In the summer of 2019 Britain baked in some of the hottest temperatures on record. Commuters stayed away from public transport and made the most of the weather by walking to work instead. If that was you, there’s very little about your walk that’s random – you can predict your movements and you already know your destination.
A random walk would look very different and as Burton G. Malkiel notes in his 1973 classic, A Random Walk Down Wall Street, it’s a good analogy for the stock market. It’s been reprinted many times but the lessons are just as valuable now, so let’s take a look at what Malkiel learns as he ambles through the financial district.
What makes it great, in a nutshell?
First up, this is a weighty book and a long read. It’s a good one and it’s well worth the time, but if there’s a central premise to distil, it’s this – trying to predict how the markets will move is a fool’s errand and low-cost index funds are a better use of your time and money.
Working through the book
Just as a random walk could take you anywhere – you can’t predict where your next steps will land, based on where you’ve been – short-run changes in stock prices can’t be predicted either. Malkiel starts by looking at two core theories of investment, first, the Firm Foundation Theory, which argues that stocks have an intrinsic value that you can reach by discounting and adding future dividends. Then there’s the Castle-in-the-Air theory (don’t worry nothing to do with Don McLean). It’s also known as Greater Fool Theory and it’s about predicting the crowd’s mood – in other words an investment is worth what people are ready to pay (a good example is the recent rollercoaster ride of cryptocurrencies).
Much of the book is given over to exploring why the second theory doesn’t hold up – in short, people aren’t logical and we see the same mistakes (with remarkably similar outcomes) throughout history. In The Madness of Crowds (Chapter 2), Malkiel cites examples of mania from the South Sea Bubble of the 18th century and the Soaring Sixties – the first ‘tech’ stock bubble – to the biggest of all, the Internet Bubble, during which the market tripled before it crashed. In every case people rushed into the new mania, which saw prices rise astronomically before crashing. He argues that markets tend towards efficiency and that each irrational binge is weeded out sooner or later, with prices returning to rational levels.
It’s not that people can’t or don’t make money during these phenomena; they do, but it’s not for everyday investors, nor is success here driven by skill – it’s driven by a very cavalier attitude to risk and, crucially, by those with the resources to cope with potentially enormous losses.
Malkiel also looks at some familiar but flawed approaches to market analysis, beginning with technical analysis, which looks for historical correlations in market movements, which he argues are spurious at best and lead analysts to focus on the micro, losing touch with the macro. Then there’s fundamental analysis, which eschews the charts but still attempts to predict the future by trying to find the underlying value of a company. These analysts look at data about a firm, its history and its health, to divine information about future earnings. But a firm’s previous earnings don’t paint an infallible picture of the future and analysts who were asked to predict the price of a stock within five years were very inaccurate, even more so over one year.
What does the book teach us?
If neither technical nor fundamental analysis can be trusted, then where to now? Malkiel does point out that while it’s not possible to predict movements, the general trend, over time, is upwards. But in the short term things are far less clear and for periods of less than a decade, it’s essentially random.
That leads him to the strategy of using index funds – “the one I most highly recommend” – and avoiding active management. He also looks at Modern Portfolio Theory, the tried and tested idea that people should build a diverse portfolio of investments that look for the best rewards with the lowest risk (because there’ll always be some risk).
The key lesson is that investors are much better off in the long run than speculators and that we’d all do well to diversify, lower costs and benchmark against our own financial and life goals, rather than trying to predict the future or using benchmarks that are unreliable and irrelevant.
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