How to Invest Wisely in the Stock Market

This article is an excerpt from the Shortform book guide to "A Random Walk Down Wall Street" by Burton G. Malkiel. Shortform has the world's best summaries and analyses of books you should be reading.

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What can you learn from A Random Walk Down Wall Street by Burton Malkiel? What are some of the best investment tactics?

A Random Walk Down Wall Street by Burton Malkiel is designed as an accessible guide to financial markets for the individual investor. The book covers everything from buying life insurance to pricing commodities to understanding credit default swaps. But, for the most part, Malkiel’s focus is on common stocks—shares in individual firms—and the stock market.

Keep reading for an overview of A Random Walk Down Wall Street by Burton Malkiel.

A Random Walk Down Wall Street by Burton Malkiel: Overview

In A Random Walk Down Wall Street by Burton Malkiel, there is a wealth of information that investors can use to make individual investments on their own, he repeatedly emphasizes the advantages of index investing. If you only take one thing away from A Random Walk Down Wall Street by Burton Malkiel, it should be this: Investors are better off putting their money in a passively managed index fund—a total market index fund, to be precise—than trading stocks themselves or investing in an actively managed mutual fund. For example, an investor who put $10,000 into an S&P 500 Index Fund in 1969 would have had a $1,092,489 portfolio in April 2018 (assuming all dividends were reinvested). An investor who put the same amount of money into an actively managed fund would’ve only had $817,741.

The one-page summary is divided into two parts. The first part covers the first three parts of A Random Walk Down Wall Street, guiding you through the key financial concepts Malkiel discusses as well as “Malkiel’s Take” on those concepts. The second part covers Malkiel’s practical investment tips.

Part 1: Firm Foundations vs. Castles in the Air

There are two basic theories for stocks’ valuation, one based on stocks’ actual characteristics, another based solely on human psychology.

The Firm-Foundation Theory

The firm-foundation theory holds that assets have an “intrinsic value” based on their present conditions and future potential. The firm-foundation theorist will calculate the stock’s intrinsic value by summing (1) the value of its present dividends and (2) the estimated growth of its dividends in the future.

Once an intrinsic value is established, the investor will make buying and selling decisions based on the difference between the actual price of the stock and the intrinsic value (because, according to the theory, the price will eventually regress to the intrinsic value).

The Castle-in-the-Air Theory

The castle-in-the-air theory of asset valuation holds that an asset is only worth what someone else will pay for it. In other words, no asset has an “intrinsic value” that can be determined analytically or mathematically; rather, the value of an asset is purely psychological—it’s worth whatever the majority of investors think it’s worth.

A castle-in-the-air investor makes her money by investing in stocks she thinks other investors will value.

Malkiel’s Take

There are glaring flaws with both theories of stock valuation.

With the firm-foundation theory, the problem is its reliance on future estimates. No analyst can know for certain how much or how long a stock’s dividends will grow—or even if they’ll grow at all

With the castle-in-the-air theory, the challenge is timing. The successful castle-in-the-air investor needs to buy an asset just before mass enthusiasm causes its price to rise (and sell before that enthusiasm wanes).

Technical Analysis vs. Fundamental Analysis

The two primary methods of security analysis that financial professionals use are technical analysis and fundamental analysis.

Technical Analysis

Technical analysis relies on stock charts—graphs of past price movements and trading volumes—to predict future price movements.

Technical analysts adhere to two primary principles: (1) that all economic data—revenues, dividends, and future performance—are reflected in a stock’s past prices; and (2) that stock prices tend to follow trends (if a price is rising, it will continue to rise, and vice versa).

Fundamental Analysis

Fundamental analysis attempts to predict a firm’s future earnings and dividends by in-depth study. Fundamental analysts pore over firms’ balance sheets, earnings reports, and tax rates; they even, on occasion, pay personal visits to companies to assess their management teams. 

Fundamental analysts also study the industry in which a company is operating. They do so to understand what is making current companies successful in that space—so they can recognize an innovator when it comes along. 

Malkiel’s Take

Although Wall Street professionals today continue to use these methods of security analysis, the empirical evidence indicates that neither is a particularly reliable way to make investment decisions.

Regarding technical analysis, the key finding among researchers is that a stock’s past performance is no indication of its future performance. (In fact, stocks’ price movements resemble a “random walk” that’s similar to the results of flipping a coin.) Any method of analysis that relies on stocks’ “momentum”—whether a stock is generally moving either up or down—is sure to prove faulty.

Regarding fundamental analysis, no matter how lucid and well-founded a fundamentalist’s value determination is, he or she simply cannot account for randomness—the appearance of a groundbreaking technology, a new legal regime, or a catastrophic event like a public-health or environmental emergency. Fundamentalists can also make random mistakes in their analysis that result in bad bets.

There’s also the problem of bad actors. Firms can fudge their earnings reports, leading fundamental analysts astray. And fundamentalists’ reports can be unduly influenced by their own employer’s clients, resulting in conflicts of interest in their buy or sell recommendations.

