A Random Walk Down Wall Street

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing was first published in 1973 by Burton G. Malkiel. It has been considered an influential book with regard to investing strategies. Malkiel explores various investing techniques, such as fundamental and technical analyses, and concludes that neither of such investing strategies is more effective than the passive buy and hold strategy. The author also provides information on how to build and maintain an investment portfolio that comprises of various asset classes in the long-term (Malkiel, 2015). Malkiel is an ardent supporter of a weak efficient market theory. In other words, the market may not exhibit efficiency at all times. However, it is adequately efficient to ensure that it is extremely costly and difficult to circumvent it. The book describes the random walk theory, which draws on the assumption that it is not possible to predict future directions based on the past. In other words, past performance is not a surety of future. In framing his support of the random walk hypothesis, Malkiel argues that the random walk theory is a debate between Wall Street and Academic, and maintains that he supports the academic point of view. Using data, Malkiel illustrates that a great number of actively managed funds could not over perform the passive buy and hold indexes. Current paper is a book report on A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. The paper provides information based on Malkiel’s observations and gives notion on the fact that even Wall Street is not perfect. Essentially, there is no established proof method that an investor can use to manage his/her investment portfolio in a market that is constantly changing.

Summary

The book commences by outlining ways of evaluating the stocks. Malkiel points out the two general approaches used in evaluating stocks, which include the firm-foundation and the castle-in-the-air theory. Before delving deep into the approaches of stock evaluation, Malkiel describes what he means by a random walk. According to Malkiel, a random walk is a kind of statement that it is impossible to predict future directions using past actions. In the stock market context, a random walk implies the impossibility of predicting short-run variations in the prices of stocks. To this end, Malkiel argues that complex chart patterns, predictions of earnings, and investment advisory services are useless. The technical and fundamental analyses are often used by market professionals, whereas academics evade such techniques through complicating the random walk theory by outlining three versions of the theory, which are the strong, semi-strong, and the weak version. The author argues that returns on investment are dependent on the future events, albeit to varying extents. Therefore, the author considers investment as a gamble, whereby the success of the investment is determined by one’s ability to forecast future events. Conventionally, professionals in the investment community utilize the two aforementioned approaches.

According to the firm-foundation theory, each investment tool, whether a real estate or a stock, has a firm basis known as an intrinsic value. The intrinsic value can be computed using a thorough analysis of future prospects and current state of affairs. When the prices reduce below the firm-foundation of intrinsic value, an opportunity to buy emerges, since the variation will be corrected subsequently. Similarly, when the market prices exceed the firm-foundation of the intrinsic value, an opportunity to sell emerges. The firm-foundation theory maintains that the value of a stock should be based on the revenue that the firm can distribute in the future through dividends. Therefore, it is assumed that when the value of present dividends is greater and that they have a high increase rate, the value of the stock will be greater in the future. As a result, differential growth rate is considered a crucial factor when valuing stock. The castle-in-the-air places emphasis on psychic values. Professional investors prefer not to waste their energies computing the intrinsic values. Instead, they focus on evaluating the future behavior of investors and their tendency to build castles in the air during times of optimism. For an investor to be successful, he/she must be able to determine the investment situations that are likely to result in public castle-building, after which be purchases first before other investors. According to John Keynes Maynard, trends in the stock market can be understood. The castle-in-the-air theory is based on the assumption that an investment is valued at a certain price, since the investor anticipates selling the investment to a price that is higher. The castle-in-the-air theory received support from both the academic and financial quarters.

Malkiel further outlines the risks associated with using the castle-in-the-air and the firm-foundation theory in stock valuation. In particular, Malkiel compares the psychology of speculation to the “theater of the absurd”. According to the author, even though the castle-in-the-air approach can be used in elucidating speculative affairs, trying to predict and overcome the reactions of an erratic crowd is a dangerous undertaking. There is a possibility of unsustainable prices persisting for long periods of time. Malkiel goes further to provide examples of where such speculation failed from the 60s all through to the 90s (Malkiel, 2015). An example is the Tulip-Bulb Craze. During the seventeenth century, the tulip bulb was a common but an expensive item among the Dutch. The Dutch developed a craze for infected tulip flowers that had colored stripes. Following the trend, merchants started predicting the most popular form of tulip bulb that will be in demand in the subsequent years and embarked on stocking them in large quantities, while anticipating price were increasing. The prices of tulip bulbs increased significantly, and with the increase in price, people considered buying tulip bulb as a smart investment. With further price increase, people invested in tulip bulbs. However, with the prices increasing 20 times higher after many people have bought their bulbs, some individuals decided to sell their tulip bulbs, and soon, many people embarked on selling them. The outcome is that the prices of the bulb reduced significantly, which resulted in public panic (Malkiel, 2015). Other examples cited by Malkiel where the speculative psychology failed include the South Sea Bubble and the Internet Bubble. Malkiel argues that markets subsequently improve themselves, although in a slow manner (Malkiel, 2015).

