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

by Burton G. Malkiel

How successful I will not say, for it is a peculiarity of the academic world that a professor is not supposed to make money. A professor may inherit lots of money, marry lots of money, and spend lots of money, but he or she is never, never supposed to earn lots of money; it’s unacademic.

A speculator buys stocks hoping for a short-term gain over the next days or weeks. An investor buys stocks likely to produce a dependable future stream of cash returns and capital gains when measured over years or decades.

“In crowds it is stupidity and not mother-wit that is accumulated,”

Skyrocketing markets that depend on purely psychic support have invariably succumbed to the financial law of gravitation.

Law’s goal in life was to replace metal as money and create more liquidity through a national paper currency. (Bitcoin promotors are following a long tradition.)

We had come full circle—having positive sales and earnings was actually considered a drawback because those profits might decline in the future. But during the late 1980s, most biotechnology stocks lost three-quarters of their market value. Even real technology revolutions do not guarantee benefits for investors.

In 1987, Minkow’s bubble burst with shocking suddenness. It turned out that ZZZZ Best was cleaning more than carpets—it was also laundering money for the mob.

Robert Shiller, in his book Irrational Exuberance, describes bubbles in terms of “positive feedback loops.” A bubble starts when any group of stocks, in this case those associated with the excitement of the Internet, begin to rise. The updraft encourages more people to buy the stocks, which causes more TV and print coverage, which causes even more people to buy, which creates big profits for early Internet stockholders. The successful investors tell you at cocktail parties how easy it is to get rich, which causes the stocks to rise further, which pulls in larger and larger groups of investors. But the whole mechanism is a kind of Ponzi scheme where more and more credulous investors must be found to buy the stock from the earlier investors. Eventually, one runs out of greater fools.

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 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.

Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the-air view of stock pricing. Fundamental analysis is the technique of applying the tenets of the firm-foundation theory to the selection of individual stocks.

Most people don’t recognize the implications of compound growth for financial decisions. Albert Einstein once described compound interest as the “greatest mathematical discovery of all time.” It is often said that the Native American who sold Manhattan Island in 1626 for $24 was rooked by the white man. In fact, he may have been an extremely sharp salesman. Had he put his $24 away at 6 percent interest, compounded semiannually, it would now be worth more than $100 billion, and with it his descendants could buy back much of the now improved land. Such is the magic of compound growth!

A useful rule, called “the rule of 72,” provides a shortcut way to determine how long it takes for money to double. Take the interest rate you earn and divide it into the number 72, and you get the number of years it will take to double your money. For example, if the interest rate is 15 percent, it takes a bit less than five years for your money to double (72 divided by 15 = 4.8 years).

The catch (and doesn’t there always have to be at least one, if not twenty-two?) is that dividend growth does not go on forever, for the simple reason that corporations have life cycles similar to most living things.

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. To this is added an important corollary: 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.

A stock selling at $100 per share with earnings of $10 per share would have the same P/E multiple (10) as a stock selling at $40 with earnings of $4 per share. It is the P/E multiple, not the price, that really tells you how a stock is valued in the market.

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.

But if you are like most investors, you value stable returns over speculative hopes, freedom from worry about your portfolio over sleepless nights, and limited loss exposure over the possibility of a downhill roller-coaster

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.

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

Although many Wall Streeters claim to see into the future, they are just as fallible as the rest of us. As Samuel Goldwyn used to say, “Forecasts are difficult to make—particularly those about the future.”

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.

One chart showed a beautiful upward breakout from an inverted head and shoulders (a very bullish formation). I showed it to a chartist friend of mine who practically jumped out of his skin. “What is this company?” he exclaimed. “We’ve got to buy immediately. This pattern’s a classic. There’s no question the stock will be up 15 points next week.” He did not respond kindly when I told him the chart had been produced by flipping a coin. Chartists have no sense of humor.

The individual investor would do well to avoid using any filter rule and, I might add, any broker who recommends it.

Randomness Is Hard to Accept Human nature likes order; people find it hard to accept the notion of randomness. No matter what the laws of chance might tell us, we search for patterns among random events wherever they might occur—not only in the stock market but even in interpreting sporting phenomena.

By examining the ratio of odd-lot purchases (the number of shares these amateurs bought during a particular day) to odd-lot sales (the number of shares they sold) and by looking at what particular stocks odd-lotters buy and sell, one can supposedly make money. These uninformed amateurs, presumably acting solely out of emotion and not with professional insight, are lambs in the street being led to slaughter. They are, according to legend, invariably wrong. It turns out that the odd-lotter isn’t such a stupendous dodo after all. A little stupid? Maybe. There is some indication that the performance of odd-lotters might be slightly worse than the stock averages. However, the available evidence indicates that knowledge of odd-lotters’ actions is not useful for the formulation of investment strategies.

Trading generates commissions, and commissions are the lifeblood of many brokerage houses. The technicians do not help produce yachts for the customers, but they do help generate the trading that provides yachts for the brokers.

An investor who frequently carries a large cash position to avoid periods of market decline is very likely to be out of the market during some periods where it rallies smartly. Professor H. Negat Seybun of the University of Michigan found that 95 percent of the significant market gains over a thirty-year period came on 90 of the roughly 7,500 trading days. If you happened to miss those 90 days, just over 1 percent of the total, the generous long-run stock-market returns of the period would have been wiped out. Studying a longer period, Laszlo Birinyi, in his book Master Trader, has calculated that a buy-and-hold investor would have seen one dollar invested in the Dow Jones Industrial Average in 1900 grow to $290 by the start of 2013. Had that investor missed the best five days each year, however, that dollar investment would have been worth less than a penny in 2013. The point is that market timers risk missing the infrequent large sprints that are the big contributors to performance.

