{"id":46422,"date":"2021-08-28T03:46:00","date_gmt":"2021-08-28T07:46:00","guid":{"rendered":"https:\/\/www.shortform.com\/blog\/?p=46422"},"modified":"2021-09-02T19:13:40","modified_gmt":"2021-09-02T23:13:40","slug":"a-random-walk-down-wall-street-by-burton-malkiel","status":"publish","type":"post","link":"https:\/\/www.shortform.com\/blog\/a-random-walk-down-wall-street-by-burton-malkiel\/","title":{"rendered":"A Random Walk Down Wall Street by Burton Malkiel"},"content":{"rendered":"\n

What can you learn from A Random Walk Down Wall Street<\/em> by Burton Malkiel? What are some of the best investment tactics?<\/p>\n\n\n\n

A Random Walk Down Wall Street <\/em>by Burton Malkiel is designed as an accessible guide to financial markets for the individual investor<\/strong>. The book covers everything from buying life insurance to pricing commodities to understanding credit default swaps<\/a>. But, for the most part, Malkiel\u2019s focus is on common stocks<\/strong>\u2014shares in individual firms\u2014and the stock market.<\/p>\n\n\n\n

Keep reading for an overview of A Random Walk Down Wall Street <\/em>by Burton Malkiel.<\/p>\n\n\n\n\n\n\n\n

A Random Walk Down Wall Street<\/em> by Burton Malkiel: Overview<\/h2>\n\n\n\n

In A Random Walk Down Wall Street<\/em> 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<\/strong>. If you only take one thing away from A Random Walk Down Wall Street<\/em> by Burton Malkiel, it should be this: Investors are better off putting their money in a passively managed index fund<\/strong>\u2014a total market<\/em> index fund, to be precise\u2014than 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\u2019ve only had $817,741.<\/p>\n\n\n\n

The one-page summary is divided into two parts. The first part covers the first three parts of A Random Walk Down Wall Street<\/em>, guiding you through the key financial concepts Malkiel discusses as well as \u201cMalkiel\u2019s Take\u201d on those concepts. The second part covers Malkiel\u2019s practical investment tips.<\/p>\n\n\n\n

Part 1: Firm Foundations vs. Castles in the Air<\/strong><\/h2>\n\n\n\n

There are two basic theories for stocks\u2019 valuation, one based on stocks\u2019 actual characteristics<\/strong>, another based solely on human psychology<\/strong>.<\/p>\n\n\n\n

The Firm-Foundation Theory<\/h3>\n\n\n\n

The firm-foundation theory holds that assets have an \u201cintrinsic value\u201d based on their present conditions and future potential. <\/strong>The firm-foundation theorist will calculate the stock\u2019s intrinsic value by summing (1) the value of its present dividends and (2) the estimated growth of its dividends in the future.<\/p>\n\n\n\n

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<\/strong>).<\/p>\n\n\n\n

The Castle-in-the-Air Theory<\/h3>\n\n\n\n

The castle-in-the-air theory of asset valuation holds that an asset is only worth what someone else will pay for it<\/strong>. In other words, no asset has an \u201cintrinsic value\u201d that can be determined analytically or mathematically; rather, the value of an asset is purely psychological<\/strong>\u2014it\u2019s worth whatever the majority of investors think <\/em>it\u2019s worth.<\/p>\n\n\n\n

A castle-in-the-air investor makes her money by investing in stocks she thinks <\/strong>other investors <\/em><\/strong>will value<\/strong>.<\/p>\n\n\n\n

Malkiel\u2019s Take<\/strong><\/h3>\n\n\n\n

There are glaring flaws with both theories of stock valuation.<\/p>\n\n\n\n

With the firm-foundation theory<\/em>, the problem is its reliance on future estimates<\/strong>. No analyst can know for certain how much or how long a stock\u2019s dividends will grow\u2014or even if they\u2019ll grow at all<\/strong>. <\/p>\n\n\n\n

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

Technical Analysis vs. Fundamental Analysis<\/strong><\/h3>\n\n\n\n

The two primary methods of security analysis that financial professionals use are technical analysis and fundamental analysis<\/a>.<\/p>\n\n\n\n

Technical Analysis<\/h4>\n\n\n\n

Technical analysis<\/a> relies on stock charts\u2014graphs of past price movements and trading volumes\u2014to predict future <\/em>price movements.<\/p>\n\n\n\n

