5 lessons every investor should know

The following is a transcript of an interview with Burton Malkiel and Charley Ellis.

Rebecca Katz: Hi. I'm Rebecca Katz from Vanguard, and I'm here with Burton Malkiel and Charley Ellis.

Dr. Malkiel's A Random Walk Down Wall Street and Dr. Ellis's Winning the Loser's Game are investment classics that have helped thousands of individuals to make smarter investment decisions. They're here to talk about a new book they've written together called The Elements of Investing. It focuses on the essentials that all of us should know.

Dr. Ellis, Dr. Malkiel, thanks so much for being here today.

Dr. Ellis: Glad to be here.

Dr. Malkiel: Pleasure.

Start with saving

Rebecca Katz: Now, Dr. Malkiel, it seems to me that the most fundamental element of investing is savings. Without savings, without money, you can't invest. So how can we become better savers?

Dr. Malkiel: Well, clearly, the easiest way to save, or not spend, is not to have the money in your checking account or in your wallet to begin with. So the easiest way to do it is to make sure that you have signed up for your 401(k) plan at work, where the money gets taken out of your salary before you even see it. That's clearly the easiest way to do it. And what, to me, is such a scandal in this country, is that so many people do not actually fund their 401(k) plans—even when the company will provide a match, even when every dollar you put in would be matched by a dollar from your company. So you're missing out on the match; it's also tax-deductible if your income is below certain limits. And that, to me, is just the easiest lesson. 

If you want to save a little more, do it through an IRA, but definitely put the money in first and put it in regularly. Don't stop.

Rebecca Katz: You talk a lot in the book about debt, though, and credit card spending.

Dr. Ellis: No one should ever allow themselves to get into debt for a credit card. The interest expenses and then the penalty charges that can be added on top of that are ferocious. So you've got to get out of credit card debt. It's the first step. And the second step, as Burt so often says, is save and save in a disciplined way. And doing it through your employer, deducting it before you even see it, is far and away the best way to do it, and you should do the maximum.

Rebecca Katz: You talk about saving often, but it's also important to save early. What's the connection between time and savings? Dr. Malkiel?

Dr. Malkiel: Albert Einstein is reported to have said once that the greatest force in the world is the force of compound interest. A dollar that you save today if you make, let's say, 6% or 7% in it, is $1.06 next year, and then it's $1.13 the year after that. In fact, one of the things that Charley and I talk about in our book is this wonderful rule of 72. That if you, let's say, were able to get 15% on your savings, you divide the 15 into the number 72 and it shows you how long it takes for your money to double. So, in that case, your money doubles in less than 5 years.

Rebecca Katz: But, unfortunately, I think, many people get closer to retirement and realize they don't have enough or they start thinking about savings when they've started families, so it's a little bit late. What can people do if they've gotten a late start, Dr. Ellis?

Dr. Ellis: If you find that you are going along in years and you haven't done what you might have done and probably should have done, then it's time to recognize you've got to play catch-up and to take bold and serious action to catch up because there are no magical solutions.

Rebecca Katz: Like what?

Dr. Ellis: Well, cut back on your expenses. And obvious expenses to cut back on, big ones, take a look at your home. Are you living in a house that's the right size for you? If you don't need to live in a house that large, you might take a serious look at living in a less costly house. Another much easier to do is instead of buying a new car, buy a second-hand car.

There are lots of different ways that we can all reduce our level of expenditure, but it is not going to be always happy, good news. Sometimes it's going to be costly, but it's important to keep in mind that you're saving for your own benefit, and you will get the benefit coming out of it later on in life when you really need the money to live the kind of life you want to be able to live.

Choose the right mix

Rebecca Katz: We've heard that getting asset allocation right is critical in investing. Can you explain, what is asset allocation and why is it so important? Dr. Ellis?

Dr. Ellis: Well, it's the most important thing you can do in investing. It's the division between stocks, bonds, and cash. It is the architecture; it's the main structure.

Rebecca Katz: In your book, you talk about different asset mixes. How should someone decide what asset allocation is right for them?

Dr. Malkiel: Younger people should probably have a larger proportion of equities—stocks—than people who are older, who are in retirement, who are living off their interest and dividends. So I would say, in general, the younger you are, because stocks are very risky, you have a long period of time to ride out the inevitable ups and downs of the stock market.

But even in retirement, someone who retires in their 60s can look forward to perhaps 20 years or more of life expectancy. So even there you do want some equities but probably less than, let's say, a 20-year-old.

Dr. Ellis: The key thing here is to be sure you know who you are and what are your intellectual skills with regard to investing. Can you do the analysis? If you don't, get someone who will walk you through what the choices really are. And then be sure you know who you are on the emotional skills. Because if you can't handle certain kinds of ups and downs, you should accept that.

