Burton Malkiel’s rules to pick quality stocks & avoid irrational decisions

Investing legend Burton G. Malkiel says that short-term fluctuations in the market makes stocks unpredictable and it’s thus usually wiser for individual investors to put most of their money in broad index funds.

Malkiel believes investors are generally better off to buy-and-hold rather than trying to chase particular strategies or make short-term moves.

“You are much better off not buying individual stocks, but buying an index fund. To go and day trade and think that you are investing, that’s what I think is absolutely wrong and is likely to be simply disastrous for people. All the evidence is that day traders in general lose money. It’s not that they can’t make money in gambling, I’ve actually won from time to time. But over the long run, this is a losing proposition,” he wrote in his book,
A Random Walk Down Wall Street.

Malkiel is the Chemical Bank Chairman’s Professor of Economics, Emeritus, and Senior Economist at Princeton University. He is also Wealthfront‘s Chief Investment Officer.

He is the author of the widely appreciated investment book,
A Random Walk Down Wall Street, which helped launch the low-cost investing revolution by encouraging investors to use index funds.

Malkiel says that there are at least four factors that cause irrational investor behavior-

Overconfidence

Malkiel says investors are overconfident about their abilities and overoptimistic about their prediction of the future.

He feels investors also tend to overestimate their own skills and reject the role of chance in their investment outcomes.

“Typically, investors attribute good outcomes to their own abilities (hindsight bias). They also attribute bad outcomes to external events. One manifestation of overconfidence is the consistent overvaluing of growth stocks,” he says.

Biased Judgments

Malkiel says investors use a number of techniques that cause them to assume a greater degree of control than they have in reality.

“Most investors fail to properly weight probability and use base rates,” he says.

Herd Mentality

According to Malkiel, investors get lured into stories of other people making money through investing and of the hot new stock that they need to invest in.

“This tendency to get swept up in speculative, get-rich-quick schemes is representative of how we get lost in herd mentality when making investment decisions,” he says.

Loss Aversion

Malkiel says loss aversion explains why so many investors sell the winners and hold on to the losers as losses hurt more than the pleasure one receives from equivalent gains.

“The pain we feel with a $100 loss is about the same as the joy we get from a $250 gain. Especially when we face a sure loss, we will hold on to losers for even longer. Losses also tap into the emotions of pride and regret. It’s tough to talk about your losses, while it’s sexy to blab about your gains,” he says.

Investment strategy

Malkiel says the core of every portfolio should consist of low-cost, tax-efficient, broad-based index funds.

“We cannot consistently beat the market or achieve outsized returns, so invest in low-cost, tax-efficient, broad-based index funds. Not only is it simple, but it’s likely to give you the best outcome as an individual investor,” he said.

Portfolio composition

Malkiel says if investors have a multi-decade investment horizon, they should be heavily invested in stocks.

He says while stocks are more volatile than other asset classes over short investment horizons, in the long run, they’re likely to get a good return.

“The longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio,” he says.

How to avoid the pitfalls of investor irrationality

Malkiel says every investor wants to earn more with less effort and at times, there are get-rich-quick schemes or trends that are incredibly tempting, but it is best to avoid these dangerous traps although it’s easier said than done.

“What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges,” he said.

Hence, he advises investors can do the following things:

Avoid herd behavior: Malkiel says any investment that becomes a topic of widespread discussion is likely to be especially hazardous to investors’ wealth and mostly, the hottest stocks or funds in one period are the worst performers in the next.

According to Malkiel as herding induces investors to take greater and greater risks during periods of euphoria, the same behavior often leads many investors simultaneously to throw in the towel when pessimism is rampant.

“The media tend to encourage such self-destructive behavior by hyping the severity of market declines and blowing the events out of proportion to gain viewers and listeners. Even without excessive media attention, large market movements encourage buy and sell decisions that are based on emotion rather than on logic,” he said.

Avoid overtrading: Malkiel says investors tend to be overconfident in their judgments and invariably do too much trading for their own financial well-being.

“Investors accomplish nothing from this behavior except to incur transaction costs and to pay more in taxes. Short-term gains are taxed at regular income tax rates. The buy-and-hold investor defers any tax payments on the gains and may avoid taxes completely if stocks are held until distributed as the gains and may avoid taxes completely if stocks are held until distributed as part of one’s estate,” he said.

Sell losers, not the winners: Malkiel says investors are far more distressed at taking losses than they are overjoyed at realizing gains. Thus, paradoxically, investors might take greater risks to avoid losses than they would to achieve equivalent gains.

Also, investors tend to avoid selling stocks that went down, in order to avoid the realization of a loss and the necessity of accepting that they made a mistake.

On the other hand, investors are generally willing to discard their winners because that enables them to enjoy the success of being correct.

“Sometimes, it is sensible to hold on to a stock that has declined during a market meltdown, especially if you have reason to believe the company is still successful,” he said.

Don’t trust “hot tips”: Malkiel says tips come to investors from all fronts from friends, relatives, the telephone, even the Internet so they should avoid trusting these tips at any cost.

“Steer clear of any hot tips. They are overwhelmingly likely to be the poorest investments of your life,” he said.

Asset allocation principles

1 .History shows that risk and return are related-

According to Malkiel, stocks have clearly provided very generous long-run rates of return and investment rewards can be increased only by the assumption of greater risk.

“There ain’t no such thing as a free lunch. Higher risk is the price one pays for more generous returns.

2. The risk of investing in stocks/bonds depends on the time you hold the assets. The longer the holding period, the lower the likely variance in asset returns.

Malkiel says the length of time investors hold on to their investment, plays a critical role in the actual risk they assume from any investment decision.

“Thus, your stage in the life cycle is a critical element in determining the allocation of your assets,” he says.

3. Dollar cost averaging can be a useful, though controversial, technique to reduce risk.

Malkiel says if investors are willing to build up their investment portfolio slowly over time with the accumulation of yearly savings, they should take advantage of dollar-cost averaging.

Dollar-cost averaging simply means investing the same fixed amount of money in, at regular intervals over a long period of time.

“Periodic investments of equal dollar amounts in common stocks can reduce (but not avoid) the risks of equity investment by ensuring that the entire portfolio of stocks will not be purchased at temporarily inflated prices,” he says.

4. Rebalancing can reduce risk, and in some circumstances, increase investment returns.

Malkiel says a very simple investment technique called rebalancing can reduce investment risk and, in some circumstances, even increase investment returns.

“The technique simply involves bringing the proportions of your assets devoted to different asset classes (e.g., stocks and bonds) back into the proportions suited to your age and your attitude toward and capacity for risk,” he says.

5. You must distinguish between your attitude toward and your capacity for risk.

Malkiel says the risks investors can afford to take depend on their total financial situation, including the types and sources of their income exclusive of investment income.

“The kinds of investments that are appropriate for you depend significantly on your non-investment sources of income. Your earning ability outside your investments, and thus your capacity for risk, is usually related to your age,” he says.

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.

(Disclaimer: This article is based on Burton G. Malkiel
‘s book “A Random Walk Down Wall Street.”)

Source link

Recent Posts

Scan to Download
ios&Android APP

Open trading account and start trading!

Join our happy customers