difficult to score excessive returns because news gets discounted quickly into prices. Prices move in the same way that a drunkard randomly meanders. Hence EMT is also known as the “random walk” theory. One of the implications of EMT is that it suggests an active investor, who picks stocks in the hope of generating an excess return, is often wasting his time. The laws of chance guarantee some people will be lucky and a few may be clever enough to beat the market; most investors will not.
 
Without getting into the debate, it is true that the more efficient the market, the tougher it is to consistently beat the indices. In the US, 90% of the actively managed funds yield lower annual returns than their respective benchmarks. Even in India, over 80% of funds underperform their benchmarks. This is compelling evidence that there is, at least, some truth to EMH even if it’s not quite EMT. If this is the case, why pay extra to research stocks? Better to eschew the extra costs since the research may not generate extra gains.

This logic leads to index-investing. By 1975, largely under the influence of Malkiel, John Bogle had established Vanguard (now the second-largest global asset management company with a focus on passive, cheap index funds).

Vanguard’s funds track indices, (much as Benchmark does in India). These no-load, no-frills instruments give returns that mimic indices. Over the past three decades, they have consistently beaten 85% of active funds.

If you accept EMT, what step should you take to safeguard your financial future? That’s the leitmotif of this book. While EMT remains at the core, Malkiel has gone a long way beyond just EMT and stocks to create a primer that explains financial planning, breaks it down into easy steps and offers a road-map for implementation. He starts with three guiding principles.

First, ignore financial advisories—most will not help you make money. Second, understand that the promise of higher returns is always accompanied with prospects of higher risks. Third, concentrate on four asset classes—stocks, bonds, real estate and cash-equivalent instruments in building a portfolio.

In the chapter on risk and return, the author makes a couple of important points on the methods that reduce equity risk while not reducing prospective returns. One is simply giving it time— equity returns get less volatile the longer the portfolio is held. Another is to diversify inside the equity universe in order to further reduce volatility.

The EMT bias comes into the picture in that Malkiel recommends picking cheap index funds in preference to activelymanaged equity funds or direct equity. Further, he suggests that you pick up global index funds to balance country-specific risks. From here onwards, it’s a straight-forward primer on financial planning. Malkiel offers 10 basic rules, spends a chapter expounding each and winds up with a scorecard that reviews the returns this style of investing has generated over the past four decades.

The rules (see box) are not rocket science. Like most of financial planning they are commonsense. But they require discipline to implement and most of us fail to cross that particular hurdle. The chapter on saving incorporates some important strategies that can help you save if you tend to be spendthrift.

The Random Walk Guide To Investing is USspecific. This means that the specific instruments and tax-saving strategies may not be available in India. But it is not that difficult to find equivalent instruments or failing that, to think in the same frame and find alternative means to implement similar strategies.

Malkiel doesn’t promise to make you rich—in fact, his emphasis is more on the dangers than the rewards. What he does say, unequivocally, is that implementing “his” rules will leave you better off than not doing so. A clear, very readable exposition of the first principles of financial planning.