Modern Portfolio Theory

Modern Portfolio Theory (MPT) builds on the “efficient market hypothesis” (EMH), which holds that stock prices already reflect all relevant information. According to the EMH, no analyst can determine whether a stock is under- or overvalued, and thus there’s no way for an analyst to “beat” the market. The only way to realize greater returns is to take on more risk.

Modern Portfolio Theory (MPT) offers a strategy of managing that risk: diversification.

A diversified portfolio is one that features holdings in a variety of industries, countries, and asset classes. The idea is that, when your holdings in one industry, country, or asset suffer, your holdings in other industries, countries, and assets will offset your losses.

Malkiel’s Take

Malkiel, who accepts the EMH as a given, is a firm believer in the benefits of diversification, especially international diversification. He notes, from 1970 to 2017, a portfolio with 82% US stocks and 18% developed-foreign-country stocks provided the highest returns with the lowest volatility of any mix of the two (including 100% US). 

Systematic Risk (Beta) vs. Unsystematic Risk 

MPT led to a number of advances in the analysis of risk, including the distinction between unsystematic risk and systematic risk.

Unsystematic risk describes the variability in a stock’s returns due to aspects of the stock in particular, whereas systematic risk describes a stock’s sensitivity to shifts in the stock market in general

The key characteristic of systematic risk, better known as “beta,” is that it cannot be diversified away by strategies like MPT. And researchers found that because it can’t be diversified away, beta is the only kind of risk that pays a “risk premium”—that is, a higher return for the higher risk.

Beta forms the starting point for a number of investment technologies including the “capital asset pricing model” (CAPM), which calculates an asset’s expected return based on its beta (among other factors) and “smart beta,” which involves the customization of indexed portfolios to lower risk. 

Malkiel’s Take

Beta is a valuable metric, but not in the way its originators or proponents imagined. This is because scholars of finance have found that higher betas don’t result in greater returns.

Nevertheless, beta does accurately describe risk, and so investors with little stomach for volatility can gravitate to stocks with low betas—which, the research shows, will produce the same returns in the long run as stocks with high betas.

(“Risk parity,” another newer investment strategy, advocates investing heavily in low-beta assets. The way risk parity generates risk—and thus greater reward—is by encouraging investors to invest on margin.)

Behavioral Finance

Behavioral finance is an approach to financial markets and economic research that foregrounds human behavior. It proceeds from the premise that, contrary to most economic and financial models, people are not fully rational decision makers. In fact, research has shown that people are irrational in systematic and predictable ways. According to the progenitors of behavioral finance, Daniel Kahneman and Amos Tversky, our irrationality stems from factors like overconfidence, groupthink, and loss aversion. (Shortform Note: For more details, see our summary of Thinking Fast and Slow).

Malkiel’s Take

Malkiel believes the behavioral finance literature has produced some key insights for investors, some of which dovetail with his own findings. Two key takeaways are:

1) Don’t Follow the Crowd

Studies in behavioral finance have shown that word of mouth is a frequent driver of stock purchases. When some new investment is the talk of the town, it’s natural to want to take part. But resist the urge: Stocks or funds that are hot one quarter are almost invariably losers the next. It’s generally better to stick with “value” stocks—securities issued by tried-and-true companies with steady revenues—than gamble on “growth” stocks with high risk.

2) Don’t Overtrade

When investors trade to realize short-term gains, they tend to incur high transaction costs and taxes. One study of 66,000 households found that the households that traded the most earned an 11.4% return on their investments—while the market returned 17.9%.

If you have to trade, trade losers. The tax benefits of incurring a loss are likely better than the gains of selling a winner.

Part 2: The Basics 

Valuable for the novice and experienced investor alike, these 10 principles are essential to realizing returns. In A Random Walk Down Wall Street by Burton Malkiel, these principles are discussed in greater detail:

1) Start saving sooner rather than later.
2) Have cash reserves and insurance
3)Invest in mutual funds to make the most of your money
4) Don’t overpay on taxes
5) Understand your tolerance for risk and invest accordingly
6) Invest in Real Estate
7) Buy Bonds Wisely
8) Tread Carefully in Gold, Collectibles, and Commodities
9) Limit Costs Wherever You Can
10) Diversify your stocks

Age-Dependent Investing

In A Random Walk Down Wall Street, Burton Malkiel also discusses investments at different ages. Age may be the most important factor in deciding how to allocate your investments. For example, a fully employed 30-year-old, with many years of labor income ahead of her, can weather more losses (and thus tolerate more risk) than a retired 70-year-old who relies on his investment income to get by.

In terms of age-dependent investing, Malkiel’s advice boils down to this: The longer you’re able to hold on to your investments, the more common stock you should have in your portfolio.

For example, a fully employed person in their mid-twenties should have a high-risk allocation: 70% stocks, 15% bonds, 10% real estate, 5% cash. A person in their sixties and about to retire should have a low-risk allocation: 40% stocks, 35% bonds, 15% real estate, 10% cash.

Saving for (and in) Retirement

Retirees’ investment options depend on how much they’ve been able to save. 

