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A Random Walk Down Wall Street

The Time-Tested Strategy for Successful Investing by Burton G. Malkiel W.W. Norton 2007 480 pages

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Take-Aways
It is not all that difficult to make money in the stock market. It is hard to resist the emotional pull of a possible windfall. Investors often ignore the lessons of financial history. Ultimately, the market finds true value or something close to it. In the long term, a stock cant be worth more than the cash it brings to investors. Investors should take advantage of tax-favored savings and investment plans. The best investment strategy is probably indexing. Most so-called market anomalies (January effect, etc.) arent really playable. Never pay more for a stock than its really worth. The market is, for all practical purposes, unpredictable, but investors do better than speculators over the long haul.

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What You Will Learn In this Abstract, you will learn the facts of investing life, without a sales pitch to distort the information. Recommendation The first edition of Burton Malkiels A Random Walk Down Wall Street appeared in 1973, a few years after the twentieth centurys first big computer technology bubble, the go-go era, popped. This, the newest and eighth edition, appears after the popping of the dot.com bubble, the last of the twentieth centurys great computer technology bubbles. Investors burned in the first bubble could have been excused; after all, they didnt have Malkiels book. But its astounding how avidly Internet speculators threw aside all that Malkiel and others had taught them. This book belongs on every investors bookshelf, and ought to be consulted, or at least touched to the forehead, before any investment decision. Most investment books arent trustworthy, because their authors are salespeople who are really making a pitch instead of trying to inform you. Malkiel is disinterested. He is a teacher with the intellectual discipline of a true financial economist, and yet he writes as vividly as a good journalist. getAbstract recommends this classic: all you need to know about the market is between its covers.

Abstract
Define a Random Walk When we say that stock prices are a random walk we mean that short-term price moves are unpredictable. This infuriates Wall Street professionals whose comfortable living often depends on people paying them for their supposedly superior knowledge of what the market is about to do. But history is pretty clear. Investors who dont try to profit by predicting market moves do better, by and large, than speculators who attempt to cash in on short term predictions. Investing in investment theories doesnt make a great deal more economic sense than that. Two of the most popular investment theories are:
Firm-foundation theory Stocks have an intrinsic value that can be calculated by discounting and summing future dividend flows. Adherents to one or another form of this theory include economist Irving Fisher and investor Warren Buffett. Castle-in-the-air theory Also known as the greater fool theory, this postulates that successful investing is based on predicting the mood of the crowd. An investment will be worth whatever people are willing to pay, and people arent very rational.
The indexing strategy is the one I most highly recommend.

It is not hard, really, to make money in the market.

Ample evidence indicates that the market behaves irrationally, sometimes setting prices way above realistic values, sometimes dragging them far below. Predicting this irrationality is quite difficult, and profiting from it is even harder. Historys most famous market manias include: Tulipmania Gripped early seventeenth century Holland, sending prices of tulip bulbs so high that people mortgaged their homes to buy them. Crashed in 1637. South Sea Bubble Seized eighteenth century England when a craze for the worthless but attractive South Sea Company spilled into a mania for stocks. Peaked and crashed in 1720. (The Mississippi Bubble inflamed France at the same time.)
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A biblical proverb states that in the multitude of counselors there is safety. The same can be said of investment.

