• Alex Vikner

A Random Walk Down Wall Street

Author: Burton Malkiel


Summary: A Random Walk Down Wall Street starts by taking you on a straightforward journey through the landscape of financial theory and concludes with practical investing advice. The central idea is that asset prices are largely random because markets are highly efficient. Consequently, one cannot consistently outperform market averages and most investors would be better off investing in low-cost, tax-efficient broad-based index funds.

Stocks and Their Value

We need to invest because inflation runs at around 2% yearly which means that you need at least a 2% return on your capital to maintain your real purchasing power. Saving accounts practically have no return so your money is becoming less valuable over time on them.


Financial bubbles (i.e. periods of irrational exuberance) generally start with the build-up of excitement around something new. This leads to positive feedback loops that drive stock prices through the roof for a short while. But eventually stock prices crash, the bubble pops and the feedback loop goes into reverse.


The consistent losers in the markets are those who are unable to resist being swept up in these bubbles. Realize that there are no get-rich-quick schemes, that's just someone getting rich off you.


Everyone wants to earn more with less effort. That is why get-rich-quick schemes are so tempting. The avoid these traps, learn to recognise them and be aware of your emotions.


Stupidity well packaged can sound like wisdom.


Security analysts always find reasons to be bullish.


Stock valuations depend upon estimations of the earning power of companies many years into the future. Such forecasts are invariably incorrect. Moreover, investment risk is never clearly perceived, so the appropriate rate at which the future should be discounted is never certain. Thus, market prices are always wrong to some extent. Yet, no person or institution can consistently know more than the market.


Technical Analysis

Technical analysis (i.e. the making and interpreting of graphs) views companies as having psychological value. The belief is that there are times to buy and sell stocks based on their price movements as stock values are roughly 90% psychological, and 10% logical.


Technical analysis is rooted in two assumptions:

  1. All news is priced into stocks.

  2. Stocks move in trends.


However, in reality price movements don't tell you information that will allow you to reliably beat the market, or a simple buy and hold strategy. Chartists don’t want to accept this theory because it puts their entire art in question. Plus, the randomness of prices is hard to accept.


Chartists believe momentum exists in the market. While it's true that the market exhibits some momentum from time to time, it does not occur dependably, and there is not enough persistence in stock prices to make trend-following strategies consistently profitable.


Over short holding periods, momentum exists in the stock market: increases in stock prices are slightly more likely to be followed by further increases than by price declines. However, over the long term, reversion to the mean will play out: when large price rises have been experienced over long periods, they are often followed by sharp reversals.


The persistence in the belief in repetitive stock market patterns is due to a statistical illusion. But no matter what the laws of chance might tell us, we search for patterns among random events wherever they might occur.


Technical strategies are usually amusing but of no real value.


Fundamental Analysis

Fundamental analysis views companies as having an intrinsic value and values them based on the net present value of their current and future cash flows. The belief is that the market is 90% logical and 10% psychological.


Ceteris paribus, a rational investor should be willing to pay a higher price for a share the:

  1. Larger the growth rate of dividends and earnings.

  2. Larger the expected dividend payout.

  3. Lower the degree of risk of the company's stock.

  4. Lower the level of market interest rates.

However, there are three caveats to fundamental analysis:

  1. Expectations about the future cannot be proven in the present.

  2. Precise figures cannot be calculated from undertermined data.

  3. What's growth for the goose is not always growth for the gander.

The big problem is that no one can reliably assess value. That is because the information and analysis may be incorrect and are subject to random events. Moreover, the market may not correct its "mistake" and the price may not converge to its value estimate.


In the end, mutual-fund portfolios have not outperformed randomly selected groups of stocks. Simply buying and holding the stocks in a broad market index is a strategy that is very hard for the professional portfolio manager to beat.


But the laws of chance de operate and allow for some amazing success stories that convince people that consistently outperforing the markets is possible when it's not.


Efficient Market Hypothesis

The efficient market hypothesis states that asset prices reflect available information. In other words, €100 bills laying around on the ground will not be there for long.


There are three forms of efficiency:

  • Weak form posits that asset prices reflect all historical price information. Hence, technical analysis is useless.

  • Semi-strong form says that asset prices reflect all publicly available information. Thereby, both technical and fundamental analysis are useless.

  • Strong form asserts that asset prices reflect all information.

If one were to believe that markets are fully efficient, 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.


High-frequency trading (HFT), rather than harming individual investors, actually benefits them by assuring that exchange-traded funds (ETFs) are fairly priced. HFT makes markets more efficient and reinforces the advnatge of index-fund investing.


Modern Portfolio Theory (MPT)

According to MPT, all else being equal, higher risk leads to higher return.


Investing risk is here defined as the probability that a security will decrease in value. The greater the risk, the greater the variance. Risk is the variance in the standard deviation of returns.


Beta is systemic or market risk which means that it measures how a stock moves with the overall market. Unsystematic risk is risk associated with a particular company. Unfortunately, a perfect risk measure does not exist.


Diversification cannot eliminate systemic risk, but it can reduce unsystematic risk. Diversification works when you have assets that are not perfectly correlated.


Assets have become increasingly correlated in recent years, but as long as they are not perfectly correlated, portfolio theory is still helpful.


The basic logic behind the capital asset pricing model (CAPM) is that there is no premium for bearing risks that can be diversified away.


The stock market appears to be an efficient mechanism that adjusts quite quickly to new information. Neither technical nor fundamental analysts seem to yield consistent benefits.


