First published in 1973, A Random Walk Down Wall Street (Eleventh Edition) by Burton G. Malkiel is an influential book on investing strategies which has been updated to an 11th edition in 2015. The author investigates different investing techniques, including technical and fundamental analysis and draws the conclusion that neither consistently beat a passive buy and hold strategy. He also offers advice on building and maintaining an investment portfolio of differing asset classes over a lifetime.
A “random walk” is one where future steps or directions can not be predicted on the basis of past history. Or in investing terms: “past performance is no guarantee of future results”. Malkiel frames this theory as an argument between Academia and Wall Street (he’s on the side of Academia), and presents data that the majority of actively managed funds fail to beat passive indexes.
The book is organized into four main sections.
Part One – Stocks and their value
In this section, Malkiel makes the case that there are two general views of asset valuation – the firm-foundation theory and the castle-in-the-air theory.
Firm-Foundation Theory is the view that each investment asset has a firm anchor called ‘intrinsic value’ which can be determined by careful analysis of present conditions and future prospects, as opposed to the current price of the asset. This view was further elaborated by the classic book, Security Analysis: Sixth Edition, Foreword by Warren Buffett (Security Analysis Prior Editions).
Promoted by John Maynard Keynes in the 30’s, this theory argues that asset prices are driven by the herd mentality and the crowd of investors who buy them. As stocks are bought the price increases, encouraging more people to buy in an open-loop cycle, and the same thing happens when the price drops regarding selling and falling prices. The successful investor is one who can estimate what castles the crowd are likely to build or destroy and react before the crowd does. This approach contains an element of psychology which is missing from the Firm-Foundation theory and investor expectations was an element in Keynes’ book, The General Theory Of Employment, Interest, And Money.
To show asset valuations gone awry, Malkiel covers investment bubbles such as Tulip Mania and South Sea Company bubbles as well as various speculative bubbles in the sixties through to the Internet bubble in the ‘naughties’.
Part Two – Technical and Fundamental Analysis
If you’ve read analysis of a stock and encountered terms such as “resistance”, “momentum”, “bollinger bands”, “stochastic oscillator” or “double top reversal patterns” then you’ve come across a technical analysis by a ‘Technician’. This is the theory of predicting the future price movement of a stock by “reading the tape”. Only the patterns shown in the stock’s trading history is used in this analysis and balance sheets, growth forecasts and market conditions are ignored.
This strategy broadly aligns with the “Castles-In-The-Air” concept discussed earlier. Malkiel is clearly against it and considers it akin to reading tea-leaves or forecasting the future with animal parts. One anecdote in the book describes how he provided a Technican with a fake stock chart generated by flipping a coin. The chart included an ‘upward breakout from an inverted head and shoulders pattern’ and could not be distinguished from any other ‘real’ stock chart.
Other technical methods are discounted in the book including the ‘Dogs of the Dow’ and the more obscure ‘Super-Bowl Indicator’ and the ‘bull markets and bare knees’ theory. The bare knees theory demonstrated a correlation between the average length of women’s dresses in a year and bull / bear markets. The shorter the skirts, the more bullish the market. Seriously? Perhaps Mr. Market really is a guy after all and just not interested in the average length of trousers, capris or shorts.
Fundamental Analysis aligns to Firm-Foundation theory. This is the study of balance sheets, market data, company management, future trends and growth prospects. Malkiel is much more sympathetic to this analysis, but notes that random events (BP Oil Spill), dubious reported earnings (Enron and others) and errors made by the analysts themselves all conspire against performance.
Malkiel states, more so than outright proves, that Fundamental Analysis is no more successful than Technical Analysis on the basis of the very few number of actively managed funds that beat the S&P over the long-term. In 1970, 358 mutual funds existed; only 84 of which exist today and of those 84, only 20 beat the average S&P return by more than 1% from 1970 to 2013.
