PDF Summary:A Random Walk Down Wall Street, by Burton G. Malkiel

...

Whatever your priority, if you only take one thing from Malkiel’s book, 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.

...

Keynes’s understanding of the castle-in-the-air theory made him a fortune. His process was as follows: Because no one can know with any certainty the future revenues or dividends of a given stock, he invested based on what he thought other investors would value. For example, if he sensed there was prevailing optimism in a certain sector of the economy, say in steel production, he would invest in steel companies regardless of their underlying fundamentals, simply because he anticipated other investors would soon rush into steel.

The key to the castle-in-the-air theory is timing: The successful investor will buy an asset just before mass enthusiasm causes its price to rise and sell before that enthusiasm wanes. A less charitable name for the castle-in-the-air theory is the “greater fool” theory—the less attuned an investor is to the prevailing winds, the more likely she’ll end up owning a stock that’s worth far less than she paid for it.

...

The Great Crash of 1929

Speculative crazes like the tulipmania in Holland and the South Sea Bubble in 18th-century England—during which a trading firm called the South Sea Company rose in value by nearly 700% in a matter of months and fell by the same amount shortly thereafter—aren’t just a thing of the distant past. The stock market crash of 1929, which precipitated the Great Depression, is another example of irresponsible castle-in-the-air thinking.

Wide prosperity in the U.S. had boosted the stock market, and increased optimism among investors, and investing on margin—that is, borrowing to speculate in the stock market—had become commonplace. Traders were also engaging in some unsavory practices, like forming investment pools, to manipulate stock prices. (An investment pool consisted of a group of traders who would collude to bid up a stock price and then sell once those outside the pool began buying the stock.)

A key indicator of investors’ irrational optimism was the price of shares of closed-end funds. (Closed-end funds are pooled assets managed by an investment company, in which investors can buy shares.) Shares in these funds typically sell at small discounts...

...

The Conglomerate Boom

Firms were able to impart the perception of growth by absorbing companies of equal or lesser value, often in wildly different industries from themselves. The crux of this boom was, again, the price-earnings multiplier: As a conglomerate absorbed more companies, thereby raising earnings, its multiplier would grow as well—but the multiplier would often outpace the actual earnings. When the conglomerates’ earnings came in far lower than the multiplier’s calculation, prices tumbled.

The Rise of “Concept” Stocks

In the later years of the decade, risk-taking fund managers banked on so-called “concept” stocks—shares in firms with a dynamic leader or good “story.” Of course, in many cases, the stories were too good to be true—the firms had no revenue-generating potential, and the stock prices were revealed to be absurdly inflated.

The 1970s

The Turn to Blue-Chip Companies

After the boom and bust of conglomerates and concept stocks in the ’60s, finance professionals placed their bets on so-called “blue-chip” companies: Firms with household names, like IBM, Disney, and McDonalds, whose growth potential was taken for granted....

...

Of course, this is precisely what happened. In January of 2000, the price-earnings multiples of stocks in the NASDAQ Index—the index of technology and Internet stocks—were over 100, and investors expected returns of between 15 and 25 percent on Internet stocks. When the bubble burst later in the year, many Internet stocks became worthless, and blue-chip Internet stocks like Cisco and Amazon lost 86.5% and 98.7% of their value.

(Shortform note: From a high of $75.25 in 2000, Amazon fell to a low of $5.51 in 2001–2002. In May 2020, Amazon stock traded for $2,411.03.)

The Role of Finance Professionals

Driving the absurdly bullish attitude toward tech stocks were the finance professionals with whom many Americans trust their life savings.

One major moral hazard that encouraged financial professionals’ magical thinking was the porous boundary between Wall Street firms’ research and investment banking arms. An investment company’s analysts are supposed to work on behalf of investors, communicating information as truthful and accurate as possible to the ones risking their money. A firm’s investment banking business, on the other hand,** caters to corporate clients who...

...

In practice, what this means is that technical analysts will study a stock’s charts to deduce trends. If there’s an “uptrend”—in other words, the stock price has risen over the course of a day or several days—then the chartist will be bullish on the stock. A head-and-shoulders pattern—where there’s a rise and fall, a greater rise and fall, and then a rise and fall similar to the first—indicates that a stock may have reached its “resistance level” and is due for a downturn.

Does Technical Analysis Have Any Validity?

