Portfolio: Your book explains the “efficient market hypothesis,” the idea that share prices quickly and accurately reflect new information. But you also talk about “tulip-mania” and other speculative bubbles through history, as well as the 1970s when earnings were good but the market went down anyway. If markets do not always move on fundamentals, in what sense are they efficient, as you argue?

Malkiel: I’m a random walker with a crutch. Markets are not perfectly rational at every point in time. What strains efficient market theory are periods such as the recent Internet bubble when the market goes to the loony bin. But such periods are the exception rather than the rule. Markets are normally efficient and get it right.

Portfolio: You take a grim view of fundamental analysis because earnings cannot be projected without making assumptions. But your heaviest criticism is reserved for technical analysis. What do you say to people who rely on chart patterns, stochastics, candlesticks and all the rest?

Malkiel: Technical analysis is about as useful as going to a fortuneteller, as far as I’m concerned. There is simply no evidence that these patterns mean anything. There is some evidence of short-term momentum in the market; the market is not always a perfect random walk where the next price change is no more predictable than a flip of a coin. But the amount of momentum is less than necessary to make any money. After transaction costs and commissions, the bid-asked spread, and the price moving against you as you buy, momentum will not beat a buy-and-hold strategy.

Portfolio: You have been called the “patron saint of indexing.” Why do you advise individual investors to index the core of their portfolios?

Malkiel: No one can consistently obtain better overall returns than the market. The evidence is remarkable how much better off individuals are in index funds than with actively managed mutual funds that try to pick winners. The index is normally ahead of two-thirds of money managers and that’s true again for the first half of 2003. In an index fund, at least you’re broadly diversified. So many people threw caution to the wind during the Internet bubble and had their money in narrow high-tech funds. With the index, you also held the value stocks that went up in 2000 and 2001.

Portfolio: How do you square this advice with sitting on the board of several mutual funds at Vanguard and owning actively managed mutual funds yourself?

Malkiel: You might also have mentioned that I’m on the board of a hedge fund. Look, you need active managers to make the market efficient. If 99 percent of investors just index, nobody would be ensuring that prices accurately reflect new information. But I wouldn’t start worrying about that until indexing reaches 90 percent of invested funds and right now it’s only around 10 percent. Vanguard has a mixed strategy; it has low cost actively managed mutual funds plus index funds. It doesn’t want its entire business in indexing.

Portfolio: You tell investors to buy and hold the index and not to try to time the market. Does this mean that you would hold index funds through a bubble and post-bubble period? For example, I’m thinking of the three years of a down market in 2000 through 2002 or the 25 years it took to get back to break even from 1929 to 1954.

Malkiel: People should only have 25 percent of their portfolio in equities as they approach retirement. For accumulators, people in their 20s, I recommend dollar-cost averaging. If someone started putting $750 a quarter into an S&P 500 index fund starting Jan. 1, 2000, they would have put in a total of $9,000 by the end of 2002. They would still have had $8,600 at the end of 2002 even though the market went down, and they would be even today. With dollar-cost averaging, you buy more share s at a beautiful price when the market goes down. The guy who started investing in September 1929 before the crash would have been buying more shares as the market continued to decline through 1932 and would have had a beautiful rate of return by 1954.

Portfolio: You pick a few individual stocks yourself, and you are merciless in weeding out the losers every year. Why not apply the same rule to index shares?

Malkiel: You could. In the book, I make a tax argument for selling losers, not a timing argument. The government helps pay me when I take a capital loss. So in a taxable account, it would have been reasonable to sell the index in 1932 in my previous example, then wait out the 30-day Wash Sale rule or buy a different index. Some people say, “Wait until the bottom of the market.”

But here’s the problem; how do you know when to get back in? Should somebody doing this after the Internet bubble have gotten back in last year? Now? I’m nervous about trying to time these things because I can miss the market’s best days by being out. That’s the difficulty with timing. You have to be right twice, getting in and getting out. But if you stayed in after Alan Greenspan’s “irrational exuberance” speech in December 1996, you would have had a 7 percent rate of return in the S&P 500 since then, bubble and all.

Portfolio: You have good things to say about REIT index funds in your book. You’re on the board of Vanguard’s REIT index fund. How are companies selected for the fund?

Malkiel: There are relatively few REITs, so it’s possible to hold the entire basket of REIT stocks. It’s what is called a total replication fund, unlike funds based on the Wilshire 5000 that have to rely on a representative sample of issues to mimic the entire index.

Portfolio: Some say that REITs are now better diversifiers than international stocks. What do you think?

Malkiel: Globalization has made international diversification somewhat less attractive. The correlation between the EAFE international index [Europe, Australasia, Far East] and the S&P 500 has risen very high, almost to one, when investors should be looking for low correlations for diversification purposes. The second rap against international diversification is that correlations in the down direction are actually stronger—when the S&P 500 goes down, international markets go down with it.

However, correlations between REITs and the S&P 500 are falling. REITs are superb diversifiers. It used to be that REITs behaved like small company stocks, but they aren’t small stocks anymore. Something has fundamentally changed. Correlations between REITs and the S&P 500 have been close to zero in recent years. I recommend that everybody have some REITs in their portfolio.

Portfolio: You say that REITs are especially good for older investors because REITs pay high dividends. Does this mean that you expect net inflows to the REIT sector as baby boomers age?

Malkiel: That’s an interesting question. People have just started studying cohort effects. I think it’s an entirely reasonable argument, one that I would accept, although I haven’t seen any good statistical work on it.

Portfolio: You have some rules for people who cannot resist picking individual stocks. You look for high earnings growth, a reasonable multiple in relation to expected growth, and a story that will eventually attract investors. How do individual REIT stocks stack up against these rules?

Malkiel: I’m a big fan of REITs. They tend to have low price/FFO multiples. Nobody thinks of them as great growth stocks but, over time, rents go up and mall sales increase, so one can expect moderate growth. They are reasonably priced and still a good story.

I’m still a believer in REIT stocks. They’re a better inflation hedge than utility stocks, which also pay high dividends. A lot of people think inflation is dead, but, if it comes back, utilities will have a profit squeeze. Their costs will go up and there will be a time lag before they can raise rates because they are regulated. REITs can often react much more quickly and some properties even have escalator clauses raising rents in the event of inflation.