Everybody has a level of capacity for emotional risk, ups and downs—and don't kid yourself. If you're not going to be comfortable with a particular kind of up and down, don't get there, don't do it.

But to the extent that you know who you are and you can find what is a pattern of market behavior that you can live comfortably with and it's "stay the course" is the most important part of long-term success in investing. Then you probably ought to be at the level that is comfortable enough for you so that you know that you will stay with it, and bold enough so that in the long run it will do you some real good.

Rebecca Katz: So, Dr. Malkiel, once you have set your asset allocation, you don't just set it and forget it. How can you keep your asset allocation on track?

Dr. Malkiel: Well, one technique that works very well for investors is the technique of rebalancing. What that means simply is that periodically, say once a year, you look at the allocation that you are comfortable with—let's say it's 50% stocks, 50% bonds just for the sake of argument, and you look each year at where you are. Suppose that the stock market went down sharply, the economy got into a recession. And at that point the monetary authorities were reducing interest rates, so that as interest rates fell, bond prices went up, and you look at your portfolio, and instead of 50/50, you had 60% in bonds and 40% in stocks.

Well, one thing that would make sense then is take some of the bonds, sell them to get down to 50%, put that money into equities to bring that up to 50%, and that's all rebalancing means. That periodically, say, once a year, you look at your portfolio and make sure that you maintain that asset allocation that you are comfortable with.

Spread your risk broadly

Rebecca Katz: In your book, you talk a lot about the benefits of diversification. What are those benefits, Dr. Malkiel?

Dr. Malkiel: One benefit of diversification, for example, if you had some bonds and some stocks in your portfolio, is that what we know is that those markets don't move in lockstep. That is to say when stocks are doing very well, it's quite often the case that bonds do very poorly and vice versa. When stocks are doing poorly, bonds often do well because, in a recession, the monetary authorities are pumping money in and interest rates go down and bond prices do very well.

So when you have, in your portfolio, a couple of asset classes where when one zigs, the other zags, when one's down, the other's up, that kind of diversification tends to reduce the risk of the portfolio and give you a much more even ride over time than if you were simply in one asset class rather than the other.

Dr. Ellis: And it protects you against being overexcited with good news and scared to the dickens with bad news, so that you're more likely to stay the course through a strong, sensible, long-term investment program that you can years later look back on and say, "I did it a sensible way, it was the right thing for me, and it worked out very well."

Rebecca Katz: So diversify among asset classes. Are there other ways of diversifying?

Dr. Malkiel: Well, even within asset classes, I think one thing that investors make a very bad mistake on is that they are too U.S.-centric. It's what we economists call the "home country bias." And I think we want to be very careful about that.

Now to be sure, if you buy U.S. stocks like General Electric and IBM, you are, in fact, buying companies that operate all over the world. But we are only about 40% of the world's economy, and we shouldn't have 100% of our stocks in U.S. stocks. Many other countries, including the emerging markets of the world, are growing much more rapidly than the United States.

And what diversification means to me is don't be just U.S.-centric. Look at the whole world economy, and, in particular, look at some of the very rapidly growing emerging markets of the world.

Rebecca Katz: So how much you allocate internationally would really depend on your own personal risk tolerance level.

Dr. Malkiel: Well, there's no question about that. As Charley and I said, on all of these things there are no hard and fast rules. And many people will ask me—I happen to be very bullish on China—how much should you invest in China? I would say simply don't ignore it. Put something in these economies such as China and India and the Southeast Asian economies. You can do it with a very well-diversified emerging market fund that has these stocks of these countries in it. I can't tell you exactly how much, but I do think that as I see most people's portfolios, they often have zero and I believe at least it ought to be more.

Dr. Ellis: There's been more coming together and more similarity of value to risk in all the different markets. You still have diversification by economy, by currency, by government, by nature of the industry, the structure of the industry. And if you looked at the total world market, you'd say roughly half of it is not in the U.S., not quite but roughly half of it is in the United States. That raises an interesting question for anybody.

If you're way low compared to the world as a whole, do you really want to be low? Have you thought about it carefully? And if you've made a decision for yourself that's really right for you, fine. But if you haven't thought about it, it's worth thinking about.

Cut your costs

Rebecca Katz: So it's a tough economy, many of us are keeping an eye on costs, but why is it so important to look at cost when it comes to investing?

Dr. Ellis: This is probably the most undiscussed and really important topic in the field of investing. Because many people talk about investment fees and say, "Oh, it's small, it's only 1%." And let's talk about that a little longer. One percent of what? One percent of my assets. But they're your assets. What are you getting from the investment manager? Oh, I'm getting a return. Oh, okay. So what's the fee as the fraction of the return? Well, let's assume I got 10% return, which is a little on the optimistic side but it makes the math very easy. That 1% fee is 10% of 10%. And what I would say to you is, "Wait a minute. Wait a minute." You can get the market rates of return by using plain vanilla index funds.