Despite its seeming arbitrariness, technical analysis does indeed have a logic.

• Technical analysts bank on mass psychology. They presume that when investors see a stock rising, they’ll hop on the bandwagon, driving the price even higher.
• Technical analysts assume unequal access to information. If a price is rising, chartists theorize that company insiders or more expert observers know something the wider market doesn’t and are driving up the price by buying stock.
• Technical analysts believe prices have a delayed reaction to new information. Some research suggests that when “earnings surprises,” either good or bad, for a company are...

...

Generally speaking, the fundamentalist investor will pay a higher price for stock in a high-growth company (especially if that company is built to last).

Principle #2: Accept a Higher Price for Large Dividends

Depending on a company’s size, management, and capital strategy, the percentage of a company’s earnings paid out in dividends will vary. Which presents a dilemma for investors: Should one invest in a high-growth-potential stock that pays near zero in dividends (as high-potential stocks commonly do)? Or go with a near-peak company that pays out a lot in dividends but won’t grow much larger?

If two companies have the same expected growth rate (in other words, the same or similar P/E multiples), the fundamentalist investor will pay a higher price for the company that disburses a higher proportion of earnings as dividends.

Principle #3: Accept a Higher Price the Less Risky the Stock

Stock prices often reflect the relative risk of an investor’s stake. For example, a “blue chip” stock—that is, stock in a well-established company more or less resilient to recessions—will sell at a premium, whereas shares in an unproven company will likely be...

...

Economists of finance typically define risk in terms of returns’ “variance” from the mean return. Simply put, the more widely dispersed real returns are around the average, the more risky the stock. For example, consider Stock 1, whose returns over the last three years are -5%, 0%, and 5%. The mean return for Stock 1 is 0%. Now examine Stock 2, whose returns over the last three years are -25%, 3%, and 22%. The mean return for Stock 2 is also 0%, but the variance is greater due to the wider dispersion around the mean—that is, an investor in Stock 2 will be assuming more risk.

How MPT Manages Risk

Essentially, MPT mitigates a portfolio’s overall risk by offsetting the risks of certain stocks with those of other stocks. These various levels of risk are determined by analyzing the “covariance”—that is, the relative variance—between two or more stocks and deducing a “correlation coefficient”—a single number between 1 and -1 that defines their relation.

For example, take two stocks, one an airline company, another a commercial aircraft manufacturer. If real-world events—say, a global pandemic—severely reduce consumers’ air travel, both stocks will suffer...

...

A stock’s “systematic” risk—its “beta”—consists in its sensitivity to the stock market in general. For example, say that the biopharma company we’ve been discussing has received funds for five years of work. For those five years, the company might have relatively low systematic risk—given the fact its funding is already in hand, its operations might not be much affected by market volatility.

As you might expect, beta cannot be diversified away. This is because all stocks, to some degree or other, parallel the market (that is, when the market falls, by definition so too do stocks in general). At least in terms of common stocks, there is no such thing as a risk-free investment; even the most diversified holdings—for example, those contained in a broad market index fund—entail some risk.

Individual betas are calculated using relatively high-level mathematics, but the concept behind the math is simple: A stock’s beta consists in a comparison of its price movements over a certain period of time with the market’s movements over that same period.

In practice, beta analysis looks like this: A broad market index is assigned a beta of 1, and stocks’ betas...

...

Four Flavors

Four common portfolio flavors that investors tend toward include:

Value

Preached by early investment sages like David Dodd and Benjamin Graham—and later adopted by Warren Buffett—“value” investing consists in buying stocks with (1) low price-earnings multiples and (2) low price–book value ratios. More rudimentarily, it means investing in companies that are realizing revenues currently and consistently rather than those promising exponential future growth.

Small Companies

A portfolio flavored in favor of smaller stocks may result in larger returns. One study examined returns from 1926 to the present and found small-company stocks produced returns about 2% higher than large-companies’. The Sharpe ratio of small-company stocks over approximately the same period was .23—which means that a diversified portfolio with a tilt toward smaller stocks might raise the overall portfolio’s ratio above the market’s.

Momentum

As noted above, in the long run, there’s no discernable “momentum” in stocks’ prices—rather, their price increases and decreases resemble a “random walk.” However, in the short run, **there is some evidence to...

...

As always, a buy-and-hold strategy is superior to trying to beat the market.