Technical analysts adhere to two primary principles: (1) that all economic data\u2014revenues, dividends, and future performance\u2014are reflected in a stock\u2019s past prices<\/strong>; and (2) that stock prices tend to follow <\/strong>trends<\/em><\/strong> (if a price is rising, it will continue to rise, and vice versa).<\/p>\n\n\n\n

Fundamental Analysis<\/h4>\n\n\n\n

Fundamental analysis<\/a> attempts to predict a firm\u2019s <\/strong>future earnings and dividends by in-depth study<\/strong>. Fundamental analysts pore over firms\u2019 balance sheets, earnings reports, and tax rates; they even, on occasion, pay personal visits to companies to assess their management teams. <\/p>\n\n\n\n

Fundamental analysts also study the industry <\/em>in which a company is operating. They do so to understand what is making current companies successful in that space<\/strong>\u2014so they can recognize an innovator when it comes along. <\/p>\n\n\n\n

Malkiel\u2019s Take<\/strong><\/h4>\n\n\n\n

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

Regarding technical analysis<\/em>, the key finding among researchers is that a stock\u2019s past performance is no indication of its future performance<\/strong>. (In fact, stocks\u2019 price movements resemble a \u201crandom walk\u201d that\u2019s similar to the results of flipping a coin.) Any method of analysis that relies on stocks\u2019 \u201cmomentum\u201d\u2014whether a stock is generally moving either up or down\u2014is sure to prove faulty.<\/p>\n\n\n\n

Regarding fundamental analysis, <\/em>no matter how lucid and well-founded a fundamentalist\u2019s value determination is, he or she simply cannot account for randomness<\/strong>\u2014the 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.<\/p>\n\n\n\n

There\u2019s also the problem of bad actors<\/strong>. Firms can fudge their earnings reports, leading fundamental analysts astray. And fundamentalists\u2019 reports can be unduly influenced by their own employer\u2019s clients, resulting in conflicts of interest in their buy or sell recommendations.<\/p>\n\n\n\n

Modern Portfolio Theory<\/strong><\/h3>\n\n\n\n

Modern Portfolio Theory<\/a> (MPT) builds on the \u201cefficient market hypothesis\u201d (EMH), which holds that stock prices already reflect all relevant information<\/em>. According to the EMH, no analyst can determine whether a stock is under- or overvalued, and thus there\u2019s no way for an analyst to \u201cbeat\u201d the market<\/strong>. The only way to realize greater returns is to take on more risk<\/strong>.<\/p>\n\n\n\n

Modern Portfolio<\/a> Theory (MPT) offers a strategy of managing that risk: diversification.<\/strong><\/p>\n\n\n\n

A diversified portfolio<\/a> is one that features holdings in a variety of industries, countries, and asset classes. <\/strong>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.<\/p>\n\n\n\n

Malkiel\u2019s Take<\/strong><\/h4>\n\n\n\n

Malkiel, who accepts the EMH as a given, is a firm believer in the benefits of diversification<\/a>, especially international diversification<\/strong>. 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). <\/p>\n\n\n\n

Systematic Risk (Beta) vs. Unsystematic Risk <\/strong><\/h3>\n\n\n\n

MPT led to a number of advances in the analysis of risk, including the distinction between unsystematic risk <\/em>and systematic risk<\/em>.<\/p>\n\n\n\n

Unsystematic risk describes the variability in a stock\u2019s returns due to aspects of the stock in particular<\/strong>, whereas systematic risk describes a stock\u2019s sensitivity to shifts in the stock market in general<\/strong>. <\/p>\n\n\n\n

The key characteristic of systematic risk, better known as \u201cbeta,\u201d is that it cannot be diversified away <\/strong>by strategies like MPT. And researchers found that because<\/em> it can\u2019t be diversified away, beta is the only kind of risk that pays a \u201crisk premium\u201d<\/strong>\u2014that is, a higher return for the higher risk.<\/p>\n\n\n\n

Beta forms the starting point for a number of investment technologies including the \u201ccapital asset pricing model\u201d (CAPM), which calculates an asset\u2019s expected return based on its beta (among other factors) and \u201csmart beta,\u201d which involves the customization of indexed portfolios to lower risk. <\/p>\n\n\n\n

Malkiel\u2019s Take<\/strong><\/h4>\n\n\n\n

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\u2019t result in greater returns<\/strong>.<\/p>\n\n\n\n

