Professor Malkiel talks about inflation hedges.
Scott Puritz: What’s the best way for investors to protect themselves against the ravages of inflation?
Burt Malkiel: One of the things that we know, Scott, is that if you look at all the possible assets that people can hold, whether it be stocks, whether it be bonds, whether it be real estate, whether it be gold, whether if I could mention the word cryptocurrencies. What we know over the long run is that common stocks, which basically represent ownership of business. Common stocks are the best long run inflation hedge we have. Much better than bonds, much better than gold which is often touted as the best inflation hedge. Stocks for the long run is clearly the answer and therefore, I have always recommended, particularly for young people that they ought to have portfolios that are almost exclusively equity oriented.
Now, not 100%, I think everybody needs insurance, everybody needs a liquid fund because there’s often a health emergency at the same time, the kid totals the family car. You need still some balance even for young accumulators but I believe that for people building up their 401(k)s, the best long run investment product is a common stock. And when I say common stock, I mean a broad-based index fund.
Scott Puritz: Great, what is diversification and why is it so important for investors?
Burt Malkiel: Well, diversification is very important in that it would tend to reduce risk. For example, one of the reasons that I want a broad-based index fund is I don’t want you just to have a bunch of growth stocks. A lot of people say, “Well, look, I want to be in the most growthy parts of the market. I just want the Amazons and the Microsofts and the alphabets and the Metas of the world.” And the problem is that those portfolios are tremendously volatile. Meta, for example, lost over two thirds of its value recently over the last year or so. The reason you want a broad-based portfolio is that when you have in it also some public utilities, also some real estate investment trust, also some natural gas companies. When you have a broad-based portfolio, when one sector of the market is down sharply, you get some benefit from the more stable parts of the market that keeps the whole portfolio stable.
And just continuing on that thought in general, what you also want is some bonds in the portfolio. While it didn’t work well in 2022 because the Federal Reserve increased interest rates by one of the sharpest amounts in a short period of time ever. And so, bonds didn’t give you the amount of protection that they normally do, but in general, bonds will tend to make the portfolio somewhat smoother and give people somewhat less sleepless nights. So again, the idea of diversification is you don’t want everything that goes up and down together in lockstep and often by holding more stocks rather than less by holding some other asset classes, some real estate, some bonds and in an inflationary period.
We have and want in the portfolio precisely for the diversification benefit are so-called inflation index bonds, where the returns that they have will increase when inflation goes up. While inflation will sometimes hurt regular bonds and often as inflation accelerates can even hurt stocks in the short run. Sure, rebalancing is one of the most effective investment tools that we know of. Let me back up and repeat again what I said before. Nobody, and I mean nobody can predict what the market is going to do.
Nobody can tell you, “Oh, we’re at bubble levels now the market’s going to collapse.” Nobody knows if and when those things are going to happen. Nobody knows how to buy low and sell high but probably the closest technique that we have to actually affect that is rebalancing. So, what does it mean? Well, let’s say you have a period where the stock market went down because we have a recession but bonds went up because the Federal Reserve, instead of fighting inflation, which they’re fighting now, was trying to fight recession by reducing interest rates. As they reduced the interest rates, bond prices would tend to go up.
So, suppose you decided you wanted a balanced portfolio of half bonds and half stocks for the sake of the argument to make it simple. When that recession happened and stocks were way down and bonds went up, and usually bonds and stocks do move in. They didn’t last year, but for most years they do move in opposite directions. So, instead of 50/50, you found that bonds were two-thirds of the portfolio and stocks were one third. Well, what rebalancing says is, “Okay, let’s take a look. Our basic mix that we wanted was 50/50, it’s now two-thirds bonds, one-third stocks. Let me sell some of my bonds and buy some stocks to bring the portfolio back to 50/50.”
And remember then what we’re doing, the bonds were up because their prices were up, the stocks were down because their prices were down. So, what we are doing is buying the cheaper asset class and selling the more expensive asset class and then vice versa. There’s a bubble in the stock market and stocks are now two thirds and bonds are one third then you do the opposite. You sell some of the stocks and by bonds and what you find is that that technique of rebalancing and you don’t have to do this every day or week or month, you could even just do it once a year. What we find is that rebalancing gives you a smoother set of portfolio values. It smooths out the fluctuations and it’s the closest thing we’ve got to enable people to buy low and sell high because we’re always selling the asset class where there has been perhaps a bit of irrational exuberance.
And the data again are very, very clear that systematic rebalancing smooths out portfolio values. And when markets are very, very volatile, they actually can improve returns. And just to give you an example, take the portfolio that you might have had in the year 2000. And the period from 2000 to 2010 was not a good period for the stock market. It wasn’t a good period at all but you actually improved your returns if you rebalanced because when the stock market then fell out of bed and was down over 40% in 2002. What you were doing was rebalancing and buying stocks, selling some of your bonds that had gone up because the Federal Reserve had lowered interest rates and you then were buying low and selling high.
And so, you not only got a smoother portfolio with less fluctuation but you actually improved your return. It’s a very important investment technique and being able to systematically rebalance is something that I recommend very strongly and show in the book the advantages of it and show it with actual data.