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

by Burton G. Malkiel

streaks of excessively high stock returns do not persist—they are typically followed by lower future returns. There is reversion to the mean. Similarly, the laws of financial gravity also operate in reverse. At least for the stock market as a whole, what goes down eventually comes back up. Yet each era’s conventional wisdom typically assumes that unusually good markets will get better and unusually bad markets will get worse.

In one set of experiments, the device was not even attached, so the players had absolutely no control over the movements of the ball. Nevertheless, when subjects were questioned after a period of playing the game, they were convinced that they had a good deal of control over the movement of the ball. (The only subjects not under such an illusion turned out to be those who had been clinically diagnosed with severe depression.)

the study found that when people went along with the group in giving wrong answers, activity increased in the area of the brain devoted to spatial awareness. In other words, it appeared that what other people said actually changed what subjects believed they saw. It seems that other people’s errors actually affect how someone perceives the external world.

a study by Harrison Hong, Jeffrey Kubik, and Jeremy Stein, three leaders in the field of behavioral finance, determined that mutual-fund managers were more likely to hold similar stocks if other managers in the same city were holding similar portfolios. Such results are consistent with an epidemic model, in which investors quickly and irreversibly spread information about stocks by word of mouth. Such herding has had devastating effects for the individual

financial economists such as Harry Markowitz constructed models where individuals made decisions based on the likely effect of those choices on the person’s final wealth. Prospect theory challenges that assumption. People’s choices are motivated instead by the values they assign to gains and losses. Losses are considered far more undesirable than equivalent gains are desirable. Moreover, the language used to present the possible gains and losses will influence the final decision that is made.

The Barber and Odean study of the trading records of 10,000 clients of a large discount brokerage firm found a pronounced “disposition effect.” There was a clear disposition among investors to sell their winning stocks and to hold on to their losing investments. Selling a stock that has risen enables investors to realize profits and build their self-esteem. If they sold their losing stocks, they would realize the painful effects of regret and loss.

The actions of individual investors are often irrational, or at least not fully consistent with the economist’s ideal of optimal decision making. In perhaps the most pathological case, individuals appear to go mad in herds and bid some categories of stocks to unreasonable heights.

the second major pillar on which some behavioralists rest their case against efficient markets is that such arbitrage is severely constrained. Behavioralists believe that important limits to arbitrage exist that prevent out-of-whack prices from being corrected.

A rise in the price of oil that makes the shorted security rise will make the arbitrageur’s long position rise as well. But this kind of arbitrage is extremely risky. Suppose the “overpriced” security reports some unusually good news, such as a significant oil strike that was not anticipated. Or suppose the “fairly valued” security suffers some unforeseen setback, such as the explosion of a deep-water oil well, which causes its price to fall. The arbitrageur could conceivably lose on both sides of the trade. The security that had been sold short could rise, and the security held long could fall. The kind of arbitrage required to correct perceived mispricings is extremely risky.

The market can remain irrational longer than the arbitrageur can remain solvent. This is especially true when the arbitrageur is credit constrained.

Constraints on short selling undoubtedly played a role in the propagation of the housing bubble during the end of the first decade of the 2000s. When it is virtually impossible to short housing in specific areas of the country, only the votes of the optimists get counted. When the optimists are able to leverage themselves easily with mortgage loans, it is easy to see why a housing bubble is unlikely to be constrained by arbitrage.

Ellis argues that most investors beat themselves by engaging in mistaken stock-market strategies rather than accepting the passive buy-and-hold indexing approach recommended in this book. The way most investors behave, the stock market becomes a loser’s game.

Any investment that has become a topic of widespread conversation is likely to be especially hazardous to your wealth. It was true of gold in the early 1980s and Japanese real estate and stocks in the late 1980s. It was true of Internet-related stocks in the late 1990s and early 2000 and condominiums in California, Nevada, and Florida in the first decade of the 2000s. Invariably, the hottest stocks or funds in one period are the worst performers in the next.

Many investors move from stock to stock or from mutual fund to mutual fund as if they were selecting and discarding cards in a game of gin rummy. Investors accomplish nothing from this behavior except to incur transactions costs and to pay more in taxes. Short-term gains are taxed at regular income tax rates. The buy-and-hold investor defers any tax payments on the gains and may avoid taxes completely if stocks are held until distributed as part of one’s estate. 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.

