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

by Burton G. Malkiel

Res tantum valet quantum vendi potest. (A thing is worth only what someone else will pay for it.)

Extraordinary Popular Delusions and the Madness of Crowds, noted that the ordinary industry of the country was dropped in favor of speculation in tulip bulbs: “Nobles, citizens, farmers, mechanics, seamen, footmen, maid-servants, even chimney sweeps and old clotheswomen dabbled in tulips.”

As late as 1693, for example, only 499 souls benefited from ownership of East India stock. They reaped rewards in several ways, not least of which was that their dividends were untaxed. Also, their number included women, for stock represented one of the few forms of property that British women could possess in their own right.

John Carswell, the author of an excellent history, The South Sea Bubble, wrote of John Blunt, a director and one of the prime promoters of the securities of the South Sea Company, that “he continued to live his life with a prayer-book in his right hand and a prospectus in his left, never letting his right hand know what his left hand was doing.”

Institutional managers blithely ignored the fact that no sizable company could ever grow fast enough to justify an earnings multiple of 80 or 90. They once again proved the maxim that stupidity well packaged can sound like wisdom.

THE DEMISE OF THE NIFTY FIFTY Security Price-Earnings Multiple 1972 Price-Earnings Multiple 1980 Sony 92 17 Polaroid 90 16 McDonald’s 83 9 Int. Flavors 81 12 Walt Disney 76 11 Hewlett-Packard 65 18 The Nifty Fifty craze ended like all other speculative manias. The same money managers who had worshiped the Nifty Fifty decided that the stocks were overpriced and made a second decision—to sell.

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.

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.

Caring little about the particular pattern of past price movements, fundamentalists seek to determine a stock’s proper value.

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. If, on the other hand, your stock sold at a multiple below the average in the market for that growth rate, the security is said to represent good value for your money.

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

The four valuation rules imply that a security’s firm-foundation value (and its price-earnings multiple) will be higher the larger the company’s growth rate and the longer its duration; the larger the dividend payout for the firm; the less risky the company’s stock; and the lower the general level of interest rates.

Peter Lynch, the very successful but now retired manager of the Magellan Fund, used this technique to great advantage during the fund’s early years. Lynch calculated each potential stock’s P/E-to-growth ratio (or PEG ratio) and would buy for his portfolio only those stocks with high growth relative to their P/Es. This was not simply a low P/E strategy, because a stock with a 50 percent growth rate and a P/E of 25 (PEG ratio of ½) was deemed far better than a stock with 20 percent growth and a P/E of 20 (PEG ratio of 1).

Because there is a long-term uptrend in the stock market, it can be very risky to be in cash. 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.

Nathan Rothschild made millions in the market when his carrier pigeons brought him the first news of Wellington’s victory at Waterloo before other traders were aware of the victory.

Two behavioral economists, Terrance Odean and Brad Barber, examined the individual accounts at a large discount broker over a substantial period of time. They found that the more individual investors traded, the worse they did. And male investors traded much more than women, with correspondingly poorer results.

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