Nevertheless, beta does <\/em>accurately describe risk, and so investors with little stomach for volatility can gravitate to stocks with low betas\u2014which, the research shows, will produce the same returns in the long run as stocks with high betas<\/strong>.<\/p>\n\n\n\n

(\u201cRisk parity,\u201d another newer investment strategy, advocates investing heavily in low-beta assets<\/strong>. The way risk parity generates risk\u2014and thus greater reward\u2014is by encouraging investors to invest on margin<\/strong>.)<\/p>\n\n\n\n

Behavioral Finance<\/strong><\/h3>\n\n\n\n

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

Malkiel\u2019s Take<\/strong><\/h4>\n\n\n\n

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:<\/p>\n\n\n\n

1) Don\u2019t Follow the Crowd<\/strong><\/p>\n\n\n\n

Studies in behavioral finance have shown that word of mouth<\/a> is a frequent driver of stock purchases<\/strong>. When some new investment is the talk of the town, it\u2019s natural to want to take part. But resist the urge<\/strong>: Stocks or funds that are hot one quarter are almost invariably losers the next. It\u2019s generally better to stick with \u201cvalue\u201d stocks<\/strong>\u2014securities issued by tried-and-true companies with steady revenues\u2014than gamble on \u201cgrowth\u201d stocks with high risk.<\/p>\n\n\n\n

2) Don\u2019t Overtrade<\/strong><\/p>\n\n\n\n

When investors trade to realize short-term gains, they tend to incur high transaction costs and taxes<\/strong>. One study of 66,000 households found that the households that traded the most earned an 11.4% return on their investments\u2014while the market returned 17.9%<\/strong>.<\/p>\n\n\n\n

If you have to trade, trade losers. <\/strong>The tax benefits of incurring a loss are likely better than the gains of selling a winner.<\/p>\n\n\n\n

Part 2: The Basics <\/strong><\/h2>\n\n\n\n

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

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\u2019t 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<\/p>\n\n\n\n

Age-Dependent Investing<\/strong><\/h3>\n\n\n\n

In A Random Walk Down Wall Street,<\/em> Burton Malkiel also discusses investments at different ages. Age may be the most important factor in deciding how to allocate your investments<\/strong>. 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.<\/p>\n\n\n\n

In terms of age-dependent investing, Malkiel\u2019s advice boils down to this: The longer you\u2019re able to hold on to your investments, the more common stock you should have in your portfolio<\/strong>.<\/p>\n\n\n\n

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

Saving for (and in) Retirement<\/strong><\/h4>\n\n\n\n

Retirees\u2019 investment options depend on how much they\u2019ve been able to save. <\/p>\n\n\n\n

For retirees with low savings<\/em>, the options are narrow. Malkiel suggests continuing to work part time<\/strong>\u2014which can have ulterior health benefits by keeping seniors active and social\u2014and delaying taking Social Security<\/strong> 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.)<\/p>\n\n\n\n

For retirees who\u2019ve managed to build up a nest egg<\/em>, there are two primary options: annuitizing your savings<\/strong> or holding onto your portfolio and establishing a spending rate<\/strong>. Malkiel recommends at least a <\/strong>partial<\/em><\/strong> annuitization <\/strong>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<\/strong>.<\/p>\n\n\n\n

Annuities<\/h4>\n\n\n\n

An \u201cannuity\u201d\u2014or \u201clong-life insurance\u201d\u2014is a contract with an insurance company for regular payments as long as the purchaser lives<\/strong>.<\/p>\n\n\n\n

Malkiel\u2019s take is that while annuities offer the security of never running out of money, they can be tax inefficient and unwieldy, <\/strong>especially <\/strong>if you want to vary your spending year over year or leave a bequest to descendants.<\/p>\n\n\n\n

Establishing Your Own Spending Rate<\/h4>\n\n\n\n

Retirees who opt to manage their investments themselves\u2014or only annuitize a portion of their nest egg\u2014should spend no more than 4% of their retirement savings annually <\/strong>(the \u201c4% rule\u201d).<\/p>\n\n\n\n

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

Second<\/em>, 4% protects you from the inevitable volatility in returns<\/strong>. If you limit your annual withdrawals in bull years, you create a backstop against bear markets<\/strong>. <\/p>\n\n\n\n

