A Random Walk Down the Wall Street Review: The Guide to Being a Successful Individual Investor
Stocks, investments, bonds, and risk parity are the most confusing terms we get confused about. We think there’s no chance to indulge and work with them on our own.
Burton Malkiel argues through this highly readable book that a monkey throwing darts often has a similar, if not better, chance of making predictions with similar profits as the professionals. He offers his argument with examples spread across decades. He gives you a comprehensive idea of how to save and invest by yourself, comparing and commenting on different theories and methodologies.
The Explosions of Speculative Bubbles and Their Irresistible Charm
- Malkiel shows how, throughout history, any innovation has caused disruptions in the market. These disruptions are caused by increased demands for stocks because of many factors, from financial analysts exaggerating and overselling the future to governments getting lax on their policies.
- Time and time again, these speculative bubbles rise and eventually fall. Be it the housing and internet bubbles in the 2000s or the conglomerates and the concept stocks in the “soaring sixties”, every sudden and unproportionate rise in the market is always followed by a crash. Therefore, it’s preferable to have a broad-based portfolio of stocks instead of getting lured into these “get rich quick” schemes.
- The author proposes that the latest speculative market can be the bitcoin bubble, as it shares similarities to the other bubbles in the past. Unfortunately, this generally makes trading in bitcoins a volatile and unsafe investment.
Firm Foundations and Castles in the Air
- Traditionally, there have been two theoretical approaches to investing: the firm foundation and the castle-in-the-air theory.
- The first argues that every stock or an investment instrument has an intrinsic value that it carries within itself. Using past, present, and future conditions, you can determine that inherent value which is the “true value” of the stock. Now, when the market prices go lower than this intrinsic value, it’s an opportunity for you to purchase it. Similarly, when the prices go higher, it’s time for you to sell the same. Warren Buffet and his incredible investing records mainly result from following the firm-foundation theory.
- Now, on to the other one: the castles-in-the-air theory. This was given by the father of modern macroeconomics, John Keynes, who used psychological concepts instead of financial ones to formulate the hypothesis. As per the principle, you don’t spend your energy in determining the intrinsic value of a stock but instead in analysing how the investors will behave in the future concerning that stock.
- This means it’s okay to spend three times the intrinsic value of an object in the present if someone is willing to pay five times its worth in the future:
- Res tantum valet quantum vendi potest. (A thing is worth only what someone else will pay for it.)
- Most of the analysis done by investment experts rely on one of these two methods. The technical analysis, done by technicians or chartists, follows the castles-in-the-air approach, using trends and charts to select stocks. The other and more popular type of analysis, based on the firm-foundation methods, is called fundamental analysis. It uses factors such as the company’s assets and current risk to predict the right stocks.
- While technicians aim for short-term investments based on past trends, fundamentalists go for stocks that provide better returns over a long period. Burton suggests a hybrid and relatively better method where you use fundamental and technical analysis together. He summarises it through three rules:
Buy only those companies with an above-average earnings growth expectation over five years or more.
- Consistent growth over a long period is essential if you wish to get stable returns on your investment over a long period.
Never pay more than a stock’s firm-foundation value.
- While it’s impossible to estimate the correct firm-foundation value of any stock, you can still have a rough idea of it. It’s also wise to invest in situations with low price-earning multiples. There’s a good chance of both earnings and multiples to rise in the future, which leads to significant gains. In cases of high multiple stocks, prospects of future growth are limited.
Give preferences to those stocks on whom castles in the air can be built quickly.
- Sometimes, stocks with average growth rates can perform brilliantly, as long as they can conjure up a dreamlike story to go with it. In short, stocks with firm foundations that can build castles in the air are usually preferable.
A Random Walk Down Wall Street
- After going through numerous examples and concepts of these two primary investment theories, one of the book's central themes begins taking shape. The first half of the book, more or less, consists of anecdotes and examples that illustrate one tenet of investing: you can’t beat the market in the long run. Whether you’re a fundamentalist or a technician, you can’t predict the market in an orderly fashion.
- Someone who simply buys and holds stocks usually have the same chances of success, if not more, as those who buy them through brokers and experts. And this is the reason behind the title of the book, which implies that investing in stocks is often like taking a random walk down wall street. Because the central message is loud and clear: You can’t beat the market.
- There are different ways through which financial experts have tried to measure risk, a popular one being the beta value from the capital-asset pricing model. And even though it can provide some idea about the market, it’s no sure-shot method of knowing how your stocks will perform at the end of the day. An excellent way to reduce your risks is through Modern Portfolio Theory.
