Burton Gordon Malkiel (born August 28, 1932) is an American economist and writer, most famous for his classic finance book A Random Walk Down Wall Street.
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=== A Random Walk Down Wall Street (2019; 12th ed.) ===
A random walk is one in which future steps or directions cannot be predicted on the basis of past history. When the term is applied to the stock market, it means that short-run changes in stock prices are unpredictable. Investment advisory services, earnings forecasts, and chart patterns are useless. On Wall Street, the term “random walk” is an obscenity. It is an epithet coined by the academic world and hurled insultingly at the professional soothsayers. Taken to its logical extreme, it means that a blindfolded monkey throwing darts at the stock listings could select a portfolio that would do as well as one selected by the experts.
1. Firm Foundations and Castles in the AirInvesting requires work, make no mistake about it. Romantic novels are replete with tales of great family fortunes lost through neglect or lack of knowledge on how to care for money. Who can forget the sounds of the cherry orchard being cut down in Chekhov’s great play? Free enterprise, not the Marxist system, caused the downfall of the Ranevsky family: They had not worked to keep their money. Even if you trust all your funds to an investment adviser or to a mutual fund, you still have to know which adviser or which fund is most suitable to handle your money. Armed with the information contained in this book, you should find it a bit easier to make your investment decisions.
1. Firm Foundations and Castles in the AirThe firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected—or so the theory goes. Investing then becomes a dull but straightforward matter of comparing something’s actual price with its firm foundation of value.
1. Firm Foundations and Castles in the AirThe castle-in-the-air theory of investing concentrates on psychic values. John Maynard Keynes, a famous economist and successful investor, enunciated the theory most lucidly in 1936. It was his opinion that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.
1. Firm Foundations and Castles in the AirHistory, in this instance, does teach a lesson: Although the castle-in-the-air theory can well explain such speculative binges, outguessing the reactions of a fickle crowd is a most dangerous game. “In crowds it is stupidity and not mother-wit that is accumulated,” Gustave Le Bon noted in his 1895 classic on crowd psychology. It would appear that not many have read the book. Skyrocketing markets that depend on purely psychic support have invariably succumbed to the financial law of gravitation. Unsustainable prices may persist for years, but eventually they reverse themselves. Such reversals come with the suddenness of an earthquake; and the bigger the binge, the greater the resulting hangover. Few of the reckless builders of castles in the air have been nimble enough to anticipate these reversals and to escape when everything came tumbling down.
2. The Madness of CrowdsPart of the genius of financial markets is that when there is a real demand for a method to enhance speculative opportunities, the market will surely provide it. The instruments that enabled tulip speculators to get the most action for their money were “call options” similar to those popular today in the stock market.
2. The Madness of CrowdsWhy are memories so short? Why do such speculative crazes seem so isolated from the lessons of history? I have no apt answer, but I am convinced that Bernard Baruch was correct in suggesting that a study of these events can help equip investors for survival. The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges. It is an obvious lesson, but one frequently ignored.
2. The Madness of CrowdsThe lessons of market history are clear. Styles and fashions in investors’ evaluations of securities can and often do play a critical role in the pricing of securities. The stock market at times conforms well to the castle-in-the-air theory. For this reason, the game of investing can be extremely dangerous.Another lesson that cries out for attention is that investors should be very wary of purchasing today’s hot “new issue.” Most initial public offerings underperform the stock market as a whole. And if you buy the new issue after it begins trading, usually at a higher price, you are even more certain to lose.
3. Speculative Bubbles from the Sixties into the NinetiesFraud aside, we should have known better. We should have known that investments in transforming technologies have often proved unrewarding for investors. In the 1850s, the railroad was widely expected to greatly increase the efficiency of communications and commerce. It certainly did so, but it did not justify the prices of railroad stocks, which rose to enormous speculative heights before collapsing in August 1857. A century later, airlines and television manufacturers transformed our country, but most of the early investors lost their shirts. The key to investing is not how much an industry will affect society or even how much it will grow, but rather its ability to make and sustain profits. And history tells us that eventually all excessively exuberant markets succumb to the laws of gravity. The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is not hard, really, to make money in the market. As we shall see later, an investor who simply buys and holds a broad-based portfolio of stocks can make reasonably generous long-run returns. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.
