A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

by Burton G. Malkiel

Street. The message of the original edition was a very simple one: Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds.

it has become increasingly clear to me that one’s capacity for risk-bearing depends importantly upon one’s age and ability to earn income from noninvestment sources.

It is also the case that the risk involved in many investments decreases with the length of time the investment can be held.

For these reasons, optimal investment strategies mus...

investing as a method of purchasing assets to gain profit in the form of reasonably predictable income (dividends, interest, or rentals) and/or appreciation over the long term.

The 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.

the intrinsic value of a stock was equal to the present (or discounted) value of all its future dividends.

castle-in-the-air theory of investing

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.

We should have known that investments in transforming technologies have often proved unrewarding for investors.

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.

The ability to avoid such horrendous mistakes is probably the most important factor in preserving one’s capital and allowing it to grow.

This change, where the derivative markets grew to a large multiple of the underlying markets, was a crucial feature of the new finance system. It made the world’s financial system very much riskier and much more interconnected.

Bubbles are particularly dangerous when they are associated with a credit boom and widespread increases in leverage both for consumers and for financial institutions.

There is no evidence that anyone can generate excess returns by making consistently correct bets against the collective wisdom of the market. Markets are not always or even usually correct. But NO ONE PERSON OR INSTITUTION CONSISTENTLY KNOWS MORE THAN THE MARKET.

Stock investors can do no better than simply buying and holding an index fund that owns a portfolio consisting of all the stocks in the market.

Determinant 1: The expected growth rate.

Rule 1: A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings.

Corollary to Rule 1: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.

high P/E ratios are associated with high expected growth rates.

Determinant 2: The expected dividend payout.

For two companies whose expected growth rates are the same, you are better off with the one that returns more cash to the shareholders.

Rule 2: A rational investor should pay a higher price for a share, other things equal, the larger the proportion of a company’s earnings paid out in cash dividends or used to buy back stock.

Determinant 3: The degre...

Most investors prefer less risky stocks, and these stocks can therefore command higher price-earnings multiples than their risky, low-quality counterparts.

Rule 3: A rational (and risk-averse) investor should pay a higher price for a share, other things equal, the less risky the company’s stock.

that a “relative volatility” measure may not fully capture the relevant risk of a company.

Determinant 4: The level of market interest rates.

Rule 4: A rational investor should pay a higher price for a share, other things equal, the lower the interest rates.

Caveat 1: Expectations about the future cannot be proven in the present.

Caveat 2: Precise figures cannot be calculated from undetermined data.

Caveat 3: What’s growth for the goose is not always growth for the gander.

there are three potential flaws in this type of analysis. First, the information and analysis may be incorrect. Second, the security analyst’s estimate of “value” may be faulty. Third, the market may not correct its “mistake,” and the stock price may not converge to its value estimate.

Rule 1: Buy only companies that are expected to have above-average earnings growth for five or more years.

Rule 2: Never pay more for a stock than its firm foundation of value.

There are special risks involved in buying “growth stocks” when the market has already recognized the growth and has bid up the price-earnings multiple to a hefty premium over that accorded more run-of-the-mill stocks.

Look for growth situations with low price-earnings multiples. If the growth takes place, there’s often a double bonus—both the earnings and the multiple rise, producing large gains. Beware of very high multiple stocks in which future growth is already discounted. If growth doesn’t materialize, losses are doubly heavy—both the earnings and the multiples drop.

Rule 3: Look for stocks whose stories of anticipated growth are of the kind on which investors can build castles in the air.

we should not take for granted the reliability and accuracy of any judge, no matter how expert.

There 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.

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

the laws of chance do operate and that they can explain some amazing success stories.

Fundamental analysis is no better than technical analysis in enabling investors to capture above-average returns.

Another major advantage of HFT is that it ensures that the exchange-traded broad-based index funds, which I recommend for individual investors, are appropriately priced. Any discrepancy between the price of the ETF and the underlying stocks can be quickly arbitraged away. Thus, HFT, rather than harming individual investors, actually benefits them by assuring that ETFs are fairly priced.

diversification cannot eliminate all risk—as it did in my mythical island economy—because all stocks tend to move up and down together. Thus, diversification in practice reduces some but not all risk.

The basic logic behind the capital-asset pricing model is that there is no premium for bearing risks that can be diversified away.

systematic risk and that this arises from the basic variability of stock prices in general and the tendency for all stocks to go along with the general market, at least to some extent.

unsystematic risk and results from factors peculiar to that particular company—for example, a strike, the discovery of a new product, and so on.

beta is the numerical description of systematic risk.

systematic risk cannot be eliminated by diversification.