Sometimes, it is sensible to hold on to a stock that has declined during a market meltdown, especially if you have reason to believe the company is still successful. Moreover, you would suffer double the regret if you sold it and the stock subsequently went up. But it makes no sense to hold on to losing stocks such as Enron and WorldCom because of the mistaken belief that if you don’t sell, you have not taken a loss. A “paper loss” is just as real as a realized loss. The decision not to sell is exactly the same as the decision to buy the stock at the current price. Moreover, if you own the stock in a taxable account, selling allows you to take a tax loss, and the government will help cushion the blow by lowering the amount of your taxes. Selling your winners will add to your tax burden.

You will never be allowed to buy the really good IPOs at the initial offering price. The hot IPOs are snapped up by the big institutional investors or the very best wealthy clients of the underwriting firm. If your broker calls to say that IPO shares will be available for you, you can bet that the new issue is a dog. Only if the brokerage firm is unable to sell the shares to the big institutions and the best individual clients will you be offered a chance to buy at the initial offering price.

Stay Cool to Hot Tips. We’ve all heard the stories. Your uncle Gene knows about a diamond mine in Zaire that’s a guaranteed winner. Please remember that a mine is usually a hole in the ground with a liar standing in front of it.

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.

“Smart beta” portfolios may not have high betas, but they do carry considerable risk.

Finally, many of the “smart beta” ETFs are more costly to buy and sell than their traditional cap-weighted brethren. Plain vanilla, such as S&P 500, index ETFs trade at prices essentially the same as their net asset values because any differences tend to be quickly arbitraged away. Many “smart beta” ETFs follow nonstandard indexes that are far more difficult to hedge against. Hence, their prices are more likely to deviate from fair value and often trade at significant premiums or discounts from the value of their underlying holdings. Moreover, the successful “smart beta” funds offered by DFA can only be purchased from investment advisers, adding an additional layer of fees.

The strongest academic evidence supporting “smart beta” portfolios is the tendency of “value” stocks to outperform “growth” stocks and the tendency of “small-cap” portfolios to outperform “large-cap” ones. Here is where the academic literature is unambiguously supportive.

It is hard to avoid the conclusion that whatever success RAFI has had in generating excess returns resulted from the assumption of greater risk rather than from the mispricing of growth stocks.

“Smart beta” strategies rely on a type of active management. They do not try to select individual stocks but rather tilt the portfolio toward various characteristics that have historically appeared to generate larger-than-market returns. In their favor, the “smart beta” portfolios provide these factor tilts at expense ratios that are lower than those charged by traditional active managers.

These funds are, however, less tax efficient than capitalization-weighted funds that do not require rebalancing. To the extent that some “smart beta” strategies have generated greater-than-market returns, those excess returns should be interpreted as a reward for assuming extra risk. In departing from the market portfolio, investors are taking on a different set of risks.

Some supporters of “smart beta” portfolios believe that markets are inefficient and see their portfolio construction methods as a way of protecting investors from bubble-priced stocks. Moreover, they argue that smarter portfolios can be formed by a reliance on academic findings that there are many statistically significant predictable patterns in the stock market.

A professor who espouses the EMH is walking along the street with a graduate student. The student spots a $100 bill lying on the ground and stoops to pick it up. “Don’t bother to try to pick it up,” says the professor. “If it was really a $100 bill, it wouldn’t be there.”

In conclusion, capitalization-weighted indexing is unlikely to be deposed as the overwhelming favorite in the battle for index supremacy.

Two-thirds of professionally managed funds are regularly outperformed by a broad capitalization-weighted index fund with equivalent risk, and those that do appear to produce excess returns in one period are not likely to do so in the next. The record of professionals does not suggest that sufficient predictability exists in the stock market to produce exploitable arbitrage opportunities.

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.

everyone needs to keep some reserves in safe and liquid investments to pay for an unexpected medical bill or to provide a cushion during a time of unemployment. Assuming that you are protected by medical and disability insurance at work, this reserve might be established to cover three months of living expenses.

any large future expenditures (such as your daughter’s college tuition bill) should be funded with short-term investments (such as a bank certificate of deposit) whose maturity matches the date on which the funds will be needed.

For individuals, home and auto insurance are a must. So is health and disability insurance. Life insurance to protect one’s family from the death of the breadwinner(s) is also a necessity. You don’t need life insurance if you are single with no dependents. But if you have a family with young children who count on your income, you do need life insurance and lots of it.

Earnings on the part of the insurance premiums that go into the savings plan accumulate tax-free, and this can be advantageous for some individuals who have maxed out on their tax-deferred retirement savings plans.

Buy term insurance for protection and invest the difference yourself in a tax-deferred retirement plan. The recommendations that follow will provide an investment plan that is far superior to that available from “whole life” or “variable life” insurance policies.

Do not buy insurance from any company with an A.M. Best rating of less than A. A lower premium will not compensate you for taking any risk that your insurance company will get into financial difficulty and be unable to pay its claims. Don’t bet your life on a poorly capitalized insurance carrier.

