A Random Walk Down Wall Street - Burton G. Malkiel

A Random Walk Down Wall Street - The Time-tested Strategy For Successful Investing

A random walk is one in which future steps or directions​ cannot be predicted on the basis of past history

This book draws on three different backgrounds to provide perspectives on the stock market. These are investment analysis and portfolio management, economics, and successful investment experience. Despite the facts and figures in this book, a layperson can find practical and beneficial principles that can help them take the random walk. Interest and desire are the fundamental requirements to make your investments work for you.

There is a difference between investment and speculation. A speculator buys stocks hoping for a short-term gain over the next days or weeks. An investor buys stocks likely to produce a dependable future stream of cash returns and capital gains when measured over years or decades. Investment requires work, yet it is fun. A successful investor is generally a well-rounded individual who puts a natural curiosity and an intellectual interest to work to earn more money.

Traditionally, the pros in the investment community have used one of two approaches to asset valuation: the firm-foundation theory or the castle-in-the-air theory. The firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. The castle-in-the-air theory of investing concentrates on psychic values. John Maynard Keynes, a famous economist, and successful investor​ enunciated the theory most lucidly in 1936. This theory says that the successful investor is the one who beats the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.

It is important to note the historical patterns of investment through the centuries so that we can learn from the past. Thus, when one makes the random walk down Wall Street, you will be better equipped to make the right decisions. In the 17th century, there was a mad rush to buy tulip bulbs in Holland. In the 18th century, it was the South Sea Bubble in England. In the early 1960s, the new-issue mania was the order of the day. The 1970s ushered in the “Nifty Fifty” craze. There was an​ 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 provide continual warnings that neither individuals nor investment professionals are immune from the errors of the past.

Why are memories so short? Why do such speculative crazes seem so isolated from the lessons of history? A study of these events can help equip investors for survival. The consistent losers in the market are those who are unable to resist being swept up in some kind of tulip-bulb craze

The greatest of all gifts is the power to estimate things at their true worth

Academics have analyzed investment results and concluded that investments are not worth the money you pay for them. A concept known as the efficient-market hypothesis (EMH) furnishes you with the skill you need to buy and hold investments without the assistance of stock investors.

There are two methods used to predict accurately the future course of stock prices and thus the appropriate time to buy or sell a stock. They are called technical or fundamental analysis. Technical analysis is a 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 the firm-foundation theory to the selection of individual stocks. 

Technical analysis is essentially the making and interpreting of stock charts. Its practitioners study the past — both the movements of common stock prices and the volume of trading — for a clue to the direction of future change. Many chartists believe that the market is only 10% logical and 90% psychological. They anticipate how the other players will behave and subscribe to the castle-in the-air view.

Fundamental analysts take the opposite tack, believing that the market is 90% logical and only 10% psychological. Fundamentalists seek to determine a stock’s proper value. Value refers to a company’s assets, its expected growth rate of earnings and dividends, interest rates, and risk. By studying these factors, the fundamentalists arrive at an estimate of a security’s intrinsic value or firm foundation of value. If this is above the market price, then the investor is advised to buy.

The fundamentalist uses four basic determinants to help estimate the proper value for any stock.

1. The expected growth rate. A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings, and the longer an extraordinary growth rate is expected to last.

2. The expected dividend pay-out. A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company’s earnings that are paid out in cash dividends.

3. The degree of risk. A rational (and risk-averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.

4. The level of market interest rates. A rational investor should be willing to pay a higher price for a share, other things being equal, the lower the interest rates.

In principle, these rules are very useful in suggesting a rational basis for stock prices and in giving investors some standard of value. But before we even think of using these rules, we must bear in mind three important caveats.

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

• Precise figures cannot be calculated from undetermined data.

• What’s growth for the goose is not always growth for the gander.

Many analysts use a combination of techniques to judge whether individual stocks are attractive for purchase. One of the most sensible procedures can easily be summarized by the following three rules.

• Buy only companies that are expected to have above-average earnings growth for five or more years.

• Never pay more for a stock than its firm foundation of value.

• Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air.

Technical analysts build their strategies upon dreams of castles in the air and expect their tools to tell them which castle is being built and how to get in on the ground floor

Technical analysis is anathema to much of the academic world for two reasons.

• After paying transaction​ costs and taxes, the method does not do better than a buy-and-hold strategy; and

• It’s easy to pick on.