This startling result was first reported by British researchers for companies in the United Kingdom in an article charmingly titled “Higgledy Piggledy Growth.”

Financial forecasting appears to be a science that makes astrology look respectable.

A firm’s income statement may be likened to a bikini—what it reveals is interesting but what it conceals is vital. Enron, one of the most ingeniously corrupt companies I have come across, led the beauty parade in this regard.

And it’s much easier to be wrong when your professional colleagues all agree with you. As Keynes put it, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

In one celebrated incident, an analyst who had the chutzpah to recommend that Trump’s Taj Mahal bonds be sold because they were unlikely to pay their interest was summarily fired by his firm after threats of legal retaliation from “The Donald” himself. (Later, the bonds did default.)

To be sure, when an analyst says “buy” he may mean “hold,” and when he says “hold” he probably means this as a euphemism for “dump this piece of crap as soon as possible.”

The efficient-market hypothesis does not, as some critics have proclaimed, 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.

Beta? How did a Greek letter enter this discussion? Surely it didn’t originate with a stockbroker. Can

But we who teach say such things often. We go on to say that part of total risk or variability may be called the security’s 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. The remaining variability in a stock’s returns is called unsystematic risk and results from factors peculiar to that particular company—for example, a strike, the discovery of a new product, and so on. Systematic risk, also called market risk, captures the reaction of individual stocks (or portfolios) to general market swings. Some stocks and portfolios tend to be very sensitive to market movements. Others are more stable. This relative volatility or sensitivity to market moves can be estimated on the basis of the past record, and is popularly known by—you guessed it—the Greek letter beta.

In Shakespeare’s Henry IV, Part I, Glendower boasts to Hotspur, “I can call spirits from the vasty deep.” “Why, so can I, or so can any man,” says Hotspur, unimpressed. “But will they come when you do call for them?” Anyone can theorize about how security markets work.

The stock market appears to be an efficient mechanism that adjusts quite quickly to new information. Neither technical analysis, which analyzes the past price movements of stocks, nor fundamental analysis, which analyzes more basic information about the prospects for individual companies and the economy, seems to yield consistent benefits.

Behavioral finance then takes that statement further by asserting that it is possible to quantify or classify such irrational behavior. Basically, there are four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion.

Steve Forbes, the longtime publisher of Forbes magazine, liked to quote the advice he received at his grandfather’s knee: “It’s far more profitable to sell advice than to take it.”

Subjects were then asked to rate the relative likelihood that eight different statements about Linda were true. Two of the statements on the list were “Linda is a bank teller” and “Linda is a bank teller and is active in the feminist movement.” Over 85 percent of subjects judged it more likely that Linda was both a bank teller and a feminist than that she was a bank teller. But this answer is a violation of a fundamental axiom of probability theory (the conjunction rule): the probability that somebody belongs to both category A and category B is less than or equal to the probability that she belongs to category A alone. Obviously, few respondents had learned much probability theory.

In the face of sure losses, people seem to exhibit risk-seeking behavior.

Behavioral-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. Two suggestions have been made to overcome people’s reluctance to save. The first is to overcome inertia and status quo bias by changing the framing of the choice. We know that if we ask employees actively to sign up for a 401(k) savings plan, many will decline to join. But if the problem is framed differently, so that one must actively “opt out” of the savings plan, participation rates will be much greater. Corporations that frame their 401(k) savings plans with an automatic enrollment feature (where a conscious decision must be made to fill out an “opt out” declaration) have far higher participation rates than do plans where em...

Night owls like myself often watch the late-night TV shows. One of the funnier bits from David Letterman’s show was the segment “Stupid Pet Tricks,” where pet owners have their animals perform all manner of dumb antics. Unfortunately, investors often act very much like the owners and pets on the TV show—and it isn’t funny. They are overconfident, get trampled by the herd, harbor illusions of control, and refuse to recognize their investment mistakes. The pets actually look smart in comparison.

Remember the advice of the legendary investor Warren Buffett: Lethargy bordering on sloth remains the best investment style. The correct holding period for the stock market is forever.

Tips come at you from all fronts—friends, relatives, the telephone, even the Internet. Don’t go there. Steer clear of any hot tips. They are overwhelmingly likely to be the poorest investments of your life. And remember: Never buy anything from someone who is out of breath.

If you believe a subset of securities will give you superior returns, you are counting on some “dumb” investors to hold portfolios producing poorer returns. Some “smart beta” advocates have been quite explicit in suggesting who these dumb investors might be. They claim that the investors in traditional capitalization index funds are the dumb beta investors, since by holding the broad index they will be holding a number of overvalued growth stocks. But that argument must be false. The holder of a broad-based index fund will by definition achieve the average return for the market. If “smart beta” funds generate above average returns, it can’t be at the expense of traditional index-fund investors—it must be at the expense of all active managers who do not hold the market portfolio. • To the extent that “smart beta” funds do generate excess returns, it is most likely because they are assuming greater risks.

“Smart beta” funds require periodic rebalancing. For example, in order for an equally weighted fund to maintain its equal weighting, stocks that have gone up more than average must be pared back. In a rising market, the trading involves transactions costs and short-term capital gains taxes. “Smart beta” funds and ETFs also carry considerably higher management expenses than traditional capitalization-weighted index funds.