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

The summary

Every asset carries two prices. One is what it’s worth — for a stock, the discounted value of all the cash it will ever pay out. The other is what the next buyer will hand you. Malkiel names these the firm-foundation theory and the castle-in-the-air theory, and forty years of editions reach one verdict: both are partly right, neither is reliable enough to trade on.

Intrinsic value versus the beauty contest

The firm foundation runs from John B. Williams, who set a stock’s intrinsic value at the discounted worth of its future dividends, through Graham and Dodd’s Security Analysis, down to Warren Buffett. Buy below the foundation, sell above it, wait for the correction. The catch: that foundation is built from guesses about how fast a company will grow and for how long. Nobody guesses well.

The castle in the air belongs to Keynes, who played the market from bed for half an hour each morning and multiplied King’s College’s endowment tenfold. His image for it is a newspaper beauty contest where the prize goes not to whoever picks the prettiest face but the face most other entrants pick. Morgenstern’s motto for investors: a thing is worth only what someone else will pay for it.

Four centuries, one script

Holland, 1634 to 1637: a virus that striped tulip petals made the oddest bulbs the most prized, and a visiting sailor ate a Semper Augustus he took for an onion — a bulb that would have fed a ship’s crew for a year. Prices rose twentyfold in January 1637, then fell further in February.

London, 1720: among a hundred bubble companies pitching everything from extracting sunlight from cucumbers to perpetual motion, the prize went to “A Company for carrying on an undertaking of great advantage, but nobody to know what it is.” A thousand people subscribed within five hours; the promoter closed the books and left for the Continent. Isaac Newton, burned by the South Sea Company itself: “I can calculate the motions of heavenly bodies, but not the madness of people.”

Then the professionals took over and did no better. Irving Fisher judged in 1929 that stocks had reached a “permanently high plateau”; most blue chips lost 95 percent by 1932. In 1998 and 1999, sixty-three companies that merely added a web-sounding name to the letterhead beat their peers by 125 percent in ten days. Then came housing: banks stopped holding the loans they wrote, issued NINJA mortgages to people with no income, no job and no assets, and coined “jingle mail” for keys posted back when prices fell a third.

Neither method beats a coin flip

Malkiel had students build stock charts by flipping coins. Out came head-and-shoulders formations, triple tops, and one gorgeous breakout that sent a chartist friend scrambling for the company’s name so he could buy. Against the placebo of buy-and-hold, no technical rule survives its own trading costs. The fringe versions are funnier: hemlines, the Super Bowl winner’s original league, and the indicator most closely correlated with the S&P 500 — butter production in Bangladesh. Rules that do work die of popularity: the Dogs of the Dow stopped beating the index once billions poured into funds built on it.

Fundamental analysis fails more respectably. Malkiel and John Cragg asked nineteen of Wall Street’s most respected research firms for earnings estimates, then checked them against reality. The five-year forecasts came in worse than naive extrapolation of past trends; when analysts protested that five years was too far out, their one-year forecasts proved worse still. Only one in eight large companies managed consistent growth through the 1990s boom, and none carried it into the next decade. Ten thousand dollars indexed in 1969 was worth $736,196 by mid-2014; in the average managed fund, $501,470.

What behavioral finance wins, and what it doesn’t

Malkiel concedes plenty. Barber and Odean tracked 66,000 households through the 1990s: the average earned 16.4 percent against a market returning 17.9, and those that traded most earned 11.4. Kahneman and Tversky measured losses as about two and a half times as painful as equivalent gains are pleasant, which is why investors dump winners and cling to losers — backwards, for tax purposes. And arbitrage, the mechanism meant to scrub prices clean, has hard limits: hedge funds in 1999 didn’t attack the internet bubble, they rode it.

What he won’t concede is a door in. Prices are often wrong, but the correction always arrives and nobody can say in advance which way the error runs. The models that flagged a bubble in early 2000 also called stocks wildly overpriced in 1992, and again at Greenspan’s “irrational exuberance” speech in 1996; returns after those two warnings ran about 9 and 7.5 percent a year.

What’s left to do

The prescription hasn’t changed since 1973, when Malkiel asked for a fund that would simply buy the whole market and stop trading. Hold broad index funds — not only the S&P 500, which leaves out thousands of smaller companies, but a total-market index, plus international stocks, bonds and real estate. Costs decide the race: index funds run at a twentieth of one percent a year, active funds average a full percent and churn nearly their whole portfolio annually. Rebalance yearly, which quietly forces you to sell what has run up. Add money steadily. Skip IPOs, which lag the market by about four points a year over five years; the ones your broker offers you are the ones nobody else wanted.

The bottom line

Prices are set by a crowd that is sometimes rational and sometimes possessed, and from the inside you can’t tell which — so stop trying, buy everything, drive costs near zero, and hold. Read it for the evidence behind the slogan: four centuries of manias, the studies that gutted both charting and stock-picking, and a working portfolio at the end. Anyone shopping for an edge should know the book’s point is that there isn’t one.