For the technician, the sequence of price changes before any given day is important in predicting the price change for that day. This is called “the wallpaper principle.” They believe that there are repeatable patterns in space and time. Chartists believe that momentum exists in the market. Hence, they advise holding on to the ​rising stock because they will continue to rise and selling the stock the moment it begins to act poorly. 

Exhaustive testing of these technical rules using stock-price data on the major exchanges goes as far back as the beginning of the 20th century. It reveals that past movements in stock prices cannot be used to reliably foretell future movements. Stock prices behave very much like a random walk and the stock market has little, if any, memory. This is not to say that technical analysis cannot earn you money. In fact, a buy-and-hold strategy using a portfolio consisting of all the stocks in a broad stock-market index has provided investors with an average annual rate of return of almost 10% over the past 80 years. Technical schemes have not produced better returns consistently.

Other elaborate technical systems have also fallen short upon subjection to scientific testing. Some of these systems are The Filter System, The Dow Theory, The Relative-Strength System, Price-Volume Systems, and the Reading Chart Patterns.

Human nature likes to see patterns​ and order in totally random events. Psychologists have shown through a series of studies that the “hot hand” phenomenon is a myth. The truth is that simply buying and holding a diversified portfolio suited to your objectives will enable you to save on investment expenses, brokerage charges, and taxes; and, at the same time, to achieve an overall performance record at least as good as that obtained using technical methods.

Analysts can’t predict consistent long-run growth, because it does not exist

Security analysts have enormous difficulty in performing their basic functions of forecasting company earnings prospects. Investors who put blind faith in such forecasts in making their investment selections are in for a ​disappointment.

Beyond security analysts, most groups of professionals are not terribly skillful at their calling. There are five factors that help explain why security analysts have such difficulty in predicting the future. These are:

• The influence of random events;

• The production of dubious reported earnings through creative accounting procedures;

• Errors made by the analysts themselves;

• The loss of the best analysts to the sales desk or to portfolio management;

• The conflicts of interest facing security analysts at firms with large investment banking operations. 

It is simply impossible to count on any fund or any investment manager to consistently beat the market — even when the past record suggests some unusual investment skill.

Can any fundamental system pick winners? A good deal of research has been done on the usefulness of dividend increases as a basis for selecting stocks that will give an ​above-average performance. Dividend increases, in fact, are usually an accurate indicator of increases in future earnings. There is also some tendency for a strong price performance to follow the dividend announcement.

There are three forms of the efficient-market theory. They are the weak form, the semi-strong form, and the strong form. The weak or “narrow” form of the theory says that technical analysis — looking at past stock prices — cannot help investors. Prices move from period to period very much like a random walk. The semi-strong form states that no public information will help the analyst select undervalued securities. [24] The strong form says that absolutely nothing that is known or even knowable about a company will benefit the fundamental analyst. The “broad” (semi-strong and strong) forms state that all that is known concerning the expected growth of the company’s earnings and dividends, all of the possible favorable and unfavorable developments affecting the company that might be studied by the fundamental analyst, is already reflected in the price of the company’s stock. 

There are, however, exceptions to the rule of the efficient market. This is because stocks sometimes do not sell on the basis of anyone’s estimate of value, useful inside information is not immediately disclosed to everybody, and there is an enormous difficulty of translating known information about a stock into an estimate of true value.

The insights from Modern Portfolio Theory (MPT) will enable you to reduce risk while possibly earning a higher return than the firm foundation and the castle-in-the-air theories

Academics have suggested that investors can increase their returns by assuming a certain kind of risk. Some other practitioners and academics have argued that psychology, not rationality, rules the market and that there is no such thing as a random walk. In truth, a common-stock index fund, which is an efficient-market application — remains the undisputed champion in taking the most profitable stroll through the market.

Investment risk is the chance that expected security returns will not materialize, and in particular, that the securities you hold will fall in price. Financial risk has been defined as the variance or standard deviation of returns. Security​ whose returns are not likely to depart much, if at all, from its average (or expected) return is said to carry little or no risk. A security whose returns from year to year are likely to be quite volatile (and for which sharp losses occur in some years) is said to be risky. The higher the standard deviation, the greater the risk.

