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

by Burton G. Malkiel

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 just as well as one selected by the experts.

It is the definition of the time period for the investment return and the predictability of the returns that often distinguish an investment from a speculation. 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.

If inflation continued at the same rate, today’s morning paper would cost more than four dollars by the year 2020. It is clear that if we are to cope with even a mild inflation, we must undertake investment strategies that maintain our real purchasing power; otherwise, we are doomed to an ever-decreasing standard of living.

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. 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.

Security analysts must estimate not only long-term growth rates but also how long an extraordinary growth can be maintained. When the market gets overly enthusiastic about how far in the future growth can continue, it is popularly held on Wall Street that stocks are discounting not only the future but perhaps even the hereafter. The point is that the firm-foundation theory relies on some tricky forecasts of the extent and duration of future growth. The foundation of intrinsic value may thus be less dependable than is claimed.

people are “largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.” Keynes, in other words, applied psychological principles rather than financial evaluation to the study of the stock market.

This theory might less charitably be called the “greater fool” theory. It’s perfectly all right to pay three times what something is worth as long as later on you can find some innocent to pay five times what it’s worth.

A call option conferred on the holder the right to buy tulip bulbs (call for their delivery) at a fixed price (usually approximating the current market price) during a specified period. He was charged an amount called the option premium, which might run 15 to 20 percent of the current market price. An option on a tulip bulb currently worth 100 guilders, for example, would cost the buyer only about 20 guilders. If the price moved up to 200 guilders, the option holder would exercise his right; he would buy at 100 and simultaneously sell at the then current price of 200.

Not all investors in the bubble companies believed in the feasibility of the schemes to which they subscribed. People were “too sensible” for that. They did believe, however, in the “greater fool” theory—that prices would rise, that buyers would be found, and that they would make money. Thus, most investors considered their actions the height of rationality, expecting that they could sell their shares at a premium in the “after market,” that is, the trading market in the shares after their initial issue.

Selling short is a way to make money if stock prices fall. It involves selling stock you do not currently own in the expectation of buying it back later at a lower price. It’s hoping to buy low and sell high, but in reverse order.

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.

Questioning the propriety of such valuations became almost heretical. Though these prices could not be justified on firm-foundation principles, investors believed that buyers would still eagerly pay even higher prices. Lord Keynes must have smiled quietly from wherever it is that economists go when they die.

Synergism is the quality of having 2 plus 2 equal 5. Thus, two separate companies with an earning power of $2 million each might produce combined earnings of $5 million if the businesses were consolidated. This magical, surefire new creation was called a conglomerate.

Managers of other conglomerates almost invented a new language in the process of dazzling the investment community. They talked about market matrices, core technology fulcrums, modular building blocks, and the nucleus theory of growth. No one from Wall Street really knew what the words meant, but they all got the nice, warm feeling of being in the technological mainstream.

An interesting footnote to this episode is that during the first two decades of the 2000s deconglomeration came into fashion. Spin-offs of company subsidiaries into separate companies were as a rule rewarded with rising stock prices. The two distinct companies usually had a higher combined market value than the original conglomerate.

The reasons were varied: too rapid expansion, too much debt, loss of management control, and so on. These companies were run by executives who were primarily promoters, not sharp-penciled operating managers.

My favorite was the “product asset valuation” method recommended by one of Wall Street’s leading securities houses. Basically, the method involved the estimation of the value of all the products in the “pipeline” of each biotech company. Even if the planned product involved nothing more than the drawings of a genetic engineer, a potential sales volume and a profit margin were estimated. The total value of the “product pipeline” would then give the analyst a fair idea of the price at which the company’s stock should sell.

The 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.

As the prices of telecom stocks continued to skyrocket well past any normal valuation standards, security analysts did what they often do—they just lowered their standards.

The proliferation of publications was a classic sign of a speculative bubble. The historian Edward Chancellor pointed out that during the 1840s, fourteen weeklies and two dailies were introduced to cover the new railroad industry.

The stock market was treated like a sports event with a pre-game show (what to expect before the market opened), a play-by-play during trading hours, and a post-game show to review the day’s action and to prepare investors for the next. CNBC implied that listening would put you “ahead of the curve.”

People who would spend hours researching the pros and cons of buying a $50 kitchen appliance would risk tens of thousands on a chat-room tip.

One of the scams perpetrated by Enron management was the establishment of a myriad of complex partnerships that obfuscated the true financial position of the firm and led to an overstatement of Enron’s earnings.

While analysts were praising stocks like Enron and WorldCom to the skies, some corporate officers were transforming the meaning of EBITDA from earnings before interest, taxes, depreciation, and amortization to “earnings before I tricked the dumb auditor.”

There were many villains in this morality tale: the fee-obsessed underwriters who should have known better than to peddle all of the crap they brought to market; the research analysts who were the cheerleaders for the banking departments and who were eager to recommend Net stocks that could be pushed by commission-hungry brokers; corporate executives using “creative accounting” to inflate their profits. But it was the infectious greed of individual investors and their susceptibility to get-rich-quick schemes that allowed the bubble to expand.

Briefly, the swap market allowed two parties—called counterparties—to bet for or against the performance of the mortgage bonds, or the bonds of any other issuer. For example, suppose I hold bonds issued by General Electric and I begin to worry about GE’s creditworthiness. I could buy and hold an insurance policy from a company like AIG (the biggest issuer of credit default swaps) that would pay me if GE defaulted. The problems with this market lay in the fact that the issuers of the insurance such as AIG had inadequate reserves to pay the claims if trouble occurred. And anyone from any country could buy the insurance, even without owning the underlying bonds. Eventually, the credit-default swaps trading in the market grew to as much as ten times the value of the underlying bonds, pushed by demand from institutions around the world. This change, where the derivative markets grew to a large multiple of the underlying markets, was a crucial feature of the new finance system.