Roaring Twenties One of Americas most maniacal speculative episodes began about 1923 and ended in the Crash of 1929, ushering in the Great Depression. Soaring Sixties The 1960s saw the first big tech stock bubble as speculators flocked to any issue with electronic in its name. The era also witnessed a speculative infatuation with conglomerates and concept stocks with interesting stories. Nifty Fifty Some 50 big growth stocks (IBM, Xerox, Avon) captivated Wall Street, which sent their P/E ratios into high double digits before the inevitable fall. Roaring Eighties A new issue flurry in 1983 made the 1960s look tame. The euphoria of the LBO boom and the biotech craze ended with the crash of 1987. The Japan Bubble At one point in 1989, the real estate under the Imperial Palace in Tokyo was worth more than all the land in California, and the Japanese stock market was valued at 45% of the worlds market capitalization. Crash came in 1990. Internet Bubble In the late 1990s, the NASDAQ Index, dominated by high-tech companies, tripled and then some, before the crash. A market bubble is like a Ponzi scheme. It prospers as long as new speculators are willing to plow in cash, but fails when new cash stops flowing. The Internet boom of the 1990s was special, though, involving an almost unprecedented abandonment of rudimentary investment rationality and a fairly substantial degree of corruption and conflict of interest, especially by analysts. Wall Street once maintained Chinese Walls separating analysts from brokers and investment bankers. Those walls turned porous during the Internet bubble. Analysts often found that their jobs depended on giving shaky stocks glowing recommendations. Why? Because their firms brokers or investment bankers could make fortunes working for the analyzed company but companies hire firms that recommend their stocks. Many Internet companies had no history or profits, and made no sense as investments when evaluated with traditional metrics, so analysts invented new metrics (i.e. measuring not sales but eyeballs, the number of people who looked at a web page). The media fueled speculation by turning dot.com parvenus into stars. As for investors, fraud aside, we should have known better. Attention to history and fundamentals can help you avoid the popping bubbles massive losses. Clearly investor passions play a role in stock prices, yet investing by the greater fool theory is risky. If you buy an unsound stock intending to sell it to a greater fool, be prepared to find that a greater fool than yourself may not come up the road any time soon.

Of course, earnings and dividends in uence market prices, and so does the temper of the crowd.

Although stock prices do plummet, as they did so disastrously during October 1987 and again during the early 2000s, the overall return during the entire twentieth century was about 9% per year, including both dividends and capital gains.

As long as there are stock markets there will be mistakes made by the collective judgment of investors.

Tools of the Crystal Ball Professionals use certain tools, including technical and fundamental analysis, to try to predict stock prices in the unknowable future. Technical analysts, or chartists, attempt to divine stock price movement patterns by charting past stock prices. Philosophically, technicians fall into the castle-in-the-air camp, believing that crowd psychology determines prices, and is both fairly repetitive and more or less predictable. Yet in fact, stock prices are random. If you flip a coin 100 times and chart the results, your chart will look very much like a chart of stock prices. Coin flips are random, but if you chart them, you can get long strings of heads or tails that look like long up or down market trends. Be particularly skeptical about these popular but worthless technical investing theories and indicators:
Filters The notion that any stock that moves some percentage up from a low or down from a high is on a trend that will continue. Filter techniques dont beat a simple buy-and-hold, when transaction expenses are factored in. (Brokers love them, though, because they generate commissions.)
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Nevertheless, one has to be im-pressed with the substantial volume of evidence suggesting that stock prices display a remarkable degree of efciency.

It should be obvious by now that any truly repetitive and exploitable pattern that can be discovered in the stock market and can be arbitraged away will self-destruct.

Dow theory Advises buying when the market surpasses its last peak and selling when it goes below the previous low. Tests prove this is a money-losing strategy. Relative strength Buy stocks that outperform the market and sell stocks that under-perform. After transaction costs, this does no better than buy and hold. Price-volume Infers investor sentiment from price drops or price increases. Pricevolume systems make a lot of trading necessary, and investors would be better off economically to simply buy and hold. The returns dont justify the transaction costs. Chart patterns Extensive computer tests demonstrate that chart patterns, such as head-and-shoulders, triple tops, diamonds and so on, have no predictive power. Hemline indicator Says that when hemlines go up, so will stock prices, and when hems go down, stocks will follow. Hemlines and stock prices have some correlation, but not much predictive value, especially in an era of pantsuits. Super Bowl indicator NFL victory precedes a bull run; AFL rings in the bears. Coincidentally, this has been true, but theres no reason why it should be a predictor. Odd-Lot theory Suggests that market amateurs cant afford full, 100-share round lots, and so buy odd lots. Because they are usually wrong, sell when they buy and buy when they sell. Nothing proves this works and trading costs make it expensive. Dogs of the Dow Buy the Dow stocks with the highest dividend yields. Even the creator of this technique admits it no longer works. January effect Buy at year-end when prices, especially of small stocks, fall, and sell during the predictable, early-January rise. In fact, trading costs cancel this out. Weekend effect Says stocks on average have negative returns Friday to Monday, so buy on Monday afternoons, not Friday. Doing this would have shut you out of astounding gain on Monday, July 29, 2002, the Dows third-biggest point gain ever. Momentum investing Momentum investors ride trends, hoping that the trend is your friend because the market will continue to do what it has just done. Studies indicate that momentum investors fare worse than buy-and-hold investors. Technical analysis doesnt work, so what about fundamental analysis? Fundamental analysts fall into the firm-foundation school. They believe that scrutinizing data about a company leads to a fair, reasonable estimate of its future earnings and, therefore, a more or less reliable estimate of its fundamental value which the market will, for better or worse, eventually recognize. But no one can predict the future with any confidence. A companys past earnings performance provides no reliable information about its future performance. Past performance is simply no guide to future results. Moreover, historical examination of earnings forecasts is disappointing. Analysts short-term predictions were even less reliable than their long-term forecasts. Why? Several reasons: Experts arent that expert They are fallible, but their fallibility is often exceeded only by their self-confidence and assurance. Stuff happens Forecasts cannot predict or account for deregulation, raw material price changes, terrorism, accidents and other random events. Creative accounting The data that analysts are looking at may be fraudulent. Incompetence Analysts are often careless, lazy and incompetent. Corruption or conflict-of-interest Analysts are not dispassionate seekers of truth. Firms only pay them because they can help sell securities. Those who dont play along dont last. The system doesnt select for reliable, high-quality analytics.