The Modern Portfolio Theory (MPT) tells investors how to combine stocks in their portfolios to give them the least risk possible, consistent with the return they seek. The theory was invented in the 1950s by Harry Markowitz and for his contribution,​ he was awarded the Nobel Prize in Economics in 1990. Markowitz discovered that as long as there is some lack of parallelism in the fortunes of the individual companies in the economy, that is, they have a negative covariance, diversification can reduce risk.

Diversification means spreading your investment across the companies that have a negative covariance. Diversification only works up to a point, as numerous studies have shown. The paradox is that the addition of a small amount of riskier foreign securities reduces overall portfolio risk. Professor William Sharpe, the former Stanford Professor, the late finance specialists John Lintner and Fischer Black focused their intellectual energies on determining what part of a security​ risk can be eliminated by diversification and what part cannot. The result is known as the capital-asset pricing model (CAPM). Sharpe got a Nobel Prize for his contribution to this work at the same time Markowitz was honored in 1990.

The basic logic behind the capital asset​ pricing model is that there is no premium for bearing risks that can be diversified away. Thus, to get a higher average long-run rate of return, you need to increase the risk level of the portfolio that cannot be diversified away. According to this theory, savvy investors can outperform the overall market by adjusting their portfolios with a risk measure known as beta. Beta is relative volatility or sensitivity to market moves which can be estimated on the basis of past record.

Systematic risk, also called market risk, captures the reaction of individual stocks (or portfolios) to general market swings. Some stocks and portfolios tend to be very sensitive to market movements. Variability in a stock’s returns is called unsystematic risk and results from factors peculiar to that particular company—for example, a strike, the discovery of a new product, and so on. While diversification eliminates unsystematic risk, CAPM helps to manage systematic risk. The proof of CAPM states that if investors did get an extra return (a risk premium) for bearing unsystematic risk, it would turn out that diversified portfolios made up of stocks with large amounts of unsystematic risk would give larger returns than equally risky portfolios of stocks with less unsystematic risk.

Behavioral finance is not a branch of standard finance: it is a replacement with a better model of humanity

Efficient-market theory, modern portfolio theory, and various asset-pricing relationships between risk and return all are built on the premise that stock-market investors are rational. This is the belief of economists. Psychologists, however, will not have any of this economic claptrap.

Two psychologists — Daniel Kahneman and Amos Tversky — blasted economists’ views about how investors behave, and in the process are credited with fathering a whole new economic discipline, called behavioral finance. Tversky died in 1996 while Kahneman won the Nobel Memorial Prize in Economic Sciences six years later.

Behavioralists believe that market prices are highly imprecise. Moreover, people deviate in systematic ways from rationality, and the irrational trades of investors tend to be correlated. Behavioral finance then takes that statement further by asserting that it is possible to quantify or classify such irrational behavior. 

Basically, there are four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion. While believers in efficient markets agree with this assertion, they also believe that the distortions caused by such factors are countered by the work of arbitrageurs. Arbitrageurs are used to describing​ people who profit from any deviation of market prices from their rational value.

Behavioralists also stress the importance of the emotions of pride and regret in influencing investor behavior. Investors find it very difficult to admit, even to themselves, that they have made a bad stock-market decision. Behavioralists believe that important limits to arbitrage exist that prevent out-of-whack prices from being corrected.

An understanding of how vulnerable we are to our own psychology can help us avoid the stupid investor delusions that can screw up our financial security. The first step in dealing with the pernicious effects of our behavioral foibles is to recognize them. Here are the most important insights from behavioral finance.

• Avoid herd behavior

• Avoid overtrading

• If you do trade: sell losers, not winners

• Be wary of new issues

• Stay cool to hot tips

• Distrust foolproof schemes

Some Behavioralists believe that the systematic errors of investors can provide opportunities for unemotional, rational investors to beat the market. They believe that irrational trading creates predictable stock-market patterns that can be exploited by wise investors.

In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well

There are pieces of general investment advice that should be useful to all investors, even if they don’t believe that securities markets are highly efficient. Think of the advice as a set of warm-up exercises that will enable you to make sensible financial decisions and increase your after-tax investment returns.

Exercise 1: Gather the necessary supplies. Start saving early and save regularly. Live modestly and don’t touch any money that’s been set aside.

Exercise 2: Don’t be caught empty-handed: cover yourself with cash reserves and insurance.

Exercise 3: Be competitive — let the yield on your cash reserve keep pace with inflation.

