Lessons Learned from A Random Walk Down Wall Street
Prior to reading Burton Malkiel’s book, A Random Walk Down Wall Street, I naively granted credibility to various methodologies claiming to have formulas to predict future stock price movements. Through my reading, my views on many of these methodologies have shifted, believing them to be more a form of speculation than prudent investing. Although there are those that have, and continue, to profit greatly from speculation, nevertheless, Professor Malkiel provides evidence supporting a more passive approach to investing.
A Random Walk Down Wall Street is essentially a supporting case study for the efficient market hypothesis (EMH). The brainchild of Professor Eugene Fama of the University of Chicago, the EMH, states that the stock market accurately reflects all available information in current prices such that no individual investor can consistently earn extraordinary returns. Malkiel takes this hypothesis a step further in popularizing the theory of a random walk, a theory proposed in late 19th century France. The theory claims that in the market all price movement are entirely random. Through this understanding, investors should look at low-cost index funds rather than choosing individual stocks through different “strategies”.
As an economics professor at Princeton, Malkiel performed a test to support the bold claim that the “past history of stock prices cannot be used to predict the future in any meaningful way.” He gave each of his students a theoretical stock, worth fifty dollars. Each day, his students would flip a coin, heads meant the stock went up a point, while tails would bring the stock down a point. After a certain period of time, Malkiel brought the fictitious stock charts to chartists, people who predict the future of stocks from its past performance, who gave firm advice on whether to buy or sell each stock. Being that these stocks had no genuine trend, Malkiel believed that this could serve as evidence that the trends in the stock market are randomized as well.
Additionally, there have been numerous statistical studies suggesting active investing to be a losing game. This is represented by the fact that approximately eighty percent of active mutual fund managers fail to beat the S&P 500 Index. Even more surprisingly, a study conducted at UC Berkeley concluded that one percent of overall active traders beat the market. Concurrently, between 2008 and 2016, the S&P 500 advanced 85.4 percent. In his book, Malkiel presents his own comparison between the passive index and an actively managed fund. A ten thousand dollar initial investment in the S&P 500 index fund and the average actively-managed mutual fund from 1969 to 1998 would have left the former investor with $311,000 and the latter with $171,950.
On average, index funds clearly offer lower expense ratios and often stronger returns, providing the individual investor a clear solution. Yet, the majority of mutual funds are actively managed. Malkiel claims that there is a psychological reason for this. He proposes that humans struggle to cope with a lack of order, thus imposing their order onto this randomized system. Malkiel believes that fund managers understand this reality and utilize it to profit off their clients, ensuring them that their expertise lends them the ability to earn superior returns than a broad market index.
Although Malkiel provides compelling support for passive investment strategies, this is only one side of one of the biggest debates in the investment management business. Many of the world’s prominent investors have made fortunes off active investing and have succeeded in beating the market time and time again. While I believe that individual investors, as opposed to professional investors, would benefit most greatly from Malkiel’s advice, the more experienced investor, too, could utilize Malkiel to challenge and strengthen their own techniques. This book is a guide for passive investors and a testament to the efficiencies of the stock market.