The cycles in the stock charts are no more true cycles than the runs of luck or misfortune of the ordinary gambler.

The mystical perfect risk measure is still beyond our grasp.

Index and Diversify for Efficiency On the whole, fundamental analysis is as useless as technical analysis. So, where does this leave the investor? Remember that the market is, by and large, efficient, so stock
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Can you continue to expect a free lunch from international diversication? Many analysts think not. They feel that the globalization of the world economies has blunted the benets of international diversication.

prices reflect most if not all the important information about a companys prospects and the markets likely direction. The market reacts quickly to new data, the key factor driving stock price moves. Even such great investors as Benjamin Graham, Warren Buffett and Peter Lynch have said that the individuals do better buying index funds than trying to pick stocks or invest with a stock-picking manager. The market is not perfectly efficient. People do get caught up in manias. Information may not find its way into stock prices as quickly as efficient-market theorists believe. But, overall, its very tough to beat the market almost impossibly tough. Yet some people get rich buying and selling stocks. What do they have that others lack? They have risk. The only way to get high returns is to take high risk. An Ibbotson Associates study shows that returns are highly correlated with risk, that is, variance in returns. Common stocks are the highest-return asset class studied, and the highest risk. Modern Portfolio Theory (MPT) says it is possible to spread your money over a portfolio of risky securities in such a way that the portfolios overall risk is lower than the risk of any one stock and still get good returns. Diversification offers the lowest level of risk consistent with a given return. Put your eggs in as many baskets as possible. An internationally diversified portfolio is less risky than a purely U.S. portfolio. From 1970 to 2002, the highest return for the lowest risk came with a portfolio with 24% non-U.S. and 76% U.S. stocks. The benefits of international diversification are disappearing, with U.S. and developed nonU.S. markets moving more and more in tandem. But currency differences and emerging market changes can disrupt market correlations. Diversify not only across common stocks, but also across asset classes. Two other asset classes worth considering are real estate investment trusts (REITS) and government bonds. REITS let you buy stock in real estate, which does not move in tandem with stock market. Inflation is the bane of bond investors, so consider inflation-protected bonds (called TIPS). Tax law isnt kind to them, so use them in tax-sheltered plans. The best advice to help the individual investor succeed in the market is to diversify and reduce costs, and not to try to outguess other investors about the future direction of prices. Even pros fail at this strategy. Studies repeatedly prove that a passive investor who holds a diversified index does better than someone who invests in an actively managed fund.

It is clear that if there are exceptional nancial managers, they are very rare, and there is no way of telling in advance who they will be.

About The Author


Burton G. Malkiel holds the Chemical Bank Chairmans Professorship at Princeton University. He is a former member of the Council of Economic Advisors and serves on the boards of several major corporations, including the Vanguard Group of Investment Companies and Prudential Financial Corporation.

Buzz-Words
Beta / Bubble / Diversification / Dow theory / Firm-foundation / Fundamental analysis / Greater fool theory / January effect / Modern portfolio theory / Momentum investing / Random walk / Efficient-market theory / Technical analysis
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