Talking the Walk With Burton Malkiel

What do you make of the argument that the S&P 500 has become, in effect, actively managed because of the hands-on roles of Standard & Poor's executive committee?

Professor Malkiel: The S&P 500 has become more actively managed over the past few years -- it has made more changes to its index of companies in recent years than it traditionally has.

This is regrettable because of the transactions costs associated with buying and selling companies added to or dropped from the index. Yes, the S&P 500 has become more actively managed. Nonetheless, it is still far less actively managed than actively managed funds, which makes it a better investment than actively managed funds.

In the more recent editions of the book, however, I have recommended investors use an index that offers a broader representation of the stock market, such as the Wilshire 5000 or Russell 3000. This is primarily because the S&P 500 only represents the largest U.S. companies that make up about 75% of the total market. Investors who only own an S&P 500 index fund don't have exposure to smaller and medium-size companies. Studies have shown that over the long run, smaller stocks tend to outperform larger-capitalization stocks, so investors would benefit from exposure to them.

If you owned a fund that tracks the Wilshire 5000 as opposed to the S&P 500, you wouldn't have had to buy shares of Yahoo!(YHOO Quote) when it was added to the index. Because you already owned the entire market with a Wilshire 5000 index fund, in effect, you would have already owned Yahoo!.

Professor Harry Markowitz, the founder of the modern portfolio theory, was once asked how he planned his portfolio for retirement. His answer: "I should have computed the historic covariances of the asset classes and drawn an efficient frontier. Instead ... I split my contributions 50-50 between bonds and equities." Do you follow your own advice and invest in index funds?

Professor Malkiel: Yes, I do. For my own portfolio, I use the asset allocation plan recommended for the most conservative investor -- aged late 60s or beyond -- in the "Life-Cycle Investment Guide" section of my book.

I modify my asset allocation depending on the nature of the investor. For my son's trust fund, for instance, I use a more aggressive plan that is also detailed in the Life-Cycle Investment Guide of the book.