4. The Explosive Bubbles of the Early 2000sOur survey of historical bubbles makes clear that the bursting of bubbles has invariably been followed by severe disruptions in real economic activity. The fallout from asset-price bubbles has not been confined to speculators. Bubbles are particularly dangerous when they are associated with a credit boom and widespread increases in leverage both for consumers and for financial institutions.
4. The Explosive Bubbles of the Early 2000sThis chapter’s review of the Internet and housing bubbles seems inconsistent with the view that our stock and real estate markets are rational and efficient. The lesson, however, is not that markets occasionally can be irrational and that we should therefore abandon the firm-foundation theory of the pricing of financial assets. Rather, the clear conclusion is that, in every case, the market did correct itself. The market eventually corrects any irrationality—albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic, and often they attract unwary investors. But, eventually, true value is recognized by the market, and this is the main lesson investors must heed.I am also persuaded by the wisdom of Benjamin Graham, author of Security Analysis, who wrote that in the final analysis the stock market is not a voting mechanism but a weighing mechanism. Valuation metrics have not changed. Eventually, every stock can only be worth the present value of its cash flow. In the final analysis, true value will win out.
4. The Explosive Bubbles of the Early 2000sTechnology will ultimately greatly improve the intentional payments system. And there will always be advantages to holding an asset that is anonymous and transportable without a physical trace. But the lessons of history are immutable. Speculative bubbles will persist. But they ultimately lead most of their participants to financial ruin. Even real technology revolutions do not guarantee benefits for investors.
4. The Explosive Bubbles of the Early 2000sThere are, I believe, five factors that help explain why security analysts have such difficulty in predicting the future. These are (1) the influence of random events, (2) the production of dubious reported earnings through “creative” accounting procedures, (3) errors made by the analysts themselves, (4) the loss of the best analysts to the sales desk or to portfolio management, and (5) the conflicts of interest facing securities analysts at firms with large investment banking operations. Each factor deserves some discussion.
7. How Good is Fundamental Analysis? The Efficient-Market HypothesisThe strong form of the EMH is obviously an overstatement. It does not admit the possibility of gaining from inside information. Nathan Rothschild made millions in the market when his carrier pigeons brought him the first news of Wellington’s victory at Waterloo before other traders were aware of the victory. But today, the information superhighway carries news far more swiftly than carrier pigeons. And Regulation FD (Fair Disclosure) requires companies to make prompt public announcements of any material news items that may affect the price of their stock. Moreover, insiders who do profit from trading on the basis of nonpublic information are breaking the law.
7. How Good is Fundamental Analysis? The Efficient-Market HypothesisThe efficient-market hypothesis does not imply, as some critics have proclaimed, that stock prices are always correct. In fact, stock prices are always wrong. What EMH implies is that no one knows for sure if stock prices are too high or too low. Nor does EMH state that stock prices move aimlessly and erratically and are insensitive to changes in fundamental information. On the contrary, the reason prices move randomly is just the opposite. The market is so efficient—prices move so quickly when information arises—that no one can buy or sell fast enough to benefit. And real news develops randomly, that is, unpredictably. It cannot be predicted by studying either past technical or fundamental information.
7. How Good is Fundamental Analysis? The Efficient-Market HypothesisPortfolio theory begins with the premise that all investors are like my wife—they are risk-averse. They want high returns and guaranteed outcomes. The theory tells investors how to combine stocks in their portfolios to give them the least risk possible, consistent with the return they seek. It also gives a rigorous mathematical justification for the time-honored investment maxim that diversification is a sensible strategy for individuals who like to reduce their risks.
8. A New Walking Shoe: Modern Portfolio TheoryThe paradoxical result of this analysis is that overall portfolio risk is reduced by the addition of a small amount of riskier foreign securities. Good returns from Japanese automakers balanced out poor returns from domestic ones when the Japanese share of the U.S. market increased. On the other hand, good returns from U.S. manufacturers offset poor returns from foreign manufacturers when the dollar became more competitive and Japan and Europe remained in a recession as the U.S. economy boomed. It is precisely these offsetting movements that reduced the overall volatility of the portfolio.