Exercise 4: Learn how to dodge the tax collector.

Exercise 5: Make sure the shoe fits: understand your investment objectives.

Exercise 6: Begin your walk at your own home — renting leads to flabby investment muscles.

Exercise 7: Investigate a promenade through the ​bond country.

Exercise 8: Tiptoe through the fields of gold, collectibles, and other investments.

Exercise 9: Remember that commission costs are not random; some are lower than others.

Exercise 10: Avoid sinkholes and stumbling blocks: diversify your investment steps.

The theories of valuation worked out by economists and the performance recorded by professionals lead to a single conclusion: There is no sure and easy road to riches.

You can become a financial bookie who realistically projects long-run returns and adapts their investment programs to their financial needs

There have been four eras of financial market returns. The four eras coincide with the four broad swings in stock-market returns from 1946 to 2009. Era 1 is the Age of Comfort, which covers the years of growth after World War II. Stockholders made out extremely well after inflation, whereas the meager returns earned by bondholders were substantially below the average inflation rate. Era 2 is the Age of Angst when a ​widespread rebellion by the millions of teenagers born during the baby boom, economic and political instability created by the Vietnam War, and various inflationary oil and food shocks combined to create an inhospitable climate for investors. No one was exempt; nether stocks or bonds fared well. The 3rd Era is the Age of Exuberance, the boomers matured, peace reigned, and noninflationary prosperity set in. It was a golden age for stockholders and bondholders. Never before had they earned such generous returns. Era 4 was the Age of Disenchantment, in which the great promise of the new millennium was not reflected in common-stock returns.

While it is difficult, if not impossible, to predict short-term movements in securities markets, it is possible to estimate the likely range of long-run rates of return that investors can expect from financial assets.

Investment strategy needs to be keyed to one’s life cycle. A 34-year-old and a 64-year-old saving for retirement should use different financial instruments to accomplish their goals. [35] Before we can determine a rational basis for making asset-allocation decisions, certain principles must be kept firmly in mind. The key principles are:

• History shows that risk and return are related;
• The risk of investing in common stocks and bonds depends on the length of time the investments are held. The longer an investor’s holding period, the lower the likely variation in the asset’s return.
• Dollar-cost averaging can be useful, though controversial, technique to reduce the risk of stock and bond investment.
• Rebalancing can reduce risk and, in some circumstances, increase investment returns.
• You must distinguish between your attitude toward and your capacity for risk. The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income.

There are three guidelines for​ tailoring a life-cycle investment plan. Though no guide will fit every individual case, you can come up with a game plan that can alter the guidelines to fit every individual case. Three broad guidelines include:

• Specific needs require dedicated specific assets;
• Recognize your tolerance for risk;
• Persistent saving in regular amounts, no matter how small, pays off.

There are three major ways to go about buying stocks. They are:

• The No-Brainer Step
• The Do-It-Yourself Step, and
• The Substitute-Player Step

Index funds have regularly produced rates of return exceeding those of active managers. Index funds are tax-friendly and are relatively predictable.

There are four rules for successful stock selection namely:

• 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.

The Malkiel Step involves a special type of fund called a closed-end fund. Closed-end​ funds differ from open-end mutual funds in that they neither issue nor redeem shares after the initial offering. To buy or sell shares, you have to go to a broker. Thus, a closed-end fund can sell at a premium above or at a discount from its net asset value.

Sensible investment policies for individuals must then be developed in two steps. First, it is crucially important to understand the risk-return tradeoffs that are available and to tailor your choice of securities to your temperament and requirements. A careful guide for this part of the walk has been provided, including a number of warm-up​ exercises concerning everything from tax planning to the management of reserve funds and a life-cycle guide to portfolio allocations.

The indexing strategy comes highly recommended. Applying sensible strategies that are consistent with the existence of reasonably efficient markets is​ strongly suggested. Admittedly, telling investors that there is no hope of beating the averages is like telling a 6-year-old that there is no Santa Claus

Conclusion

Investing is a bit like lovemaking in the sense that it is an art that requires a certain talent and the presence of a mysterious force called luck. The game of investing is also like lovemaking in that it is too much fun to give up. If you have the talent to recognize stocks that have good value, and the art to recognize a story that will catch the fancy of others, it’s a great feeling to see the market vindicate you.

Apply the principles of buying stock to determine the type of stock that is suited to you.