A Random Walk Down Wall Street: The Best Investment Guide That Money Can Buy

by Burton G. Malkiel

Adjusted earnings are often called “earnings before all the bad stuff,” and give firms license to exclude any expenses they deem to be “special,” “extraordinary,” and “non-recurring.”

Generally too lazy to make their own earnings projections, they prefer to copy the forecasts of other analysts or to swallow the “guidance” released by corporate managements without even chewing.

One indication of the tight relationship between security analysts and their investment banking operations has been the traditional paucity of sell recommendations.

Even worse, researchers at Dartmouth and Cornell found that stock recommendations of Wall Street firms without investment banking relationships did much better than the recommendations of brokerage firms that were involved in profitable investment banking relationships with the companies they covered.

“Analyze investment performance,” the chorus is saying, “not earnings forecasts.”

the records of one group of professionals—the mutual funds—are publicly available.

Investors have done no better with the average mutual fund than they could have done by purchasing and holding an unmanaged broad stock index. In other words, over long periods of time, mutual-fund portfolios have not outperformed the market.

It is the nature of an average that some investors will beat it. With large numbers of investment managers, chance will—and does—explain some extraordinary performances.

The index performance is not mediocre—it exceeds the results achieved by the typical active manager.

Index investing is smart investing.

Now more money invested by individuals and institutions is invested in index funds and indexed ETFs than in actively managed funds. And that percentage continues to grow each year.

The academic community has rendered its judgment. Fundamental analysis is no better than technical analysis in enabling investors to capture above-average returns.

The “semi-strong” form says that no public information will help the analyst select undervalued securities.

The “strong” form says that absolutely nothing that is known or even knowable about a company will benefit the fundamental analyst.

The strong form of the EMH is obviously an overstatement. It does not admit the possibility of gaining from inside information.

The “narrow” (weak) form of the EMH says that technical analysis—looking at past stock prices—cannot help investors. Prices move from period to period very much like a random walk.

The “broad” (semi-strong and strong) forms state that fundamental analysis is not helpful either. All that is known concerning the expected growth of the company’s earnings and dividends, all of the possible favorable and unfavorable developments affecting the company that might be studied by the fundamental analyst, is already reflected in the price of the company’s stock.

The efficient-market hypothesis does not imply, as some critics have proclaimed, that stock prices are always correct. In fact, stock prices are always wrong.

The market is so efficient—prices move so quickly when information arises—that no individual investor can buy

or sell fast enough to benefit.

the rarefied world of the “new investment technology” created within the towers of the academy.

One insight—modern portfolio theory (MPT)—is so basic that it is now widely followed on the Street.

The efficient-market hypothesis explains why the random walk is possible. It holds that the stock market is so good at adjusting to new information that no one can predict its future course in a superior manner.

Many academics agree; but the method of beating the market, they say, is not to exercise superior clairvoyance but rather to assume greater risk. Risk, and risk alone, determines the degree to which returns will be above or below average.

Investment risk, then, is the chance that expected security returns will not materialize and, in particular, that the securities you hold will fall in price.

Thus, financial risk has generally been defined as the variance or standard deviation of returns.

Portfolio theory begins with the premise that all investors are like my wife—they are risk-averse. They want high returns and guaranteed outcomes. The theory tells investors how to combine stocks in their portfolios to give them the least risk possible, consistent with the return they seek.

What Markowitz discovered was that portfolios of risky (volatile) stocks might be put together in such a way that the portfolio as a whole could be less risky than the individual stocks in it.

Whatever happens to the weather, and thus to the island economy, by diversifying investments over both of the firms, an investor is sure of making a 12½ percent return each year.

Markowitz’s great contribution to investors’ wallets was his demonstration that anything less than perfect positive correlation can potentially reduce risk.

In other words, is there a point at which diversification is no longer a magic wand safeguarding returns? Numerous studies have demonstrated that the answer is yes. As shown in the following chart, the golden number for American xenophobes—those fearful of looking beyond our national borders—is at least fifty equal-sized and well-diversified U.S. stocks

It turns out that about fifty is also the golden number for global-minded investors.

the international diversified portfolio tends to be less risky than the one drawn purely from U.S. stocks.

The paradoxical result of this analysis is that overall portfolio risk is reduced by the addition of a small amount of riskier foreign securities.

International diversification provided the closest thing to a free lunch available in our world securities markets.

Globalization led to an increase in the correlation coefficients between the U.S. and foreign markets as well as between stocks and commodities.

an investment in the S&P 500 did not make any money during the first decade of the 2000s. But investment in a broad emerging-market index produced quite satisfactory returns.

to get a higher average long-run rate of return, you need to increase the risk level of the portfolio that cannot be diversified away.

According to this theory, savvy investors can outperform the overall market by adjusting their portfolios with a risk measure known as beta.

“We can reasonably describe the total risk of any security (or portfolio) as the total variability (variance or standard deviation) of the returns from the security”?

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 portfoli...

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.

Basically, beta is the numerical description of systematic risk.

The beta calculation is essentially a comparison between the movements of an individual stock (or portfolio) and the movements of the market as a whole. The calculation begins by assigning a beta of 1 to a broad market index. If a stock has a beta of 2, then on average it swings twice as far as the market. If the market goes up 10 percent, the stock tends to rise 20 percent. If a stock has a beta of 0.5, it tends to go up or down 5 percent when the market rises or declines 10 percent. Professionals call high-beta stocks aggressive investments and label low-beta stocks as defensive.

The growth arc of the market is long and it bends up and to the right.

Unsystematic risk (also called specific or idiosyncratic risk) is the variability in stock prices (and, therefore, in returns from stocks) that results from factors peculiar to an individual company.

The risk associated with such variability is precisely the kind that diversification can reduce. The whole point of portfolio theory is that, to the extent that stocks don’t always move in tandem, variations in the returns from any one security tend to be washed away by complementary variation in the returns from others.

Thus, the capital-asset pricing model says that returns (and, therefore, risk premiums) for any stock (or portfolio) will be related to beta, the systematic risk that cannot be diversified away.

The proposition that risk and reward are related is not new.

What is different about the new investment technology is the definition and measurement of risk.