Our 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.

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.

The fact that the best and the brightest on Wall Street cannot consistently distinguish correct valuations from incorrect ones shows how hard it is to beat the market. 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.

Technical analysis is essentially the making and interpreting of stock charts. Thus, its practitioners, a small but abnormally dedicated cult, are called chartists or technicians. They study the past—both the movements of common-stock prices and the volume of trading—for a clue to the direction of future change. Many chartists believe that the market is only 10 percent logical and 90 percent psychological. They generally subscribe to the castle-in-the-air school and view the investment game as one of anticipating how the other players will behave.

Fundamental analysts take the opposite tack, believing that the market is 90 percent logical and only 10 percent psychological. Caring little about the particular pattern of past price movements, fundamentalists seek to determine a stock’s proper value. Value in this case is related to a company’s assets, its expected growth rate of earnings and dividends, interest rates, and risk. By studying these factors, the fundamentalist arrives at an estimate of a security’s intrinsic value or firm foundation of value. If this is above the market price, then the investor is advised to buy. Fundamentalists believe that eventually the market will reflect the security’s real worth. Perhaps 90 percent of the Wall Street security analysts consider themselves fundamentalists.

The chartist’s vocabulary features such terms as “double bottoms,” “breakthrough,” “violating the lows,” “firmed up,” “big play,” “ascending peaks,” and “buying climax.” And all this takes place under the pennant of that great symbol of sexuality: the bull.

In estimating the firm-foundation value of a stock, the fundamentalist’s most important job is to estimate the firm’s future stream of earnings and dividends. The worth of a share is taken to be the present or discounted value of all the cash flows the investor is expected to receive. The analyst must estimate the firm’s sales level, operating costs, tax rates, depreciation, and the sources and costs of its capital requirements.

The fundamentalist uses four basic determinants to help estimate the proper value for any stock. Determinant 1: The expected growth rate.

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).

Consider the leading corporations in the United States over a hundred years ago. Such names as Eastern Buggy Whip Company, La Crosse and Minnesota Steam Packet Company, Savannah and St. Paul Steamboat Line, and Hazard Powder Company would have ranked high in a Fortune top 500 list of that era. All are now deceased.

this brings us to the first fundamental rule for evaluating securities: 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.

Suppose you were considering the purchase of a stock with an anticipated 8½ percent growth rate and you knew that, on average, stocks with 8½ percent growth sold, like General Electric, at 18 times earnings. If the stock you were considering sold at a price-earnings multiple of 20, you might reject the idea of buying the stock in favor of one more reasonably priced in terms of current market norms.

Determinant 2: The expected dividend payout. The amount of dividends you receive at each payout—as contrasted to their growth rate—is readily understandable as being an important factor in determining a stock’s price.

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 degree of risk. Risk plays an important role in the stock market, no matter what your overeager broker may tell you. There is always a risk—and that’s what makes the market so fascinating. Risk also affects the valuation of a stock. Some people think risk is the only aspect of a stock to be examined.

This leads to a third basic rule of security valuation: 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.

Determinant 4: The level of market interest rates. The stock market does not exist as a world unto itself. Investors should consider how much profit they can obtain elsewhere. Interest rates, if they are high enough, can offer a stable, profitable alternative to the stock market.

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. Predicting future earnings and dividends is a most hazardous occupation. It is extremely difficult to be objective; wild optimism and extreme pessimism constantly battle for top place.

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

Take a company that you’ve heard lots of good things about. You study the company’s prospects, and you conclude that it can maintain a high growth rate for a long period. How long? Well, why not ten years? You then calculate what the stock should be “worth” on the basis of the current dividend payout, the expected future growth rate, and the general level of interest rates, perhaps making an allowance for the riskiness of the shares. It turns out to your chagrin that the price the stock is worth is just slightly less than its present market price. You now have two alternatives. You could regard the stock as overpriced and refuse to buy it, or you could say, “Perhaps this stock could maintain a high growth rate for eleven years rather than ten. After all, the ten was only a guess in the first place, so why not eleven years?” And so you go back to your computer, and lo and behold you now come up with a worth for the shares that is larger than the current market price. Armed with this “precise” knowledge, you make your “sound” purchase. The reason the game worked is that the longer one projects extraordinary growth, the greater is the stream of future dividends. Thus, the present value of a share is at the discretion of the calculator. If eleven years was not enough to do the trick, twelve or thirteen might well have sufficed. There is always some combination of growth rate and growth period that will produce any specific price.

Caveat 3: What’s growth for the goose is not always growth for the gander. The difficulty comes with the value the market puts on specific fundamentals. It is always true that the market values growth, and that higher growth rates and larger multiples go hand in hand. But the crucial question is: How much more should you pay for higher growth?

Not only can the average multiple change rapidly for stocks in general, but so can the premium assigned to growth.

The persistent, patient reader will recognize that the rules are based on principles of stock pricing I have developed above. Rule 1: Buy only companies that are expected to have above-average earnings growth for five or more years. An extraordinary long-run earnings growth rate is the single most important element contributing to the success of most stock investments. Google and practically all the other really outstanding common stocks of the past were growth stocks.