I Took A Random Walk...

Burton G. Malkiel, a Princeton economist, originally published A Random Walk Down Wall Street in 1973. Since then the book has sold well over a million copies and been updated for a new generation of investors. Malkiel discusses various approaches to investing on his premise that, “buying and holding all the stocks in a broad stock-market average was likely to outperform professionally managed funds whose high expense charges and large trading costs detract substantially from investment returns.” An important distinction made by Malkiel for the audience is that he intends to discuss and advocate for the act of investing rather than investment speculation. Candidly, he compares financial analysts who boast their valuations to a bare-assed monkey, claiming that both are equally fit to pick stocks. A Random Walk Down Wall Street is intended to establish confidence in the curious investor by providing tangible evidence and commentary supporting his thesis. It is Malkiel’s hope that we will emphasize the act of investing rather than expending energy on hollow speculation.

A theme in A Random Walk Down Wall Street is human psychology. He affectionally refers to stock psychology as crowd madness, citing several bubble crazes as evidence. One such instance of emotion trumping proper analysis is the tulip bubble craze. Tulip bulbs were introduced to Leyden from an Austrian professor looking to sell them at a profit, while he was unsuccessful the Dutch became fascinated with the beautiful flower. Slowly, demand grew, and bulbs were being bought a year ahead in enormous quantities. Then, tulipmania became a ubiquitous trade; surpassing other industries the tulip business cemented its place as the economic driver. For three years between 1634 and 1637 this craze escalated, and real financial instruments facilitated the practice. Call options gave the holder the right to purchase bulbs that may cost 100 guilders for only 20 guilders. The return with options proved to offer better return and motivate larger participation in the market. Financial historian, Peter Garber, analyzed this period to better understand how tulips rose to economic prominence. His findings indicate that bulbs were always highly prized for their beauty, but he finds no resolve on the issue of how they experienced a twenty-fold increase in price. Naturally, prices being what they were, people were inclined to sell. The mass sell-off sent the market to a deflation, prices fell, dealers went bankrupt, and finally the bulbs were worthless flowers. Malkiel makes the point that the tulipmania and subsequent crazes are indicative of the folly in group think behavior. He asserts that the losers in the market are those who throw money at get rich quick investments. Author Gustave Le Bon notes, “skyrocketing markets that depend on purely psychic support have invariably succumbed to the financial law of gravitation.” Light as a flower may be, it must certainly float down if we are to toss it high in the air.

A critique Malkiel makes of investment analysis is of technical practices. This is the practice of utilizing historical price movements to determine future patterns for a stock. For the elementary investor this data is proof enough to invest or pass on a certain stock. Malkiel suggests that this technique, while common, is overrated. He cites Richard Quandt to draw on a metaphor, "technical analysis is akin to astrology and every bit as scientific.” It is certainly not Malkiel's claim that technical analysis cannot earn someone a quality return but rather that the proportion of effort to results lacks. Reminding us that he wrote the book for the favor of the reader's wallet, he argues that after an investor pays taxes and transaction fees, they won't do much better than if they simply employed a buy-and-hold strategy. He acknowledges that a stock chart seemingly reveals patterns over time, but he asserts that even this supposed statistical evidence is refutable. To illustrate this Mallkiel conducted an experiment with his students: Let a hypothetical stock start at $50.00 and flip a coin, heads will move the stock 0.5 points higher with a tails flip moving the stock down 0.5 points. The charted results resembled the look of any standard stock chart, there were highs and lows and even patterned cycles. Observed on a stock chart, these cycles are supposedly meaningful investment measures. On a coin flip chart, the cycles are of course, meaningless. Malkiel draws the conclusion that stock cycles are, "no more true cycles than the runs of luck or misfortune of the ordinary gambler.” Continuing with the theme of investor psychology, Malkiel proposes a question of why, if technicians are overrated, do we continue to turn to their analysis? His belief is that humans aren't equipped for the mental burden of randomness. His belief is not unfounded; human psychology tells us that we often will seek out patterns in purely random circumstances. Malkiel finds this to be true in basketball philosophy. Many would agree that if LeBron James made the last 10 jump shots, he has a better likelihood to make the 11th, he's got the hot-hand. The flawed assumption is that each new shot is related to the last when they are in fact completely independent actions. The same is true with investment, if shares in Tesla get the "hot hand" then it is likely that investors will rave about the stock more than they should.

