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

by Burton G. Malkiel

What should we conclude from these studies? It is clear that people set far too precise confidence intervals for their predictions.

Selling stocks with gains (outside tax-advantaged retirement accounts) involves paying capital gains taxes. Selling stock on which losses have been realized involves reducing taxes on other realized gains or a tax deduction, up to certain limits.

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.

Typically in selling short, the security that is shorted is borrowed in order to deliver it to the buyer.

Charles Ellis, a longtime observer of stock markets and author of the brilliant investing book Winning the Loser’s Game, observes that, in the game of amateur tennis, most points are won not by adroit plays on your part but rather by mistakes on the part of your opponent. So it is in investing. 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.

Don’t be your own worst enemy: Avoid stupid investor tricks. Here are the most important insights from behavioral finance.

1. Avoid Herd Behavior

2. Avoid Overtrading

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.

3. If You Do Trade: Sell Losers, Not Winners

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.

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.

4. Other Stupid Investor Tricks

Be Wary of New...

My advice is that you should not buy IPOs at their initial offering price and that you should never buy an IPO just after it begins trading at prices that are generally higher than the IPO price. Historically, IPOs have been a bad deal. In measuring all IPOs five years after their initial issuance, researchers have found that IPOs underperform the total stock market by about 4 percentage points per year. The poor performance starts about six months after the issue is sold.

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.

Stay Cool to Hot Tips.

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.

Distrust Foolproof Schemes.

“Market timing can only be accomplished by liars.”

“smart beta” is not a smart way to go for the individual investor, and it argues that the tried-and-true approach—investing in low-cost, broad-based, capitalization-weighted index funds—is still the best way to build an investment portfolio.

If an investor buys a low-cost Total (U.S.) Stock Market index fund, as I have recommended, she will receive the market rate of return as well as assume the risks of the characteristic ups and downs of the U.S. stock market.

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.

In general, the records of “smart beta” funds and ETFs have been spotty. Many “smart beta” ETFs have failed to produce reliable excess returns, although a few have “beaten the market” over the lifetime of the funds. These funds are, however, less tax efficient than capitalization-weighted funds that do not require rebalancing.

There is no reason to adjust the long-standing advice of the earlier editions of this book: The core of every portfolio should consist of low-cost, tax-efficient, broad-based index funds. If you do want to take a chance that some risk factor will generate excess returns in the future, you can do so most prudently if the core of your portfolio consists of capitalization-weighted broad-based index funds. And if you do wish to add an additional risk factor to your portfolio, such as some extra exposure to small-company stocks, you can do so most efficiently and effectively by purchasing a low-cost, capitalizationweighted fund that follows an index of small-cap stocks.

Montier, global strategist at Société Générale, writing in the Financial Times, declared that the theory suggesting that markets are efficient was “utter garbage” and should be consigned to the dust bin. 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. We have seen, however, that these patterns are not dependable in every period, and that some of the patterns based on fundamental valuation measures of individual stocks may simply reflect a better proxy for measuring risk. In addition, many of these patterns could self-destruct in the future, as many of them have already done.

CAPITALIZATION-WEIGHTED INDEXING REMAINS AT THE TOP OF THE CLASS

In conclusion, capitalization-weighted indexing is unlikely to be deposed as the overwhelming favorite in the battle for index supremacy. Even if markets were inefficient, departing from the weightings given by the market as a whole would have to be a zero-sum game. All the stocks in the market must be held by someone. If some investors hold portfolios that do better than the market, it must follow that some other investors hold portfolios that do worse. Because of their greater costs, however, active management or “smart” indexing must be a negative-sum game. On average, these higher-cost portfolios must underperform capitalization-weighted index funds that can be purchased at close to zero cost.

Think of the advice that follows as a set of warm-up exercises that will enable you to make sensible financial decisions and increase your after-tax investment returns.

EXERCISE 1: GATHER THE NECESSARY SUPPLIES

The harsh truth is that the most important driver in the growth of your assets is how much you save, and saving requires discipline.

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 secret of getting rich slowly (but surely) is the miracle of compound interest.

EXERCISE 2: DON’T BE CAUGHT EMPTY-HANDED: COVER YOURSELF WITH CASH RESERVES AND INSURANCE

But 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.

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.

would avoid buying variable-annuity products, especially the high-cost products offered by insurance salespeople. A deferred variable annuity is essentially an investment product (typically a mutual fund) with an insurance feature.

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. The only reason you should even consider a variable annuity is if you are super wealthy and have maxed out on all the other tax-deferred savings alternatives. And even then you should purchase such an annuity directly from one of the low-cost providers such as the Vanguard Group.

EXERCISE 3: BE COMPETITIVE—LET THE YIELD ON YOUR CASH RESERVE KEEP PACE WITH INFLATION

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 existed at the end of 2014.

Money-Market Mutual Funds (Money Funds)

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 fun...

Interest rates on these funds generally ranged from 1 to 5 percent during the fi...

Not all money-market funds are created equal; some have significantly higher expense ratios (the costs of running and managing the funds) than others. In general, lower expenses mean higher returns. A sample of relatively low-expense funds is presented in the Ran...

Bank Certificates of Dep...

A reserve for any known future expenditure should be invested in a safe instrument whose maturity matches the date o...

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.

Bank CD rates vary widely. Use the Internet to find the most attractive returns. Go to www.bankrate.com and search the site for the highest rates around the country. Deposits at all banks and credit unions listed at this site are insured by the Federal Deposit Insurance Corporation. Addresses and phone numbers are given for each listing, and you can call to c...

Internet...