Index Funds and Smart Stock Picking Rules

After fourteen chapters of theory, history, and bubbles, Malkiel finally gets to the practical stuff. Chapter 15 is called “Three Giant Steps Down Wall Street.” It’s his playbook. Three ways to actually invest your money.

This post covers the first two steps. The first is for people who want to keep it simple. The second is for people who can’t resist picking their own stocks.

Step 1: The No-Brainer Step

Buy index funds.

That’s it. That’s the step. Malkiel has been building to this conclusion for the entire book. The S&P 500 beats most professional fund managers over time. Not sometimes. Most of the time. You can count the number of mutual funds that have beaten index funds by a meaningful margin on your fingers.

Back in 1973, when Malkiel wrote the first edition, he basically begged someone to create a fund that would just buy all the stocks in the market and sit there. No trading. No stock picking. Just own the market. In 1976, Vanguard made it happen with the Vanguard 500 Index Trust.

The logic is almost embarrassingly simple. All the stocks in the market are owned by someone. So the average investor earns the market return. An index fund gets you that market return with almost no fees. Actively managed funds charge about 1 percent per year in expenses and trade constantly, which adds more costs. So the average active fund must underperform the index by the amount of those extra costs. It’s basic math.

Malkiel compares it to Garrison Keillor’s Lake Wobegon, where all the children are above average. In the real world, all active managers can’t be above average. Someone has to be below.

Why Index Funds Keep Winning

Malkiel lists the advantages, and they stack up fast.

Lower fees. Index funds charge less than one-tenth of 1 percent. Active funds charge around 1 percent. That gap compounds over decades.

Less trading. Active funds flip their entire portfolio roughly once a year. Every trade costs money. Index funds barely trade at all.

Tax efficiency. This one is big. Every time an active fund sells a stock at a profit, you owe capital gains taxes. Index funds rarely sell, so they rarely trigger taxes. Two Stanford economists studied this and found that $1 invested in mutual funds in 1962 grew to $21.89 pre-tax by 1992. After taxes? Only $9.87. Taxes ate more than half the gains.

Predictability. You know what you’re getting with an index fund. It tracks its index. With an active fund, last year’s star manager might be next year’s disaster.

Even big institutions figured this out. By 2010, about a third of institutional investment money was indexed. Intel, Exxon, Ford, Harvard University. They all put chunks of their portfolios into index funds.

Go Broader Than the S&P 500

Malkiel makes an important point. Don’t just buy an S&P 500 fund and call it a day. The S&P 500 only covers large companies. It misses thousands of smaller, faster-growing companies.

He recommends a Total Stock Market fund instead. Something that tracks the Russell 3000 or Wilshire 5000. These include small and mid-size companies that have historically produced higher returns than the big names.

And don’t stop at the U.S. border. The United States represents only about 40 percent of the world economy. Malkiel suggests holding developed international market funds, emerging market funds, bond index funds, and real estate index funds (REITs). All of them come in index fund form. All of them have beaten their actively managed counterparts.

ETFs: The Tax-Friendly Cousin

Exchange-traded funds are another way to index. They work like index mutual funds but trade on a stock exchange. They can be even more tax-efficient because of how they handle redemptions (the technical details involve “in-kind” transfers that avoid triggering capital gains).

Malkiel names specific ones. Vanguard Total Stock Market (VTI), Vanguard Emerging Markets (VWO), Vanguard Total Bond Market (BND). Rock-bottom expense ratios.

But he adds a warning from John Bogle, the founder of Vanguard: “Investors cut their own throats when they trade ETFs.” The point of an ETF is to buy and hold. If you start day-trading them, you’ve defeated the purpose.

Step 2: The Do-It-Yourself Step

Malkiel knows some people just can’t resist picking stocks. He gets it. He admits he’s had the gambling urge since childhood. So for those who insist, he offers four rules he first wrote in 1973. He says they still hold up.

Rule 1: Buy companies that can sustain above-average earnings growth for at least five years. Growing earnings is the game. When a company’s earnings grow consistently, two good things can happen. The earnings go up, and the price-to-earnings multiple the market is willing to pay also goes up. Double benefit.

Rule 2: Never pay more than the firm foundation of value justifies. Don’t overpay. Look at the price-to-earnings ratio. Buy stocks that trade at multiples near the market average, or only slightly above if the growth prospects are genuinely strong. Malkiel calls this GARP, growth at a reasonable price. Stocks with sky-high multiples have priced in years of perfect growth. If anything goes wrong, the earnings drop and the multiple drops. Double trouble.

Rule 3: Pick stocks with stories that let investors build castles in the air. This is where Malkiel blends both investing theories from the book. A stock needs real value (firm foundation), but it also needs a story that excites other investors. People are emotional. A company with solid numbers but a boring story might never get the market’s attention. Find companies where the growth story can catch on.

Rule 4: Trade as little as possible. Every trade costs you money in fees and taxes. Hold your winners. Sell your losers before the end of the year to capture the tax deduction. But don’t churn your portfolio. Frequent trading just makes your broker rich.

The Honest Disclaimer

Even after laying out these rules, Malkiel is refreshingly honest. He says the efficient market theory warns that even sensible rules like these probably won’t lead to consistently beating the market. Picking stocks is like “breeding thoroughbred porcupines.” You study carefully and proceed even more carefully. The winners might just be lucky.

His real recommendation? Index the core of your portfolio. Use broad index funds for the bulk of your retirement savings. Then, if you want to pick some individual stocks on the side, go ahead. With a strong indexed core, the mistakes you make with your stock picks won’t be fatal.

Even if you use index funds for everything, you can still make small adjustments. Malkiel himself overweights China in his portfolio because he thinks it gets underrepresented in most global indexes due to how “float weighting” works.

But the bottom line is clear. Index funds should be the foundation. Everything else is extra.

Previous: Investing at Every Age: A Life-Cycle Guide Next: Picking Your Own Stocks: Rules and Final Strategies Part of the series: A Random Walk Down Wall Street Book by Burton G. Malkiel | ISBN: 978-0-393-08169-5