The third part of the book focuses on investment technologies. One such technology is the Capital-Asset Pricing Model (CAPM), developed by John Lintner and Fischer Black. The logic of the model is, "there is no premium for bearing risk that can be diversified away.” Malkiel explains that a strong investor can perform better than the market by using the Beta risk measure. Beta is defined as a measure of systematic risk or volatility. The calculation of Beta is performed by assigning a "1" to a market index, if we judge a stock to have a beta of 3 then it swings three times as far as the market. Malkiel notes that systematic risk defined by Beta is in tandem with market changes and that it is not possible to diversify off this type of risk. Instead, an investor can successfully diffuse unsystematic risk through diversification. This variation of risk refers to events that are independent of the market and exclusive to a company: Enron's fraudulent accounting scandal. Understanding this distinction strengthens the integrity of the CAPM theory. An analyst working prior to CAPM inception might incorrectly judge a portfolio as having a stronger return than another because certain stocks are riskier. Analysts today look to beta in the capital asset pricing model to separate the two categories of risk, and better measure reward relative to risk.

Malkiel aims to empower his reader with practical guidance in the fourth part of the book. He cites finance professional, Roger Ibbotson, who claims, "more than 90% of an investor's total return is determined by the asset categories that are selected and their overall proportional representation.” As we age our financial strategies must certainly change, Malkiel proposes fundamental principles an investor should consider as they age. Firstly, history indicates that risk and return are related. Secondly, the risk of investing in common stocks and bonds depends on the length of time they're held. Thirdly, dollar-cost averaging can be a viable technique in reducing risk. Fourthly, rebalancing can reduce risk and potentially increase return. Finally, you must distinguish between your attitude toward and your capacity for risk. With the foundation cemented, Malkiel provides four pie charts intended as asset allocation advice for different age groups. Someone in their twenties living a fast lifestyle is counseled to contribute 70% of their wealth to stocks and a mere 5% to cash, their appetite for risk can be higher. An investor in their sixties looking towards retirement has less risk appetite. They are counseled to contribute only 40% of their wealth to stocks with 35% allocated to bonds, and 10% to cash. For a new investor picking stocks feels thrilling, apps like Robinhood are user friendly and get their members started with a free stock. Malkiel offers four rules to advise and ground the excited investor. The first rule is to confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years. If a company can prove sustainable growth then it makes sense to jump on board, the investment may not light up like a slot machine, but it should be a positive experience all the same. The second rule is to never pay more for a stock than can reasonably be justified by a firm foundation of value. It is worthwhile to gauge stock price on how reasonable it may or may not be, and that ratios like price to earnings is a serviceable measure for a publicly traded company. Rule three is to look at investments with the kinds of stories of anticipated growth that get other investors excited. Some stocks are sexier than others; Tesla, Apple, or Facebook have outspoken CEO’s with cutting-edge products that make their companies prevalent talking points. A common investor can proudly announce these holdings like a badge of honor. Psychological investment behavior drives prices; as an investor these principles are worth considering when picking stocks. The final rule is to trade as little as possible. Riding the winners and divorcing from the losers enables the investor to recognize gains and avoid accompanying transactions.

A Random Walk Down Wall Street has raving fans because of its high-level ideas, presented in an accessible way. The reader develops a deeper appreciation for how the emotionally driven investor impacts the market and how modern investment theories can elevate their investing process. Wise counsel from Burton G. Malkiel will drive intelligent and specific actions that enhance performance for an investor’s goals.

“An investment in knowledge pays the best interest”

-?????????Benjamin Franklin