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By Christine Benz | 09-03-2013 12:00 PM

Malkiel: What the Crisis Should Have Taught Investors

Author and Princeton professor Burton Malkiel says investors who are avoiding equities altogether today have learned the wrong lesson from the 2008 market crash.

Christine Benz: Hi. I'm Christine Benz from Morningstar.com. What lessons did investors learn from the financial crisis, and what lessons should they have learned? Joining me to discuss those topics is Burton Malkiel. He is a Princeton University professor and the author of several books, including A Random Walk Down Wall Street. Professor, thank you so much for being here.

Burton Malkiel: My pleasure.

Benz: Let's get into what investors learned during the financial crisis. We're five years out from the Lehman bankruptcy filing. What important lessons do you think investors appear to have learned?

Malkiel: Unfortunately, I'm afraid the main lesson that a number of investors have learned is a very bad lesson. Namely, I think the lesson that they have learned is, "Hey, we should never trust equities again," because when you look at flows of money into equity mutual funds since the crisis, it's been just about zero. There's been a little flow recently as markets have looked quite good, but nothing like the kinds of things that happened in the past, where you might have expected that as the S&P 500 has done so well over the last two years, you would have a rush of money into equities. Yes, you've had a little more recently, but by and large people have not put money into equities since the great crash.

Of course, they took money out of equities in 2007 and '08 at an unprecedented rate. I have been doing some work on what might be called the retirement crisis in the United States. I can't tell you how many people I see who really believe that equities are not suitable for a 401(k) plan. That to me is, unfortunately, the lesson they've learned, and it's a bad lesson.

Benz: What do you think investors can do? We tend to see this tendency to drive with the rearview mirror and pour the flows into whatever has been performing well, and for much of the past five years that has been bonds and bond funds. What can investors do to counter their own worst tendencies of chasing whatever has been the strong performer in the recent past?

Malkiel: I think that the old, timeless lessons of very broad diversification, and that means if you have equities, you don't simply want U.S. equities because U.S. equities have done better than any place else. You want to have some of the depressed European equities. You want to have some of the depressed emerging-markets equities. You want some things that move with real estate prices, such as a REIT fund. You'll probably still want some bonds, but you don't simply want U.S. government bonds today because I think they're not going to produce the sorts of returns that we've seen in the past.

Again, I think the old lesson of very broad diversification and rebalancing because what rebalancing makes an investor do is exactly the opposite of what the investor does. Rebalancing says, "Let's take a bit of money off the table from the asset class that's done particularly well and put it in some of the asset classes that have done a little less well." My guess is that for most investors, because behavioral considerations make them do exactly the wrong thing, having this put on automatic, where someone's going to do the rebalancing for you, is probably a pretty good idea.

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