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A Few Notes on A Random Walk Down Wall Street

Posted in Big Ideas, Strategic Allocation

In the preface to the eleventh (2015) edition of his book entitled A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, author Burton Malkiel states: “The message of the original edition was a very simple one: Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds. …Now, over forty years later, I believe even more strongly in that original thesis… Why, then, an eleventh edition of this book? …The answer is that there have been enormous changes in the financial instruments available to the public… In addition, investors can benefit from a critical analysis of the wealth of new information provided by academic researchers and market professionals… There have been so many bewildering claims about the stock market that it’s important to have a book that sets the record straight.” Based on a survey of financial markets research and his own analyses, he concludes that:

From Chapter 1, “Firm Foundations and Castles in the Air” (Page 36): “…no one can disregard the new issue mania of the early 1960s, or the ‘Nifty Fifty’ craze of the 1970s. The incredible boom in Japanese land and stock prices and the equally spectacular crash of those prices in the early 1990s, the ‘Internet craze’ of 1999 and early 2000, and the U.S. real estate bubble that ended in 2007 provide continual warnings that neither individuals nor investment professionals are immune from the errors of the past.”

From Chapter 2, “The Madness of Crowds” (Page 55): “The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.”

From Chapter 3, “Speculative Bubbles from the Sixties into the Nineties” (Page 75): “The lessons of market history are clear. Styles and fashions in investors’ evaluations of securities can and often do play a critical role in the pricing of securities. …For this reason, the game of investing can be extremely dangerous. …investors should be very wary of purchasing today’s hot ‘new issue.’ Most initial public offerings underperform the stock market as a whole.”

From Chapter 4, “The Explosive Bubbles of the Early 2000s” (Page 105): “Anomalies can crop up, markets can get irrationally optimistic, and often attract unwary investors. But, eventually, true value is recognized by the market, and this is the main lesson investors must heed. …Markets are not always or even usually correct. But NO ONE PERSON OR INSTITUTION CONSISTENTLY KNOWS MORE THAN THE MARKET.”

From Chapter 5, “Technical and Fundamental Analysis” (Pages 110, 133): “Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the-air view of stock pricing. Fundamental analysis is the technique of applying the tenets of firm-foundation theory to the selection of individual stocks. …Although the rules I have outlined seem sensible, the important question is whether they really work. After all, lots of people are playing the game, and it is by no means obvious that anyone can win consistently.”

From Chapter 6, “Technical Analysis and the Random-Walk Theory” (Pages 135, 157): “I have personally never known a successful technician, but I have seen the wrecks of several unsuccessful ones. …the broke technician is never apologetic. …he will tell you quite ingenuously that he made the all-too-human error of not believing his own charts. …The past history of stock prices cannot be used to predict the future in any meaningful way. Technical strategies are usually amusing, often comforting, but of no real value.”

From Chapter 7, “How Good Is Fundamental Analysis? The Efficient-Market Hypothesis” (Pages 182, 184): “The academic community has rendered its judgment. Fundamental analysis is no better than technical analysis in enabling investors to capture above-average returns. …The efficient-market hypothesis does not…state that stock prices move aimlessly and erratically and are insensitive to changes in fundamental information. On the contrary, the reason prices move randomly is just the opposite. The market is so efficient…that no one can buy or sell fast enough to benefit. And real news develops randomly, that is, unpredictably.”

From Chapter 8, “A New Walking Shoe: Modern Portfolio Theory” (Pages 202, 208): “…about fifty [stocks] is…the golden number for global-minded investors. …the timeless lessons of diversification are as powerful today as they were in the past.”

From Chapter 9, “Reaping Reward by Increasing Risk” (Pages 226-227): “It appears that the only way to obtain higher long-run investment returns is to accept greater risks. Unfortunately, a perfect risk measure does not exist. …The actual relationship between beta and rate of return has not corresponded to the relationship predicted by theory during long periods of the twentieth century. Moreover, betas for individual stocks are not stable… …we must be careful not to accept beta or any other measure as an easy way to assess risk…”

From Chapter 10, “Behavioral Finance” (Page 253): “Bow to the wisdom of the market. Just as the tennis amateur who simply tries to return the ball with no fancy moves is the one who usually wins, so does the investor who simply buys and holds a diversified portfolio…”

From Chapter 11, “Is ‘Smart Beta’ Really Smart?” (Pages 282-283): “In general, the records of ‘smart beta’ funds and ETFs have been spotty. Many ‘smart beta’ ETFs have failed to produce reliable excess returns, although a few have ‘beaten the market’ over the lifetime of the funds. These funds are, however, less tax efficient than capitalization-weighted funds… To the extent that some ‘smart beta’ strategies have generated greater-than-market returns, those excess returns should be interpreted as a reward for assuming extra risk.”

From Chapter 12, “A Fitness Manual for Random Walkers and Other Investors” (Page 327): “High returns can be achieved only through higher risk-taking (and perhaps through acceptance of lesser degrees of liquidity). The amount of risk you can tolerate is partly determined by your sleeping point.”

From Chapter 13, “Handicapping the Financial Race: A Primer in Understanding and Projecting Returns from Stocks and Bonds” (Pages 345, 347): “It is hard to imagine that bond investors will be well served by the yield available in 2014. …The Shiller CAPE in 2014 averaged just over 25. CAPEs do a reasonably good job of forecasting returns a decade ahead and confirm the expectation presented here of modest single-digit returns over the years ahead.”

From Chapter 14, “A Life-Cycle Guide to Investing” (Pages 366-367): “For those in their twenties, a very aggressive investment portfolio is recommended. …The portfolio is not only heavy in common stocks but also contains a substantial portion of international stocks, including the higher-risk emerging markets. …As investors age, they should start cutting back on riskier investments and start increasing the proportion of the portfolio committed to bonds and bond substitutes… By the age of fifty-five, investor should start thinking about the transition to retirement and moving the portfolio to income production. …In retirement, a portfolio heavily weighted in a variety of bonds and bond substitutes is recommended.”

From Chapter 15, “Three Giant Steps Down Wall Street” (Page 380): “For most investors, especially those who prefer an easy, lower-risk solution to investing, I recommend bowing to the wisdom of the market and using domestic and international index funds for the entire portfolio. For all investors,…I recommend that the core of the investment portfolio–especially the retirement portion–be invested in index funds or ETFs.”

In summary, investors will find this eleventh edition of A Random Walk Down Wall Street a useful synthesis of financial markets from the perspective of essential belief in market efficiency.

Cautions regarding conclusions include:

  • The messiness of real-world financial markets inference, from imperfect data to modeling deficiencies to disagreements in formal research findings to poorly-performing theories, is perhaps insufficient to the strength of belief expressed in the book.
  • A reasonable interpretation of the efficient market hypothesis is that the diversity of observed outcomes is essentially due to luck, regardless of individual efforts expended toward proficiency.
  • A reasonable interpretation of the advice offered mostly strongly in the book is that investors should aim to be average.

 

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