Book Review: A Random Walk Down Wall Street

I recently re-read the classic investing text A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (W. W. Norton & Company, 464 pp) by Princeton Professor Burton Malkiel.  In my opinion (and many others), this is the single best investing book ever written.  Malkiel covers a wide array of topics including stock valuation theories, bubbles, technical and fundamental analysis (even explicitly covering individual technical strategies and debunking the conclusions of repeated outperformance), modern portfolio theory, behavioral finance (a particularly interesting topic in my mind), efficient-market theory, and then a guide to come up with a portfolio that will challenge those on Wall Street.  Before creating a portfolio for the first time, get this book.

There are certainly easier texts to read for beginners.  Thus, if you're just starting and want a more simplified approach than a 450+ page text, you might look elsewhere.  However, Malkiel writes in a very accessible manner such that even neophytes can understand more complex theories.  I'd say that the average investor would be able to follow A Random Walk Down Wall Street more easily than The Intelligent Investor, for instance.  There's a reason that the book has been repeatedly updated over the course of 35 years and has sold over a million copies.  What I especially enjoy about this book is not only the broadness of topics covered, but also how Malkiel methodically analyzes various strategies and supports his conclusions with ironclad findings.  He doesn't dismiss other points of views simply by saying "trust me," but rather provides ample evidence to backup his viewpoint.  Malkiel worked in the financial industry for several years and has been in academia for quite some time, churning out economic studies.

The first portion of the text covers stocks and their value.  Malkiel divides each section clearly to explain various topics in a concise manner.  This also provides a simplified manner in which to jump around a bit, if so desired.  One doesn't need to read the text from page 1 to page 464 in order to gain great insight.  Rather, it's certainly doable to skip to the section that most interests you.
Near the beginning, Malkiel posits the two main theories and approaches to asset evalution: the firm-foundation theory and the castle-in-the-air theory.  Down to their most basic premise, the former simply argues that each investment derives its value from the analysis of present company metrics and market conditions as well as future prospects.  That is, the stock's trading price is tied to the firm's earnings and growth patterns; when the price becomes at odds with those fundamentals, the market corrects itself.  One would consider Benjamin Graham, Warren Buffett, and David Dodd to subscribe to this perspective.

On the other hand, the castle-in-the-air theory posits that stock prices are determined simply by what other people are willing to pay for it.  That is, how will the crowd react to various reports and news of the firm.   Will the crowd view the stock in an optimistic and favorable light?  That will cause the price to increase, and the castle-in-the-air specialist seeks to make the move prior to most others.  John Keynes is the most famous economist to hold this view.

Malkiel then goes on to describe "the madness of crowds," illustrated perfectly with the tulip bulb craze in Holland in the late 16th century when prices spiraled out of control.  The book then gives a brief history of stock evaluations from the 60s to the 90s, giving a great historical look at investing and the market.  To conclude part one, the author discusses bubbles, specifically highlighting surfing on the internet.

Part two is the big debunking of Wall Street (my words) section.  Essentially, Malkiel describes how various contenders such as fundamentalists and technical analysts play the game and why such strategies fall short.  In part three, he describes the modern portfolio theory in a clear manner that defines risk and how diversification works in practice.  He then covers behavioral finance, giving space to overconfidence, herding, and loss aversion among other topics.  Finally, Malkiel head-on addresses various beliefs as to why the efficient-market theory doesn't hold true.

Finally, at part four, Malkiel gives real-world advice for individual investors and how to make one's portfolio better.  This is really the meat and potatoes of the text and if you simply want guidance to your individual portfolio and asset allocation, I'd skip to this section.  Malkiel recognizes that many investors cannot accept the indexing model, and thus offers four rules on picking individual stocks, while emphasizing the odds are stacked against outperformance when choosing individual companies to invest in.

In the end, Malkiel shuns Wall Street's antics and its rampant marketing that the pros always win.  He credits the majority of the outperformance of the select few fund managers to dumb luck saying that very few individuals actually possess the capabilities and foresight to continually pick winners.  After eliminating the selection bias of surviving funds, you'll see how poorly Wall Street truly performs and that the fees they charge you are excessive.  Malkiel professes to a low-cost diversified set of index funds that gradually grow more conservative as you near retirement.  As he concludes, "The indexing strategy is the one I most highly recommend [...] Investing is a bit like lovemaking.  Ultimately, it is really an art requiring a certain talent and the presence of a mysterious force called luck.  Indeed, luck may be 99 percent responsible for the success of the every few people who have beaten the averages [...] If you know you will either win or at least not lose too much, and if you index at least the core of your portfolio, you will be able to play the game with more satisfaction."

Rating: 5 out of 5

2 comments:

  1. I agree that the book is a must read for the serious investor. Fortunately the end result of Malkiel's findings are pretty basic and stated in the simplified "The Elements of Investing" by Malkiel and Ellis (another giant in the field). I guess my view would be that if someone wants to do their own investing then read "A Random Walk Down Wall Street" and if they just want to know enough to choose an investment manager then read "The Elements of Investing".
    If I had a dollar for everytime I recommended "A Random Walk..." I wouldn't have to keep an eye on my investments:).

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  2. I have heard bob brinker on money talk recommend thas book many times.

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