3) Sell Losers, Not Winners

If you do decide to trade, make sure you sell your losers, not your winners.

Most investors think it’s best to unload stocks that have risen in value (to realize a gain) and hold on to stocks that have declined in value (to avoid realizing a loss). As noted above, selling a winning stock can result in prohibitive tax liability.

And although holding on to a sinking stock can be worthwhile—if the stock has a chance to rebound—it’s often better to unload that stock and realize the tax breaks of the loss.

4) Don’t Fall for IPOs

Even the savviest investors are prone to falling for “get rich quick” schemes, and few are as prevalent and as pernicious as highly publicized initial public offerings.

Simply put, an individual investor should never buy an IPO at its initial price. Though the stock may pop right after trading begins—because institutional investors are snapping up the stock at the offering price—studies have shown that IPOs underperform the stock market by about 4% per annum. And it’s common to see** IPO values drop exactly six...

...

Although the high-premium products have advantages—primarily tax-free contributions—the commissions and fees can be prohibitive. Thus Malkiel favors buying low-premium term insurance and investing the difference between the high-premium product and the low-premium product in a tax-deferred retirement plan.

(The same advice applies to variable-annuity products, which typically tack on an insurance feature to an investment product like a mutual fund. These products often entail steep commissions and fees—unnecessary expenses for the typical investor. Only extremely high-wealth individuals who’ve maxed out all other tax-deferred alternatives should consider annuities.)

Ideally, the term insurance product will be renewable without the need for a doctor’s visit and feature an “A” rating from A.M. Best (don’t buy anything with a rating lower than “A”). And you should shop around for the best product on your own rather than consulting an insurance agent—the agent’s commission will be tacked onto your premium payment.

Principle #3: Set Up Your Cash to Keep Pace With Inflation

Keeping a robust cash reserve is essential for emergencies, but it can also be a losing...

...

To calculate returns in the short run, investors must include a third term: the price/earnings multiple. (Analysts will also sometimes use the price/dividend multiple). These ratios of share price to earnings/dividends are highly variable year to year, and so they better reflect the impact of short-run market conditions on returns.

Take Thingamajig again. You’ve bought a share at $100, with a dividend yield of 5% and an estimated annual growth rate of 5%. Let’s say Thingamajig reports earnings of $10 per share. That means its P/E multiple is 10 (because a share of Thingamajig sells for 10x its per-share earnings). Now, imagine a year after you bought Thingamajig, the market enters a recession, and its price plummets to $50. Even if earnings and dividends stay constant, you end up with a lower return at the end of that year—because the P/E multiple has been reduced by half.

The Decline of Dividends

Some security analysts argue that dividends are no longer a useful indicator of future returns. This is because more and more companies are electing to distribute profits to shareholders through stock buybacks rather than dividends.

The rationale for...

...

Bonds, too, mellow with age. If you’re able to hold a bond until maturity, you should see a return at or near the initial yield. If you have to sell the bond a year after you’ve purchased it, though, you might see a null or negative return.

As noted above, the longer you can hold onto your investments—that is, if you’re currently earning a wage and have no need to sell assets to maintain your quality of life—the more common stock you should have in your portfolio. If you’re past working age and need a reliable stream of income from your investments, a higher concentration of bonds is the more prudent choice.

3) Reduce Risk Further With Dollar-Cost Averaging

Dollar-cost averaging is simply a fancy term for investing in fixed amounts at regular intervals over a long period of time. The classic example is electing to contribute some percentage of your monthly paycheck to a 401(k). By investing regularly and in consistent amounts over an extended period, you mitigate the risk of buying into the market at inflated prices (because the market will fluctuate over the period you’re investing).

For example, if you had made an initial investment of $500...

...

Not only are returns better with broad market index funds, fees and expenses tend to be, too. Because index funds are passively managed—that is, they adjust their holdings more or less automatically on the basis of market values—they tend to have extremely low expense ratios (.0005% or less for some). And because index funds only trade to rebalance their weights, they incur low trading costs as well.

While the S&P 500 index funds are generally the most popular type of index fund—and they will outperform actively managed funds on average—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, as Modern Portfolio Theory teaches (see Chapter 8), 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...

...

Simply put, as far Malkiel is concerned, index funds are a clear positive for individual investors—and for society as a whole.