Picking Your Own Stocks: Rules and Final Strategies

We left off with Malkiel’s stock-picking rules and the suggestion to index the core of your portfolio. Now comes the rest of Chapter 15, where he tackles what to do if you’d rather let someone else do the work. And then he wraps up the whole book.

The Substitute-Player Step: Hire a Pro

Not everyone wants to pick stocks themselves. Fair enough. Malkiel’s third step is to hire a professional “walker.” In practice, this means buying actively managed mutual funds and letting a fund manager make the calls.

There are thousands of fund managers to choose from. The question is: can you pick one who will actually beat the market?

Malkiel used to recommend specific managers by name. He stopped doing that. Two reasons. First, most of the good ones retired. Even Warren Buffett was well above retirement age at the time of writing. Second, and more important, Malkiel became convinced that past performance records are basically useless for predicting future success. The rare cases of consistent outperformance happen about as often as you’d expect from pure chance.

Don’t Chase Hot Funds

Fund advertisements love to shout about being “number one.” Malkiel digs into one example. A fund advertised itself as the top performer through “booms, busts, and 11 presidential elections.” Sounds like forty-four years of dominance. The fine print? It was number one for one specific three-month period, and only compared to funds in a narrow size category.

Malkiel tested a simple strategy: buy last year’s top-performing funds. Year after year. The result? It doesn’t work. The hot performers of one period are often the dogs of the next. No matter how you slice the data, you cannot guarantee above-average returns by chasing past winners.

Morningstar: A Better Tool

If past performance isn’t reliable, what should you look at? Malkiel points to Morningstar, the mutual fund information service. He calls it one of the two best things to happen to the fund industry. The other being Jack Bogle and Vanguard.

Morningstar publishes detailed reports on each fund. Past returns, risk ratings, portfolio composition, investment style, fees, expense ratios, turnover, unrealized gains. It’s a one-stop shop for fund data.

Morningstar also uses a five-star rating system. Five stars for the best past performers. But here’s the catch. Unlike Michelin stars (which basically guarantee a great meal), Morningstar stars do not guarantee future performance. Five-star funds have not reliably beaten three-star or even one-star funds going forward.

So what does predict future performance? Two things: expense ratios and turnover. Lower expenses mean more money stays with you. Lower turnover means fewer taxes and trading costs eating into returns. Malkiel’s recommendation: only buy actively managed funds with expense ratios below 0.50% and turnover under 50%. Look beyond the stars.

The Malkiel Step: Closed-End Funds

Here’s a move Malkiel has recommended for decades. Buy closed-end funds when they trade at big discounts.

Regular mutual funds issue and redeem shares at their net asset value. Closed-end funds don’t. They trade on an exchange like stocks, and their price can drift above or below what the underlying assets are actually worth. During the late 1970s and early 1980s, some of these funds sold at discounts of 40 percent.

Think of it this way. Imagine a savings account with $100 earning 5% interest. Normally you’d pay $100 for it. But what if someone sold it to you for $75? You still earn $5 a year in interest. That’s a 6.67% return on your $75. The discount gives you a bonus just for showing up.

The strategy worked even better than expected. Those discounts eventually narrowed, and investors who bought at the lows made extra money on top of the dividends. By the time this edition was written, domestic closed-end funds had mostly lost their discounts. The opportunity had closed. But some emerging-market closed-end funds still traded at discounts of 10% or more, and those remained worth watching.

The Paradox of Good Advice

This brings Malkiel to a key paradox about investing advice. If a strategy becomes widely known, it stops working. When everyone rushes to buy the “good buy,” the price rises until it’s no longer a bargain.

This is the backbone of efficient-market theory. If information spreads freely, prices adjust to reflect it. Malkiel predicted in 1981 that the generous closed-end fund discounts wouldn’t last forever. He was right. He also warns that popular rules like “buy low P/E stocks” or “buy small-company stocks” won’t produce abnormal returns indefinitely either.

He tells the story of the finance professor and his students who spot a $100 bill on the sidewalk. “If it were real,” the professor says, “someone would have picked it up already.” The students ignore the professor and grab the money.

Malkiel’s real point: $100 bills do appear sometimes. But you’d better pick them up fast, because someone else will.

A Final Walk

Looking back over the entire book, Malkiel repeats his core message. Beating the market consistently is extremely rare. Neither chart reading nor fundamental analysis produces reliably superior results. Even professional fund managers regularly lose to a random dartboard.

His practical advice stays simple. Understand the risk-return tradeoff. Match your investments to your age and temperament. Index the core of your portfolio. If you must pick individual stocks, follow the four rules and keep a strong index fund base so your mistakes won’t be fatal.

Malkiel compares investing to lovemaking. It requires talent, art, and luck. Luck might account for 99% of the success among the few who beat the averages. But the game is too fun to quit.

The Timeless Lessons

After ten editions of the book, Malkiel closes with four pieces of advice that haven’t changed in over forty years:

1. Diversify broadly. Don’t put everything in one country or asset class.
2. Rebalance annually. Bring your portfolio back to its target mix each year.
3. Use index funds. They’re cheap, tax-efficient, and hard to beat.
4. Stay the course. Don’t panic. Don’t chase trends. Keep investing through good times and bad.

Even during the brutal 2000s, when a U.S.-only stock fund lost money over the entire decade, a diversified portfolio with annual rebalancing produced satisfactory returns. Dollar-cost averaging made the results even better.

The book’s final message is clear. You don’t need to be brilliant. You don’t need insider knowledge. You just need patience, diversification, low costs, and the discipline to keep walking.

Previous: Index Funds and Smart Stock Picking Rules Next: A Random Walk Down Wall Street: Final Thoughts Part of the series: A Random Walk Down Wall Street Book by Burton G. Malkiel | ISBN: 978-0-393-08169-5