For retirees with low savings, the options are narrow. Malkiel suggests continuing to work part time—which can have ulterior health benefits by keeping seniors active and social—and delaying taking Social Security for as long as possible to maximize those benefits. (Seniors in poor health with lower life expectancy might opt to begin taking Social Security as soon as possible to realize the benefits while they can.)

For retirees who’ve managed to build up a nest egg, there are two primary options: annuitizing your savings or holding onto your portfolio and establishing a spending rate. Malkiel recommends at least a partial annuitization of your retirement savings and, if you choose to manage your own investments, spending only 4% of the total value of your nest egg annually.

Annuities

An “annuity”—or “long-life insurance”—is a contract with an insurance company for regular payments as long as the purchaser lives.

Malkiel’s take is that while annuities offer the security of never running out of money, they can be tax inefficient and unwieldy, especially if you want to vary your spending year over year or leave a bequest to descendants.

Establishing Your Own Spending Rate

Retirees who opt to manage their investments themselves—or only annuitize a portion of their nest egg—should spend no more than 4% of their retirement savings annually (the “4% rule”).

First, 4% is likely to be below the average return rate of a diversified portfolio of stocks and bonds minus inflation. This means that the portfolio will continue to offset the reduction in purchasing power inflicted by inflation. 

Second, 4% protects you from the inevitable volatility in returns. If you limit your annual withdrawals in bull years, you create a backstop against bear markets

Picking Investments

Once you’ve determined the ideal asset allocation for your age, economic situation, and risk tolerance, the next step is to decide which precise securities to purchase. Malkiel proposes three strategies for picking stocks: The “autopilot” strategy, the “interested-and-engaged” strategy, and the “trust-the-experts” strategy.

The Autopilot Strategy

The autopilot strategy consists of purchasing broad index mutual funds or exchange-traded index funds (ETFs) rather than individual stocks or industries.

The autopilot strategy is Malkiel’s preferred method of investing. No matter how knowledgeable or engaged the investor, Malkiel advises building the core of a portfolio around index funds and only making active bets with excess cash.

While the S&P 500 index funds are generally the most popular type of index fund, Malkiel actually recommends that investors choose a total market index fund over an S&P 500 fund. This is because the S&P 500 index excludes smaller stocks that, historically and on average, have outperformed larger ones. Try to find a fund indexed to the Russell 3000, the Wilshire Total Market Index, the CRSP Index, or the MSCI US Broad Market Index. 

Of course, diversification is the key to a successful portfolio. But one need not abandon index funds to diversify: There are funds that track REIT, corporate bonds, international capital, and emerging market indices.

The Interested-and-Engaged Strategy

No matter what, for large sums like your retirement savings, a diverse portfolio of index funds is the strategy that Malkiel recommends. That said, some investors—for example, those with a taste for gambling—will find indexing an entire portfolio boring and may want to try their luck picking winners. Malkiel advises that thrillseekers only speculate with secondary monies that they can afford to lose, and that they follow four key principles.

Principle #1: Only buy stocks whose earnings growth promises to be above average for at least five years

Simply put, earnings growth is what produces winners. Not only do consistently above-average earnings boost dividends, they also result in higher price-earnings (P/E) multiples. That means higher capital gains on top of dividends.

Principle #2: Never overpay for a stock without a firm foundation of value

The ideal stock is reasonably priced with positive growth prospects. Although determining the precise value of a stock is effectively impossible, you can tell whether a stock is reasonably priced by comparing its P/E multiple to that of the market as a whole. If a stock’s P/E is well beyond the market’s, you might be wise to stay away. (Note that it’s OK to buy stocks with P/E multiples greater than market’s as long as growth prospects are above average as well.)

Principle #3: Keep an eye out for castles in the air, and take advantage

If you come across a firm-foundation stock around which buzz might build—for example, because the company is about to hire a charismatic CEO or debut a new technology—those are stocks worth purchasing. The key is to buy in before the builders of castles of air drive the price up.

Principle #4: Trade as little as possible

You should hold your purchases as long as possible, and, if you have to trade, sell your losers before your winners—the tax benefits of incurring a loss are likely to be more beneficial than the tax burden of realizing a gain.

The “Trust-the-Experts” Strategy

Some investors might prefer to entrust their money to a professional. But Malkiel’s years of studying actively managed mutual funds have yielded two key insights: One, that fund managers’ past performance has little bearing on future performance, and two, actively managed funds rarely beat the average market return for long.

The above overview of A Random Walk Down Wall Street by Burton Malkiel will help you understand the very best investment theories and tactics.

A Random Walk Down Wall Street by Burton Malkiel

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Elizabeth Shaw

Elizabeth graduated from Newcastle University with a degree in English Literature. Growing up, she enjoyed reading fairy tales, Beatrix Potter stories, and The Wind in the Willows. As of today, her all-time favorite book is Wuthering Heights, with Jane Eyre as a close second. Elizabeth has branched out to non-fiction since graduating and particularly enjoys books relating to mindfulness, self-improvement, history, and philosophy.

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