When you think of Wall Street, you think of Vegas for smart people with the idea that if you’re clever enough, you will make it big. This sexy lure to invest successfully on Wall Street is perfectly encapsulated in Hollywood movies such as “Limitless,” “Wall Street,” “The Big Short” and “Wolf of Wall Street.” In the films, you see all these smart people making millions upon millions of dollars.
This lure to be a successful trader and investor is understandable. We all want to make a lot of money. Unlike gambling, however, instead of the odds being in the house’s favor, the odds are in your favor. For this reason, throughout history analysts, hedge funds, banks and big investors would kill themselves and compete over who has the better strategy and stock picks to beat the market.
Not everyone can be the Wolf of Wall Street
Throughout the 20th century, people believed that in order to make money in the market, you would give your money to a smart broker with a special formula to beat the market, who would manage your portfolio for a premium. Your returns would be so good that you would be able to afford your broker’s fee. However, in 1973, Burton Malkiel, an economics professor at Princeton University, challenged the traditional narrative on how the market works. In his book, A Random Walk Down Wall Street, Malkiel claims that “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.”
So what’s with all the monkey business?
What exactly does Malkiel mean by this? Well, Malkiel elaborates that “The stock market can’t be consistently predicted by any theory. The only predictable thing we have about the market is that the whole thing tends to go up over time. No one is able to consistently pick winners over anyone else.” Well that sounds great and all, but is all of this true? Fast forward decades later and analysts, the media, investors and other financial institutions discover that the Malkiel theory was wrong. Well, then why am I even reading this article, where is the exit?
Before you leave, let me explain. His monkey theory was wrong because in actuality, his theory did better than the experts.
What does this mean for you? Enter index funds
Does this mean you should purchase a monkey, hand them darts and hope for the best? Not exactly. Around the same time as Malkiel wrote his book, other investors and management funds started implementing this idea. Enter the low-cost, passively managed index funds. Simply speaking, an index fund is a basket of hundreds to thousands of stocks that is held passively without discriminating losers from winners. One of the more popular and well-known indexes that you might have heard of is the Standard & Poor’s 500 Index (S&P 500), which consists of the 500 of the largest publicly-traded companies in the U.S. You also might have heard on the news of the NASDAQ and the Dow Jones Industrial Average (DJIA). Over the long term, these low-cost index funds on average will out-earn actively managed funds. Plus you won’t have the expensive management fees that come with it. The point that Malkiel was making is that you shouldn’t pay expensive fees for the experts if you can do just as well if not better in the long-term with a cheap, passively managed index fund.
Sage advice from Warren Buffett
Even Warren Buffet recommends that a low-income investor is better off investing in an index fund for retirement because it’s already heavily diversified. Instead of spending thousands of dollars buying hundreds of individual stocks, you can be just as diversified at the fraction of the price with index funds. So, if you are too nervous to take on the risk of investing in individual stocks and don’t have time to do a lot of research, then index funds are something to look into.