Picking Investments<\/strong><\/h3>\n\n\n\n

Once you\u2019ve determined the ideal asset allocation for your age, economic situation, and risk tolerance, the next step is to decide which precise securities to purchase<\/strong>. Malkiel proposes three strategies for picking stocks<\/a>: The \u201cautopilot\u201d strategy<\/strong>, the \u201cinterested-and-engaged\u201d strategy<\/strong>, and the \u201ctrust-the-experts\u201d strategy<\/strong>.<\/p>\n\n\n\n

The Autopilot Strategy<\/strong><\/h4>\n\n\n\n

The autopilot strategy consists of purchasing broad index mutual funds or exchange-traded index funds (ETFs) <\/strong>rather than individual stocks or industries.<\/p>\n\n\n\n

The autopilot strategy is Malkiel\u2019s preferred method of investing. No matter how knowledgeable or engaged the investor, Malkiel advises building the core of a portfolio around index funds<\/strong> and only making active bets with excess cash<\/strong>.<\/p>\n\n\n\n

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<\/strong> over an S&P 500 fund. This is because the S&P 500 index excludes smaller stocks<\/strong> that, historically and on average, have outperformed larger ones<\/strong>. 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. <\/p>\n\n\n\n

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<\/strong>.<\/p>\n\n\n\n

The Interested-and-Engaged Strategy<\/strong><\/h4>\n\n\n\n

No matter what, for large sums like your retirement savings<\/strong>, a diverse portfolio of index funds is the strategy that Malkiel recommends. That said, some investors\u2014for example, those with a taste for gambling\u2014will find indexing an entire portfolio boring and may want to try their luck picking winners. Malkiel advises that thrillseekers only speculate with secondary monies <\/strong>that they can afford to lose, and that they follow four key principles.<\/p>\n\n\n\n

Principle #1: Only buy stocks whose earnings growth promises to be above average for at least five years<\/h5>\n\n\n\n

Simply put, earnings growth is what produces winners<\/strong>. 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<\/strong>.<\/p>\n\n\n\n

Principle #2: Never overpay for a stock without a firm foundation of value<\/h5>\n\n\n\n

The ideal stock is reasonably priced with positive growth prospects<\/strong>. Although determining the precise value of a stock is effectively impossible, you can <\/em>tell whether a stock is reasonably priced by comparing its P\/E multiple to that of the market as a whole. If a stock\u2019s P\/E is well beyond the market\u2019s, you might be wise to stay away<\/strong>. (Note that it\u2019s OK to buy stocks with P\/E multiples greater than market\u2019s as long as growth prospects are above average as well<\/strong>.)<\/p>\n\n\n\n

Principle #3: Keep an eye out for castles in the air, and take advantage<\/h5>\n\n\n\n

If you come across a firm-foundation stock around which buzz might build\u2014for example, because the company is about to hire a charismatic CEO or debut a new technology\u2014those are stocks worth purchasing<\/strong>. The key is to buy in before the builders of castles of air drive the price up.<\/p>\n\n\n\n

Principle #4: Trade as little as possible<\/h5>\n\n\n\n

You should hold your purchases as long as possible<\/strong>, and, if you have to trade, sell your losers before your winners<\/strong>\u2014the tax benefits of incurring a loss are likely to be more beneficial than the tax burden of realizing a gain.<\/p>\n\n\n\n

The \u201cTrust-the-Experts\u201d Strategy<\/strong><\/h4>\n\n\n\n

Some investors might prefer to entrust their money to a professional. But Malkiel\u2019s years of studying actively managed mutual funds have yielded two key insights: One, that fund managers\u2019 past performance has little bearing on future performance<\/strong>, and two, actively managed funds rarely beat the average market return for long<\/strong>.<\/p>\n\n\n\n

The above overview of A Random Walk Down Wall Street by Burton Malkiel will help you understand the very best investment theories<\/a> and tactics.<\/p>\n","protected":false},"excerpt":{"rendered":"

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\u2019s focus is on common stocks\u2014shares in individual firms\u2014and the stock market. Keep reading for an overview of A Random Walk Down Wall Street by Burton Malkiel.<\/p>\n","protected":false},"author":12,"featured_media":47478,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[40,81,31],"tags":[469],"class_list":["post-46422","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-books","category-economics","category-money","tag-a-random-walk-down-wall-street","","tg-column-two"],"yoast_head":"\nA Random Walk Down Wall Street by Burton Malkiel - Shortform Books<\/title>\n<meta name=\"description\" content=\"What can you learn from A Random Walk Down Wall Street by Burton Malkiel? 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