The next section of the book focuses on the two fundamental approaches of stock valuation analysis, which are the fundamental and technical analyses. Technical analysis focuses on forecasting the most suitable time to purchase or sell a stock based on the castle-in-the-air valuation stock approach. On the other hand, fundamental analysis involves the application of the firm-foundation theory in choosing individual stocks. Essentially, technical analysis involves making and analyzing stock charts. Therefore, such practicing technical analyses are known as chartists or technicians. Majority of chartists are of the belief that the market is 90 percent psychological and only 10 percent logical. They adhere to the castle-in-the-air school of thought. For them, Malkiel points out that the investment game deals with anticipating the behavior of other players (investors). Charts are used to convey the past behavior of investors. Technical analysis is based on the hope that performing a careful analysis of other investors will provide important insights regarding their future behaviors. On contrast, fundamental analysis is of the view that the market is 10 percent psychological and 90 percent logical. Therefore, fundamental analysts maintain that the market will eventually reveal the real worth of stocks. Malkiel points out that 90 percent of stock analysts in the Wall Street are fundamental analysts (Malkiel, 2015).

For technical analysts, all information relating to the dividends, earnings, and the firm’s future performance is automatically found in the past market prices of the company. Technical analysis is also based on the principle that prices have a tendency to follow trends. Therefore, it is assumed that a stock that is rising will definitely continue rising, whereas stagnating stocks may depict similar trends in the future. Such trends can only be disrupted when something occurs that shifts the balance between demand and supply. Although Malkiel does not prefer the usage of the charting method, he provides a rationale for its use. First, Malkiel shows that trends might be observed as a result of the crowd instinct associated with mass psychology and unequal distribution and access to critical information regarding the firm. In terms of mass psychology, cumulative increases in prices can attract more investors. Malkiel also points out that chartists believe that accessing inside information and monitoring movements in prices is sufficient to enable them determine smart investments, which allow them to get an advantage over the general public. Malkiel also outlines situation where charting might not work as expected. It can be attributed to the fact that the chartist only purchases after the establishment of the price trends and sells stocks following the disruption of such trend. Due to the possibility of abrupt reversals in the trends, the chartist is not always able to control the situation. In other words, an uptrend signal may be late. A second scenario where the charting method may not work deals with the fact that the given techniques are undoubtedly self-defeating (Malkiel, 2015). It means that with more people using the charting method, the value associated with the technique declines.

While technical analysts place emphasis on the past records relating to the price of stocks, fundamental analysis is concerned with the real worth of stock. Malkiel points out that the most important task of the fundamental analyst is to compute the future dividends and earnings stream for the firm in the future. In order to perform the task, the fundamental analyst estimates the cost of capital, source of capital, depreciation policies, tax rates for corporate income, operating costs, and the sales figures for the firm. Since the general prospects of a firm depends on the industry’s economic position, the most logical starting point for fundamentalists is industry prospects. Malkiel outlines the reasons why the fundamental analysis might not work as an investment strategy. In such respect, the three possible flaws in fundamental analysis include the possibility of incorrect information and analysis, possibility of faulty estimates of the value, and the fact that the market may fail to correct itself resulting in a situation where the price may not converge at the estimated value. Moreover, there is a possibility that the stock analysts may not be able to translate the accurate facts into the correct forecasts of the earnings for the firm in the future. Even in a situation where the stock analysis performs a correct estimated growth, it is possible that the market may have already reflected such information. Another problem associated with fundamental analysis is that, even when the analyst has estimated the values and information correctly, the possibility of the stock prices reducing cannot be controlled (Malkiel, 2015). Simply stated, the market changes in a rapid manner, and so is the estimated growth.