Remember the overarching rule for achieving financial security: keep it simple. Avoid any complex financial products as well as the hungry agents who try to sell them to you.

Money-market mutual funds often provide investors the best instrument for parking their cash reserves. They combine safety and the ability to write large checks against your fund balance, generally in amounts of at least $250. Interest earnings continue until the checks clear. Interest rates on these funds generally ranged from 1 to 5 percent during the first decade of the 2000s. In 2014, however, interest rates were very low and money-fund yields were near zero.

Suppose you have set aside money for junior’s tuition bills that will need to be paid at the end of one, two, and three years. One appropriate investment plan in this case would be to buy three bank CDs with maturities of one, two, and three years. Bank CDs are even safer than money funds, typically offer higher yields, and are an excellent medium for investors who can tie up their liquid funds for at least six months. Bank CDs do have some disadvantages. They are not easily converted into cash, and penalties are usually imposed for early withdrawal. Also, the yield on CDs is subject to state and local income taxes. Treasury bills (short-term U.S. government IOUs), which are discussed below, are exempt from state and local taxes.

Issued and guaranteed by the U.S. government, T-bills are auctioned with maturities of four weeks, three months, six months, or one year. They are sold at a minimum $1,000 face value and in $1,000 increments above that. T-bills offer an advantage over money-market funds and bank CDs in that their income is exempt from state and local taxes. In addition, T-bill yields are often higher than those of money-market funds.

In 2014, you could take $5,500 per year and invest it in some investment vehicle such as a mutual fund and, for people with moderate incomes, deduct the entire $5,500 from taxes. (Individuals who earn relatively high incomes cannot take an initial tax deduction, but they still get all the other tax advantages described below.) If you are in the 28 percent tax bracket, the contribution really costs you only $3,960 since the tax deduction saves you $1,540 in tax.

In addition, you can Roth and roll. You can roll your regular IRA into a Roth IRA if your income is below certain thresholds. You will need to pay tax on all the funds converted, but then neither future investment income nor withdrawals at retirement will be taxed. Moreover, there are no lifetime minimum distribution requirements for a Roth IRA, and contributions can continue to be made after age seventy and a half. Thus, significant amounts can be accumulated tax-free for the benefit of future generations.

Self-Employed Plans. For self-employed people, Congress has created the SEP IRA. All self-employed individuals—from accountants to Avon ladies, barbers to real estate brokers, doctors to decorators—are permitted to establish such a plan, to which they can contribute as much as 25 percent of their income, up to $52,000 annually. If you moonlight from your regular job, you can establish a SEP IRA for the income you earn on the side. The money paid into a SEP IRA is deductible from taxable income, and the earnings are not taxed until they are withdrawn. The plan is self-directed, which means the choice of how to invest is up to you.

“529” college savings accounts allow parents and grandparents to give gifts to children that can later be used for college education. Named after the provision of the tax code that sanctioned them, the gifts can be invested in stocks and bonds, and no federal taxes will be imposed on the investment earnings as long as the withdrawals are made for qualified higher education purposes.

529 plans are sanctioned by individual states, and some states allow you to take a tax deduction on your state income tax return for at least part of your contribution. Thus, if you live in such a state, you will want to get a plan from that state. If your state does not allow a tax deduction, choose a plan from a low-expense state such as Utah.

Keep in mind that colleges are likely to consider 529 assets in determining need-based financial aid. Thus, if parents believe they will be eligible for financial aid when their child goes to college, they could be better off keeping the assets in their own names or, better still, in the names of the child’s grandparents. Of course, if you won’t qualify for need-based aid in any case, by all means establish a low-expense 529.

In sum, real estate has proved to be a good investment providing generous returns and excellent inflation-hedging characteristics.

two important tax breaks: (1) Although rent is not deductible from income taxes, the two major expenses associated with home ownership—interest payments on your mortgage and property taxes—are deductible; (2) realized gains in the value of your house up to substantial amounts are tax-exempt. In addition, ownership of a house is a good way to force yourself to save, and a house provides enormous emotional satisfaction. My advice is: Own your own home if you can possibly afford it.

although common stocks should be a major part of your portfolio, they should not be the sole investment instrument. Just remember the teary-eyed ex-Enron employees who held nothing but Enron stock in their retirement plans. When Enron went under, they lost not only their jobs but all their retirement savings as well. Whatever the investment objectives, the investor who is wise diversifies.

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.

Although I remain convinced that no one can predict short-term movements in securities markets, I do believe that it is possible to estimate the likely range of long-run rates of return that investors can expect from financial assets.