Criticism against Random Walk’s dismissal of Fundamental Analysis is often aimed at the Efficient Market Hypothesis (and its various flavors) itself which has been under fire of late, insider knowledge being one reason why the market is not efficient. Warren Buffet rebutted the book and the Efficient Market Hypothesis in his 1984 speech, The Superinvestors of Graham and Doddsville.
Malkiel has not formally responded to Warren Buffett’s argument. However he does include a quotation from Benjamin Graham before he died in 1976, suggesting that he was on the ‘efficient market’ school of thought.
I think it is important to separate the two ideas when reading this book. Much of a Random Walk is about the randomness of the market and how to mitigate risk in order to maximize returns. It is not really trying to prove or justify the EMH itself, rather he makes a point that the market is efficient because prices move quickly in response when news arises. Because news itself develops randomly and unpredictably, it follows that the market itself can not be reliably predicted.
Time for a joke. An academic professor promoting Efficient Market theory is walking with a student when they both see $100 on the floor. The student stops to pick it up but the professor stops him. “Don’t try to pick it up, if it really was a $100 bill it wouldn’t be there.” The lesson about efficient markets is not so much if there are $100 bills lying around, but the fact that any bills lying around will not be lying around for long.
Part Three – Modern Portfolio Theory
The third section is dedicated to Modern Portfolio Theory which is about using the different levels of risk or volatility between asset classes to improve total return in a diversified portfolio. It was first invested in the 1950’s by Harry Markowitz and earned him the Nobel Prize for Economics in 1990.
In the case of stocks, he shows that holding 50 diversified US stocks reduces overall portfolio risk by 60% with additional positions above having little impact. Adding international stocks to the portfolio reduces risk even further.
An investment’s risk is categorized into two portions – systematic risk (the effect of the economy / market as a whole) and unsystematic risk (risks specific to the individual company e.g. the impact of strikes or new product development). Diversifying a portfolio with more stocks reduces unsystematic risk but can not eliminate the overall systematic risk from the market. The key measurement of a stock’s vulnerability to systematic risk is commonly known as beta, although Malkiel views the usefulness of beta with suspicion.
Section three also includes a chapter on Behavioral Finance which I enjoy reading about. It discusses the problems of Overconfidence (taking on risk), Bias (the illusion of control), Herding (follow the crowd), Loss Aversion (behavior when things go wrong), Pride (holding onto bad investments). He also offers some advice to avoid some of these behaviors.
Section three ends with a discussion on “Smart Beta” portfolios – this chapter is new for this edition of the book. Smart Beta portfolios do not use market capitalization as their weighting criteria, but instead use other fundamental data such as value (low multiples of price, cash-flow or book value), absolute size (smaller companies typically outperform larger ones) or momentum (relative growth). Blended approaches combining a number of factors are also possible.
Part Four – Fitness manual for random walkers
The last section of the book gives practical advice and strategies for constructing an investment portfolio and includes a number of warm-up exercises to prepare the investor ranging from managing cash reserves to defining objectives and tax considerations.
The historical returns of stocks vs. bonds is discussed, as well as a comparison of how the three main contributors to a stocks total return (initial dividend yield, earnings growth and change in valuation) have changed through recent decades.
The final chapters describe different portfolios for different investor profiles, consisting of various combinations of Cash, Bonds & Bond Substitutes, Stocks and Real Estate (REITs).
While he generally advises broad stock selections via index funds, Malkiel’s four rules for stock purchases described in the book are
- Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years.
- Never pay more for a stock than can reasonably be justified by a firm foundation of value.
- It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air.
- Trade as little as possible.
This is a great book! I found A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Eleventh Edition) engaging to read and easy to follow. Anecdotes and examples are used to illustrate points and the book flows well. There’s some humor too so it’s not a dry read. The book contains practical advice and suggestions that are useful for any long-term investor regardless of their strategy. At 448 pages it’s a fairly sized book (I read the Kindle version) but it kept me turning the pages.
The immediate take-away for me were the benefits of international stocks, where even individually volatile stocks can reduce overall risk. This influenced my recent BBL purchase as well as the asset allocation in my new IRA.
Quote of the day
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