Malkiel also discusses the use of both technical and fundamental analyses together in determining the attractiveness of an investment. He recommends three rules to be followed. First, investors must only purchase the stock of companies anticipated to exceed the above average growth for at least five years. Second, investors should not purchase stocks at a value that is higher that the firm-foundation value. Third, Malkiel recommends looking for stocks having expected growth stories, which may result in investors building castles in the air. Although the rules mentioned by Malkiel seem sensible, he raises concerns with respect to their effectiveness in determining the attractiveness of an investment.

The book also highlights the flaws associated with the technical and fundamental analyses in ascertaining the attractiveness of an investment. Malkiel states that he has not met a successful technical analyst yet. The author argues that the belief by technical analysts that the market has momentum is flawed. Malkiel uses past examples and studies to emphasize that past trends in stock prices are not reliable in predicting their future patterns. Malkiel also points out that even though positive correlations might exist between past, present and future movements in price, such correlations are small and tend towards zero. Malkiel also asserts that even though the market might not be a perfect random walk, potential systematic relationships that might exist are insignificant to an investor. An important revelation by Malkiel is that the buy and hold strategy is yet to be outperformed by either technical or fundamental analyses, which forms the basis of the random walk theory. In addition, the book reveals that the random walk is better suited to approximate the market than the trend-based strategies, even when erratic crowd behavior witnessed in the stock market. The author also points out that having small information regarding the pricing trends is not adequate to overcome the costs of transactions associated with initiating actions on that information.

According to Malkiel, there are two opposing sides with respect to the effectiveness of fundamental analysis in determining the attractiveness of an investment. Stock analysts at Wall Street are of the view that fundamental analysis is increasingly becoming a more powerful tool. Such view is also supported by Lo & MacKinlay (2011), who argue that the stock markets have some predictable elements and that they are not completely random as Malkiel states. However, academics maintain that fund managers together with their fundamentalists are not better than a rank amateur considering the process of picking stocks. Fundamentals analysis has been criticized on the basis that it is not capable of consistently predicting long-term growth because the growth is inexistent. The author also points out that, although some fundamental analysts report better than average return, studies do not show consistent pattern with respect to their performance. Fundamental analysis is further complicated by the impact of random events. Studies also show no significant differences in returns from investments managed by portfolio managers and analysts and buying unmanaged stocks. The fundamental argument preached by Malkiel in his book is that fundamental and technical analyses have not been able to outperform the buy and hold strategy. The efficient market hypothesis does not posit that the prices of stocks move in an erratic and aimless manner. By contrast, trends of prices follow a random walk because the market is very efficient. As a result, prices shift quickly with the emergence of new information. Such movement occurs quickly to an extent that the investors cannot purchase and sell stocks fast enough to profit. Moreover, news develops in a random fashion. Malkiel sides with academics, who maintain that investment professionals cannot outdo randomly chosen stock portfolios having the same risk characteristics. It is contrasted with the investment managers who are of the view that professionals outdo casual and amateur investors in questions regarding money management.

After evaluating the investment strategies, the following section of the book is dedicated to the modern portfolio theory (PMT), which focuses on the use of different risk levels with the aim of enhancing the total returns associated with a diversified portfolio. In the academic community, there is an agreement that assuming greater risk helps in beating the market. Only risk influences the level to which the returns on the investment will be below or above average. As a result, risk is an important aspect of stock valuation with respect to the market. Malkiel cites studies that have shown that greater risk translates to higher returns for investors. The author states that PMT is one of the strategies that investors can use to reduce risk. PMT draws upon the assumption that all investors have a negative attitude towards risk. For Malkiel, risky stock portfolios can be combined in a manner that the risk level of the portfolio as a whole is less when compared to the individual stocks found in the portfolio. Therefore, portfolio diversification plays an important role in reducing risk levels. In the context of stocks, Malkiel illustrates that holding 50 diversified US securities lessens the overall risk of the portfolio by an estimated 60 percent. The author further shows that including international securities in one’s portfolio may lower the risk. There are two forms of investment risk, which include systematic and unsystematic risks. The author also recommends global investors to include stocks from emerging markets in their portfolio. Diversification can also be achieved in terms of asset classes. For instance, real estate investment trusts can be included in the portfolio to lessen its overall volatility. Systematic risks refer to the impacts of the economy on the market as a whole, whereas unsystematic risks denote a risk that is specific to a particular firm, such as strikes and delayed product releases. Portfolio diversification helps in reducing unsystematic risk, although it cannot mitigate the overall systematic risk associated with the market. The underlying objective of the PMT is that variations in returns from one stock can be smoothened by a complementary difference in the returns obtained from the other stocks. The core factor used in determining the vulnerability of the stock to systematic risk is beta, although Malkiel is skeptical about such measurement. The author also points out that the stock market seems to operate using an efficient mechanism, which adjusts rapidly to the emergence of new information. In such way, neither fundamental nor technical analysis is capable of yielding consistent benefits. It is evident that the only way to achieve higher returns on investments in the long-term is by accepting higher risks.