The second problem people don't pay any attention to, is if you're in a fairly high turnover portfolio, a lot of that turnover is going to be, if profits, is going to be short-term gains. Those gains get taxed at a higher rate than long-term gains, and any tax is a removal from your portfolio. So to the extent you can reduce transactions to a minimum, you can reduce the taxes that you have to pay, and you will reduce the rate at which taxes are charged from ordinary income to capital gains. And if you can do that at the same time that you're reducing the cost that you're paying for the investment results that you're getting, you've got two major forces at work on your behalf.

Rebecca Katz: Dr. Malkiel, you've done a lot of research around investment costs and returns. What is the connection?

Dr. Malkiel: I have spent my life studying mutual fund returns. I do these studies usually every several years or so. And what I find very clearly in the statistics is that the reported results for mutual funds are very well-explained by the costs and the turnover, even without the tax disadvantage of the turnover. My own work suggests that the surest way to make sure that you are in a top quartile equity mutual fund, is to buy one with bottom quartile costs and bottom quartile turnover.

Steer clear of blunders

Rebecca Katz: So you've both been in the industry a long time, both as investors and observers. What is the biggest mistake that investors make?

Dr. Ellis: Truthfully, there are so many different mistakes, to pick out any one would be hard. For an example, people don't start saving early enough. That's a very common problem. The second is if they work for a company that has a 401(k) plan or defined contribution plan, they don't participate. And if they do participate, they don't participate fully. Another major change, or mistake that people make, is in a bad market environment, when things really look spooky and scary, to take action and take a temporary loss and make it a permanent loss. And that is really too bad.

Another is that people don't think carefully about themselves and who are they? And they put themselves in situations which they're not really ready for. Either they're emotionally not ready for it, or they haven't done that kind of analysis to be that alert to the specific details of a specific situation. 

One last that I'd really put on the table real quick, and that is people do believe some of the gee-whiz statements that get said, and they shouldn't. They should be more long-term in their thinking about the data, and they should be very skeptical of people who say I've got the greatest thing, you just let me show you what I've done in the last 6 months, the last 2 years, the last 3 years. That's not long-term investing.

Rebecca Katz: Dr. Malkiel?

Dr. Malkiel: I would say 3 main mistakes. One, as Charley said, not saving, not funding the 401(k) plan. 

Number 2 would be that people ignore costs. I think we all need to be very modest about what we know about the stock market. I've studied it all my life, but the only thing I'm absolutely sure about is, that the lower the expenses that I pay to the purveyor of the investment product, the more there will be for me.

And the third big mistake is thinking that you know, that you can time the market, and that you don't simply put money in regularly over time but you put some in at one time and some in at another time. You tend to put it in when you're optimistic.

And while we often will read numbers such as since 1926 the stock market has given a rate of return between 9.5% and 10%. The average investor doesn't get anything like that return because the average investor puts his money in at the wrong time, buys the wrong funds, and tends to take it out making a temporary loss, a permanent loss, as Charley says. That is just a killer for investors. So the investor doesn't make the 9.5% but considerably less.

Rebecca Katz: So you said you wrote this book in part for your grandchildren, to give them some advice. What advice would you give them to keep from making these blunders?

Dr. Ellis: It's such a great question. I think there are a couple of things. I have to admit, my grandchildren are all 6 years young and younger, so the chances that they would pay any attention right now is a little bit slight. But when they get to be older, when they're 15, 20, in that zone, and I don't mean waiting until they're 30 or 40, somewhere between 15 and 20, I want to talk with them about the value, and the fun, and the satisfaction of saving. Because at that age, kids really get a kick out of saving because they can see the money piling up and they know they're going to be able to do something with it they'd like to.

And the second thing is I would like to teach them how hard it is to be smarter than all the other kids. And that's a rule that's really worth keeping in mind for the rest of your life.

And the third thing is just like riding a bicycle, you have to know what you're doing and do it with some real conscientiousness, and don't do things that are dangerous. For an example, you don't go on a superhighway with a bicycle. And you don't come anywhere near doing that sort of thing. You just do what you know you can handle and handle really well. And that would be a good lesson for any investor.

Rebecca Katz: You've given us some great food for thought. Thank you so much for being here today.

Dr. Ellis: It's been a pleasure.

Dr. Malkiel: It's been our pleasure; believe me.

Notes:

All investments are subject to risk. Investments in bonds and bond funds are subject to interest rate, credit, and inflation risk.

Foreign investing involves additional risks including currency fluctuations and political uncertainty. Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

Opinions expressed are not necessarily those of Vanguard.

Past performance is not a guarantee of future results.

Diversification does not ensure a profit or protect against a loss in a declining market.

© 2010 The Vanguard Group, Inc. All rights reserved.