8. A New Walking Shoe: Modern Portfolio TheoryTo the great relief of assistant professors who must publish or perish, there is still much debate within the academic community on risk measurement, and much more empirical testing needs to be done. Undoubtedly, there will yet be many improvements in the techniques of risk analysis, and the quantitative analysis of risk measurement is far from dead. My own guess is that future risk measures will be even more sophisticated—not less so. Nevertheless, we must be careful not to accept beta or any other measure as an easy way to assess risk and to predict future returns with any certainty. You should know about the best of the modern techniques of the new investment technology—they can be useful aids. But there is never going to be a handsome genie who will appear and solve all our investment problems.
9. Reaping Reward By Increasing RiskBehavioral-finance theory also helps explain why many people refuse to join a 401(k) savings plan at work, even when their company matches their contributions. If one asks an employee who has become used to a particular level of take-home pay to increase his allocation to a retirement plan by one dollar, he will view the resulting deduction (even though it is less than a dollar because contributions to retirement plans are deductible from taxable income up to certain generous amounts) as a loss of current spending availability. Individuals weigh these losses much more heavily than gains. When this loss aversion is coupled with the difficulty of exhibiting self-control, the ease of procrastinating, and the ease of making no changes (status quo bias), it becomes, as psychologists teach us, perfectly understandable why people tend to save too little.
10. Behavioral FinanceInvestors should certainly be aware of new methods of portfolio construction. And high net worth investors might consider adding a multifactor smart beta offering or a risk-parity portfolio to the overall mix of their investments. Factor investing can potentially increase returns at the cost of assuming a somewhat different set of risk exposures than those of a standard broad-based index fund. And investors who are able to accept the added risks inherent in leverage might profitably add a risk-parity portfolio to their set of investments. Such offerings should only be considered, however, if they are low cost and if their potentially adverse tax effects can be offset in other parts of the overall portfolio. And I continue to believe that a broad-based total stock market index fund should be the core of everyone’s portfolio. Certainly, for investors who are starting to build an equity portfolio in planning for retirement, standard capitalization-weighted index funds are the appropriate first investments they should make.
11. New Methods of Portfolio Construction: Smart Beta and Risk ParityA widely held belief is that the ticket to a comfortable retirement and a fat investment portfolio are instructions on what extraordinary individual stocks or mutual funds you should buy. Unfortunately, these tickets are not even worth the paper they are printed on. The harsh truth is that the most important driver in the growth of your assets is how much you save, and saving requires discipline. Without a regular savings program, it doesn’t matter if you make 5 percent, 10 percent, or even 15 percent on your investment funds. The single most important thing you can do to achieve financial security is to begin a regular savings program and to start it as early as possible. The only reliable route to a comfortable retirement is to build up a nest egg slowly and steadily. Yet few people follow this basic rule, and the savings of the typical American family are woefully inadequate.
12. A Fitness Manual for Random Walkers and Other InvestorsRemember Murphy’s Law: What can go wrong will go wrong. And don’t forget O’Toole’s commentary: Murphy was an optimist. Bad things do happen to good people. Life is a risky proposition, and unexpected financial needs occur in everyone’s lifetime. The boiler tends to blow up just at the time that your family incurs whopping medical expenses. A job layoff happens just after your son has totaled the family car. That’s why every family needs a cash reserve as well as adequate insurance to cope with the catastrophes of life.
12. A Fitness Manual for Random Walkers and Other InvestorsMost people need insurance. Those with family obligations are downright negligent if they don’t purchase insurance. We risk death every time we get into our automobile or cross a busy street. A hurricane or fire could destroy our home and possessions. People need to protect themselves against the unpredictable.
12. A Fitness Manual for Random Walkers and Other InvestorsAs I’ve already pointed out, some ready assets are necessary for pending expenses, such as college tuition, possible emergencies, or even psychological support. Thus, you have a real dilemma. You know that if you keep your money in a savings bank and get, say, 2 percent interest in a year in which the inflation rate exceeds 2 percent, you will lose real purchasing power. In fact, the situation is even worse because the interest you get is subject to regular income taxes. Moreover, short-term interest rates were abnormally low during the 2010s. So what’s a small saver to do? There are several short-term investments that are likely to help provide the best rate of return, although no very good alternatives exist when interest rates are very low.