The book also provides information on the disadvantages of the efficient market theory in stock markets with respect to risks. There are various authors who agree with Malkiel’s assertion that the predicting the stock market is an overstatement (Baird, 2009; Kirkpatrick & Dahlquist, 2010). Therefore, the authors support the use of the buy and hold strategy. Malkiel points out that no institution or individual cannot record consistent, long-term returns for risk-adjusted stocks, especially when they incur transaction costs and sub taxes. In addition, the author cautions investors against problems associated with pride, loss aversion, herding, bias, and overconfidence. Pride is characterized by persistently participating in bad investments. Loss aversion denotes the behavior when investments do not turn out as anticipated. Herding entails following the crowd, whereas bias is characterized by having an illusion of being in control. At the same time, overconfidence involves taking the risk. Malkiel also provides information on how investors can refrain from such behaviors. Several warm-exercises are also incorporated into the book to help prospective investors. The last part of the book provides practical evidence for people seeking to make use of the random walk approach to investing (Malkiel, 2015). The book also describes the historical returns of bonds and stocks and the trends in the stocks returns that have varied in the course of recent decades. The last chapters provide a description of the various portfolios for different profiles of investors, such as real estate, and cash.

Evaluation

Malkiel’s book is engaging and is relatively easy to follow. It stems from the fact that the arguments in the book are logically organized. Malkiel starts by discussing the approaches used in evaluating stocks and then proceeds to the investment strategies (techniques) used in determining the attractiveness of an investment. The investment techniques are the basic issues of the book. In this section, Malkiel performs an objective evaluation of the methods, including their strengths and weaknesses to conclude that they are not better than the buy and hold strategy. It is followed by a discussion on how investors can reduce risk using portfolio diversification. Lastly, the author provides practical recommendations for investors seeking to adopt the random walk approach in investing. The logical organization of arguments help in convincing the reader of the main argument being preached in the book: the stock market operates efficiently but it is adequately sufficient to an extent that it becomes extremely costly and difficult to beat it. Simply stated, the trends-based investment strategies, such as fundamental and technical analyses, are not better than the buy and hold strategy. Another crucial point is the importance of portfolio diversification. The author frames his argument on the side of the academic community against the Wall Street professionals, which further contributes to understanding the underlying issues articulated in the book. The writing is also effective in the sense that Malkiel employs examples and anecdotes in illustrating his points. For instance, the book outlines cases where the market speculation failed. Moreover, Malkiel consistent cites studies to support his arguments, which adds credence to the main points expressed in the book. In addition, the book contains data to compare the various investment strategies in an attempt to illustrate that technical and fundamental analyses are not superior to buy and hold strategy as frequently argued by the Wall Street professionals. Additionally, the credibility of the author cannot be compromised. Malkiel is a professor of economics at the Princeton University. Therefore, there is no doubt that he is well-aware of the subject matter. Overall, the book is an interesting for reading and is recommended for people seeking to venture into the investment activities.

Conclusion

In A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Malkiel advocates for a random walk approach to investment. The random walk denotes a stock market theory that posits that past movements of the overall market or the stock prices cannot be used in forecasting their future behavior. In other words, stocks may turn out to be unpredictable and random. Adherent of random walk maintain that outperforming the market is an impossible task unless a greater risk is assumed. Malkiel further maintains that fundamental and technical analyses are useless for investors and have to prove their efficiency in dealing with the markets. As a result, Malkiel maintains that the long-term buy and hold approach is the best alternative to timing the market based on predictions. Attempts made with the help of fundamental and technical analyses and other trend-based strategies may bring positive outcomes. Malkiel supports his arguments using statistics and empirical studies.