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

by Burton G. Malkiel

The new theory says that the total risk of each individual security is irrelevant. It is only the systematic component that counts as far as extra rewards go.

as the number of securities in the portfolio approached sixty, the total risk of the portfolio was reduced to its systematic level.

only the undiversifiable or systematic risk will command a risk premium.

The beta for any security is essentially the same thing as the covariance between that security and the market index as measured on the basis of past experience.

If the realized return is larger than that predicted by the portfolio beta, the manager is said to have produced a positive alpha.

There was no relationship between returns for stocks or portfolios and their beta risk measures.

Fama and French concluded that the relationship between beta and return is essentially flat. Beta, the key analytical tool of the capital-asset pricing model, is not a useful single measure to capture the relationship between risk and return.

The financial community is not ready to write an obituary for beta at this time.

Professor Richard Roll

it is very difficult (indeed probably impossible) to measure beta with any degree of precision.

Moreover, the total market includes bonds, real estate, commodities, and assets of all sorts, including one of the most important assets any of us has—the human capital built up by education, work, and life experiences. Depending on exactly how you measure the “market,” you can obtain very different beta values.

Two economists from the University of Minnesota, Ravi Jagannathan and Zhenyu Wang, find that when the market index (against which we measure beta) is redefined to include human capital and when betas are allowed to vary with cyclical fluctuations in the economy, the support for the CAPM and beta as a predictor of returns is quite strong.

Two factors are used in addition to beta to describe risk. The factors derive from their empirical work showing that returns are related to the size of the company (as measured by the market capitalization) and to the relationship of its market price to its book value.

THE FAMA-FRENCH RISK FACTORS •Beta: from the Capital-Asset Pricing Model •Size: measured by total equity market capitalization •Value: measured by the ratio of market to book value

I have argued here that no single measure is likely to capture adequately the variety of systematic risk influences on individual stocks and portfolios.

Behavioralists believe that many (perhaps even most) stock-market investors are far from fully rational.

Efficient-market theory, modern portfolio theory, and various asset-pricing relationships between risk and return all are built on the premise that stock-market investors are rational. As a whole, they make reasonable estimates of the present value of stocks, and their buying and selling ensures that the prices of stocks fairly represent their future prospects.

I wonder if there is an analogous political theory about voter behavior.

But they quickly wriggle out by declaring that the trades of irrational investors will be random and therefore cancel each other out without affecting prices. And even if investors are irrational in a similar way, efficient-market theory believers assert that smart rational traders will correct any mispricings that might arise from the presence of irrational traders.

Daniel Kahneman and Amos Tversky—blasted economists’ views about how investors behave and in the process are credited with fathering a whole new economic discipline, called behavioral finance.

Basically, there are four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion.

In a strict sense, the word “arbitrage” means profiting from prices of the same good that differ in two markets.

The term “arbitrage” is generally extended to situations where two very similar stocks sell at different valuations or where one stock is expected to be exchanged for another stock at a higher price if a planned merger between the two companies is approved.

In the loosest sense of the term, “arbitrage” is used to describe the buying of stocks that appear “undervalued” and the selling of those that have gotten “too high.” In so doing, hardworking arbitrageurs can smooth out irrational fluctuations in stock prices and create an efficiently priced market.

One of the most pervasive of these biases is the tendency to be overconfident about beliefs and abilities and overoptimistic about assessments of the future.

Daniel Kahneman has argued that this tendency to overconfidence is particularly strong among investors. More than most other groups, investors tend to exaggerate their own skill and deny the role of chance. They overestimate their own knowledge, underestimate the risks involved, and exaggerate their ability to control events.

men typically display far more overconfidence than women, especially about their prowess in money matters.

First and foremost, many individual investors are mistakenly convinced that they can beat the market. As a result, they speculate more than they should and trade too much.

month relative to the market as a whole. This illusion of financial skill may well stem from another psychological finding, called hindsight bias. Such errors are sustained by having a selective memory of success.

was going to quintuple right after its initial public offering.” People are prone to attribute any good outcome to their own abilities. They tend to rationalize bad outcomes as resulting from unusual external events.

Hindsight promotes overconfidence and fosters the illusion that the world is far more predictable than it really is.

Steve Forbes, the longtime publisher of Forbes magazine, liked to quote the advice he received at his grandfather’s knee: “It’s far more prof...

(The only subjects not under such an illusion turned out to be those who had been clinically diagnosed with severe depression.)

Nevertheless, the prices at which players were willing to sell their cards were systematically higher for those who chose their cards than for the group who had simply been given a card.

It is this illusion of control that can lead investors to see trends that do not exist or to believe that they can spot a stock-price pattern that will predict future prices.

Biases in judgments are compounded (get ready for some additional jargon) by the tendency of people mistakenly to use “similarity” or “representativeness” as a proxy for sound probabilistic thinking.

Kahneman and Tversky came up with the term “representative heuristic” to describe this finding.

One cardinal rule of probability (Bayes’ law) tells us that our assessment of the likelihood that someone belongs to a particular group should combine “representativeness” with base rates (the percentage of the population falling into various groups).

the representativeness heuristic is likely to account for a number of investing mistakes such as chasing hot funds or excessive extrapolation from recent evidence.

In general, research shows that groups tend to make better decisions than individuals.

an all-powerful central planner cannot possibly achieve any semblance of market efficiency in deciding what goods to produce and how resources should be allocated.

One widely recognized phenomenon in the study of crowd behavior is the existence of “group think.” Groups of individuals will sometimes reinforce one another into believing that some incorrect point of view is, in fact, the correct one.

Asch conjectured that social pressure caused participants to pick the wrong line even when they knew that their answer was incorrect.

Reminds me of the first story in Italo Calvino's collection, where a crowd assembles on the street and joins a man's calls for a woman in an upper level, even after the original caller leaves.

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.

Eventually one runs out of greater fools.

Such results are consistent with an epidemic model, in which investors quickly and irreversibly spread information about stocks by word of mouth.

Although long-run returns from the stock market have been generous, the returns for the average investor have been significantly poorer. This is because investors tended to buy equity mutual funds just when exuberance had led to market peaks.

In addition, investors tend to put their money into the kinds of mutual funds that have recently had good performance.

One of the most important lessons of behavioral finance is that individual investors must avoid being carried away by herd behavior.

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.

In the face of sure losses, people seem to exhibit risk-seeking behavior.