12. A Fitness Manual for Random Walkers and Other InvestorsBy telling this story, I do not mean to suggest that you attempt to cheat the government. But I do mean to suggest that you take advantage of every opportunity to make your savings tax-deductible and to let your savings and investments grow tax-free. For most people, there is no reason to pay any taxes on the earnings from the investments that you make to provide for your retirement. Almost all investors, except those who are super wealthy to begin with, can build up a substantial net worth in ways that ensure that nothing will be siphoned off by Uncle Sam. This exercise shows how you can legally stiff the tax collector.
12. A Fitness Manual for Random Walkers and Other InvestorsDetermining clear goals is a part of the investment process that too many people skip, with disastrous results. You must decide at the outset what degree of risk you are willing to assume and what kinds of investments are most suitable to your tax bracket. The securities markets are like a large restaurant with a variety of menu choices suitable for different tastes and needs. Just as there is no one food that is best for everyone, so there is no one investment that is best for all investors.
12. A Fitness Manual for Random Walkers and Other InvestorsThe amount of risk you can tolerate is partly determined by your sleeping point. The next chapter discusses the risks and rewards of stock and bond investing and will help you determine the kinds of returns you should expect from different financial instruments. But the risk you can assume is also significantly influenced by your age and by the sources and dependability of your noninvestment income.
12. A Fitness Manual for Random Walkers and Other InvestorsIn principle, common stocks should be an inflation hedge, and stocks are not supposed to suffer with an increase in the inflation rate. In theory at least, if the inflation rate rises by 1 percentage point, all prices should rise by 1 percentage point, including the values of factories, equipment, and inventories. Consequently, the growth rate of earnings and dividends should rise with the rate of inflation. Thus, even though all required returns will rise with the rate of inflation, no change in dividend yields (or price-earnings ratios) will be required. This is so because expected growth rates should rise along with increases in the expected inflation rate. Whether this happens in practice we will examine below.
13. Handicapping The Financial Race: A Primer in Understanding and Projecting Returns from Stocks and BondsWith these broad time periods set, let us now look at how the determinants of returns developed during those eras and look especially at what might have been responsible for changes in valuation relationships and in interest rates. Recall that stock returns are determined by (1) the initial dividend yield at which the stocks were purchased, (2) the growth rate of earnings, and (3) changes in valuation in terms of price-earnings (or price-dividend) ratios. And bond returns are determined by (1) the initial yield to maturity at which the bonds were purchased and (2) changes in interest rates (yields) and therefore in bond prices for bond investors who do not hold to maturity.
13. Handicapping The Financial Race: A Primer in Understanding and Projecting Returns from Stocks and BondsAs a random walker on Wall Street, I am skeptical that anyone can predict the course of short-term stock-price movements, and perhaps we are better off for it. I am reminded of one of my favorite episodes from the marvelous old radio serial I Love a Mystery. This mystery was about a greedy stock-market investor who wished that just once he would be allowed to see the paper, with its stock-price changes, twenty-four hours in advance. By some occult twist his wish was granted, and early in the evening he received the late edition of the next day’s paper. He worked feverishly through the night planning early-morning purchases and late-afternoon sales that would guarantee him a killing in the market. Then, before his elation had diminished, he read through the remainder of the paper—and came upon his own obituary. His servant found him dead the next morning.Because I, fortunately, do not have access to future newspapers, I cannot tell how stock and bond prices will behave in any particular period ahead. Nevertheless, I am convinced that the moderate long-run estimates of bond and stock returns presented here are the most reasonable ones that can be made for investment planning decades into the twenty-first century. The point is not to invest with a rearview mirror projecting double-digit returns from the past into the future. We are likely to be in a low-return environment for some time to come.
13. Handicapping The Financial Race: A Primer in Understanding and Projecting Returns from Stocks and BondsBefore we can determine a rational basis for making asset-allocation decisions, certain principles must be kept firmly in mind. We’ve covered some of them implicitly in earlier chapters, but treating them explicitly here should prove very helpful. The key principles are:1. History shows that risk and return are related.2. The risk of investing in common stocks and bonds depends on the length of time the investments are held. The longer an investor’s holding period, the lower the likely variation in the asset’s return.3. Dollar-cost averaging can be a useful, though controversial, technique to reduce the risk of stock and bond investment.4. Rebalancing can reduce risk and, in some circumstances, increase investment returns.5. You must distinguish between your attitude toward and your capacity for risk. The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income.
14. A Life-Cycle Guide to Investing
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