Lessons from Behavioral Finance

The EMH is built on the idea that investors are rational beings who make decisions that maximize their wealth, but are constrained by their individual risk tolerance. Behavioral finance debunks this idea and highlight four factors that cause irrational investor behavior:

  1. Overconfidence: investors tend to overestimate their own skill and deny the role of chance in their outcomes. Typically, they attribute good outcomes to their own abilities (hindsight bias) and bad outcomes to external events. One manifestation of overconfidence is the consistent overvaluation of growth stocks.

  2. Biased Judgments: investors tend to assume to have a greater degree of control than they have in reality. Most fail to properly weight probability and use base rates.

  3. Herd Mentality: there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich. We all get lured into tales of the hot new stock that we need to invest in. This tendency to get swept up in speculative, get-rich-quick schemes shows how easily we get lost in herd mentality when making investment decisions.

  4. Loss Aversion: losses hurt more than the joy we receive from equivalent gains. This explains why so many investors sell the winners and hold on to the losers. Losses also tap into the emotions of pride and regret. Talking about your losses is tough but talking about gains makes you look cool.

To avoid the pitfalls of investor irrationality:

  1. Avoid herd behavior

  2. Avoid overtrading

  3. Sell losers, not the winners

  4. Don’t buy into IPOs or trust “hot tips”

However, even if market participants are irrational, it doesn’t mean that the market is by default inefficient. That’s highlighted by the difficulty of consistently finding arbitrage opportunities.


Practical Guide for Random Walkers

The most important driver in the growth of your assets is how much you save, and saving requires discipline. You can only get poor quickly. To get rich, you will have to do it slowly, and you have to start now. The secret to gettng rich slowly (but surely) is compound interest.


Remember Murphy's Law: what can go wrong will go wrong (and Murphy was an optimist).


Keep some reserves in safe and liquid investments to pay for an unexpected medical bill or to provide a cushion during a time of unemployment.


Let the yield of your cash reserve keep pace with inflation (money funds, T-bills, CDs) and buy renewable term insurance.


Take advantage of every opportunity to make your savings tax-deductible and to let your savings and investments grow tax-free.


Before you invest, you need to understand your investment objectives. Determining clear goals is a part of the investment process that too many people skip, with disastrous results. You must know your risk tolerance and what kinds of investments are most suitable to your tax bracket. Your age and psychological makeup also influences the degree of risk you should assume.


Real estate has proved to be a good investment providing generous returns and excellent inflation-hedging characteristics. Direct real estate requires substantial capital, low-expense REIT index funds don't.


Zero-coupon bonds can be useful to fund future liabilities, no-load bond funds can be appropriate vehicles for individual investors, and tax-exempt bonds are useful for high-bracket investors.


Practically all gold trading is for the purpose of hoarding or speculating so that the bullion can be sold later at a higher price. Almost none of the gold is actually used. In this kind of market, no one can tell where prices will go.


To earn money collecting, you need great originality and taste. Most people who think they are collecting profit are really collecting trouble.


There is much about investing you cannot control. You can't do anything about the ups and downs of the stock and bonds markets. But you can control your investment costs. And you can organize your investments to minimize taxes. Controlling the things you can control should play a central role in developing a sensible investment strategy.


Diversification reduces risk and makes it far more likely that you will achieve the kind of good average long-run return that meets your investment objective.


Stocks and Bond Valuation

The value of a stock is determined by 3 factors:

  1. Initial dividend yield

  2. Growth rate of earnings

  3. Changes in valuation in terms of P/E or price/dividend ratios

The value of a bond is determined by 2 factors:

  1. Initial yield to maturity at time of purchase

  2. Changes in interest rates (yields) if you don’t hold the bond to maturity


Asset Allocation Principles

The risk of investing in stocks/bonds depends on the holding period. The longer the holding period, the lower the likely variance in asset returns.


Dollar cost averaging can be a useful, though controversial, technique to reduce risk.


Rebalancing can reduce risk, and in some circumstances, increase investment returns.


You must distinguish between your attitude toward and your capacity for risk. Be aware of your risk tolerance. Your investments should never disturb your sleep. So invest up to the point at which you can handle the day to day variance and still sleep just fine.


Specific needs require dedicated specific assets.


Persistent savings in regular amounts, no matter how small, pays off.


Portfolio Composition

The longer your holding time, the greater should be the share of common stocks in your portfolio.

If you have a multi-decade investment horizon, you should be heavily invested in stocks. While stocks are more volatile than other asset classes over short investment horizons, in the long run, you’re likely to get a good return.


Mid-20s

  • Cash (5%)

  • Bonds (15%)

  • Stocks (70%)

  • Real estate (10%)

Late 30s to Early 40s

  • Cash (5%)

  • Bonds (20%)

  • Stocks (65%)

  • Real estate (10%)

Mid-50s

  • Cash (5%)

  • Bonds (27.5%)

  • Stocks (55%)

  • Real estate (12.5%)

Late 60s and Beyond

  • Cash (10%)

  • Bonds (35%)

  • Stocks (40%)

  • Real estate (15%)


The 4% rule states that when you retire, spend no more than 4% of your investments annually to secure your nest egg. Generally this will allow you to make it through the point at which you die.


Because we cannot consistently beat the market, the core of every portfolio should consist of low-cost, tax-efficient, broad-based index funds. Not only is it simple, but it’s likely to give you the best outcome as an individual investor. Moreover, the single most important thing you can do to achieve financial security is to begin a regular savings program and to start it as early as possible. And because of the power of compound interest, we should begin this savings and investment program as early as possible.

© Alex Vikner

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