Modern Portfolio Theory (MPT)
- Let’s suppose you have two businesses in one region. One company sells umbrellas while the other handles resorts with beaches. One of them would gain profits during the summer season (during which the other would be incurring losses), and the other business would be profitable when it rains. So instead of investing in one business exclusively, it’s much better to invest equally in both (considering all other factors are identical) to earn profits regardless of whether some year has longer summers or monsoons.
- This forms the crux of MPT: diversify your stocks. Invest in stocks with hostile relations so that if one goes down, the other goes up. This helps reduce the unsystematic or specific risks, especially with globalisation and open markets.
As per behavioural economics studies, there are different types of irrational behaviours that lead to mistakes in selecting the right stocks and making related calculations. And not just that, these behaviours are observed continually.
- Investors are often overconfident in their estimations and how the market behaves. Not only that, we tend to forget our failures and only remember the successes and positive outcomes in hindsight. These biases then go on to affect the stock market and the way investors purchase different stocks.
- Humans tend to feel a sense of control over things when there’s nothing. But unfortunately, this tendency can lead investors to see trends and patterns where there’s nothing in the first place. This is even more so in the case of chartists and technicians.
- What do you do when the entire class answers unanimously to the same question, and you’re the last one remaining? There’s a high probability that you’ll give the same answer even if you’d thought of a different one at the beginning. This isn’t merely because of social pressure; observing a group of people make a similar decision also changes our perception of the same.
- So it is with stocks where investors often tend to buy the stocks of something everyone else is also purchasing. It’s crucial not to get swayed by herd mentality and to make independent decisions.
- We tend to run as far away from losses as possible. This manifests itself in the world of investing when investors leave instruments with substantial risks but with gains that make them worthwhile.
Pride & Regret
- Often emotions of pride and regret come into play when investors hold on to their losing stocks just because they don’t want to admit defeat. Even though selling the losing stocks means you get tax exemptions that are preferable over holding onto them just because of your pride.
Lessons from Behavioral Economics
Malkiel gives rules based on these behavioural observations shown by analysts and investors:
- Avoid showing herd behaviour
- Avoid trading excessively
- Sell your losing stocks, and not the winning ones
- Be cautious toward new financial instruments in the market
- Keep away from get-quick-rich schemes and the “latest hot tip” furnished by some relative
How to be a Successful Individual Investor
- At the outset, it seems impossible, too complex to execute, but as Burton repeatedly shows throughout the book, it’s not. By taking some basic precautions and not getting ahead of yourself, you can beat those expert analysts by yourself. The primary thing to do here is to evaluate your risk tolerance depending on your age, finances, and temperament.
- As J. Kenfield Morley has said, the amount of interest you want in investing money should depend on whether you want to eat well or sleep well.
- Remember this when choosing bonds or stocks with higher returns for yourself. What degree of risk can you choose? Can you live with the loss of your investment? Or is it affecting your sleep and lifestyle? Depending on your situation, you should select the volatility of your stock.
- The best way to index at any given point is to invest in cheap index funds for an extended period. The longer the time, the more likely you’ll get great returns on your investment. You should predominantly invest in index funds, followed by bonds and real estate. Depending on your age, these proportions vary. The younger the investor, the higher the percentage of index funds should be in his portfolio and the lesser the rate of bond investments.
- Investing fixed amounts at regular intervals also helps reduce the market's overall price volatility and brings down the average cost of your shares. This process is called dollar-cost averaging. Suppose you change the ratio of the amounts allocated to different investments for some reason or another (say, the stocks are performing very well). In that case, it’s preferable to rebalance the allocations afterwards. This helps reduce the risks and get you higher returns on average.
To provide a very brief overview of everything we saw and read so far,
- Both fundamental and technical forms of analysis are ineffective in predicting the suitable types of stocks to purchase.
- You can’t beat the market over a long duration, for navigating the market is much akin to taking a random walk down wall street.
- Behavioural science shows how investors display similar irrational behaviours again and again.
- Investing in cheap index funds and having a diverse portfolio to beat the market and its ups and downs is always better than most other options.
- Keep your risk tolerance in mind before investing, and invest for more extended periods for better and safer returns.
It’s even better if you can read the complete book, for it further expands on each concept, showing and explaining the different ideas we’ve covered cursorily here.