Foolish Special

[ April 13, 2000 ]

A Random Walk Down Wall Street, by Burton G. Malkiel

By Maynard Paton (TMFMayn)

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Rochester, Kent -- From the start, any Foolish reader will know they are in for some sound financial advice, plus a hint of controversy, when the author kicks off the book with this statement:

"It has now been thirty years since I began writing the first edition of A Random Walk Down Wall Street. The message from the original edition was a very simple one: Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds. Now, some thirty years later, I believe even more strongly in that original thesis, and there's more than a six-figure gain to prove it."

And that lays the foundation for the book. The Random Walk theory put forward by Malkiel suggests that "the short-run changes in stock prices cannot be predicted". That's nothing new to most investors, but Malkiel continues: "Investment advisory services, earnings predictions and complicated chart patterns are useless". Strong words.

By and large, Malkiel supports the Efficient Market Hypothesis, those dart-throwing chimps and all that. Rather than try to beat the market using fundamental and technical analysis, Malkiel puts forwards arguments against such investment investigations and instead promotes the use of basic tracker funds.

Probably the best parts of the book are the first few chapters. Malkiel proposes two theories of stock valuations -- the "castle in the air" and "firm foundation" -- to back up his claims. The castle-in-the-air theory is based on "psychic values". Or in other words "investment bubbles". This leads to a very enjoyable chapter describing the madness of crowds, and it recounts the many investment booms and crazes that eventually led to financial disaster.

Episodes such as Tulipmania, the South Sea Bubble (which led Isaac Newton, who lost a fortune in the mania, to proclaim "I can calculate the motions of heavenly bodies, but not the madness of people") and the Florida real estate boom, are all given as historical examples of the unpredictable nature of investors and their wild enthusiasm.

Further evidence that Malkiel gives to criticise the momentum or "greater fool" investor is recounting the stories from the "electronics boom" of the sixties, the "nifty-fifty" of the seventies, the "biotech bubble" of the eighties and the "Internet craze" of the nineties. These last four tales of optimistic growth investing are recommended reading for current "new economy" bulls and bears alike.

Malkiel steps onto rockier ground when he attempts to outline the flaws in the firm-foundation approach to investing, an approach where fundamental financial data is used to determine whether a company is "good value" or not. Before the pitfalls are described, there is a brief acceptance of the existence of Warren Buffett, an investor who has "compiled a legendary record, allegedly following the firm-foundation approach". Allegedly? Oh, come on...

As a fundamental investor myself, I have to say that some of the reasons firm-foundation investing may fail to work are tenuous. Information about a company may be incorrect, an analyst may be unable to translate correct data into valid earnings estimates, or general market re-valuations that scupper prior investment recommendations are all put forward as reasons to be wary of fundamental investing.

Not only that, but the security analyst's job is apparently made much harder by random events and creative accounting. The fact that an investor should be put off from fundamental investing by unpredictable events that by their nature may not happen at all doesn't wash with me. In fact, unforeseen "surprises" can lead to great fundamental investment opportunities. And creative accounting? I think most analysts worth their salt these days can at least sense something fishy is going on.

Charting takes a somewhat flimsy battering from Malkiel too. Having described in detail the premise of technical analysis, the reader is then referred to other studies that "reveal past movements in stock prices cannot be used reliably to foretell future movements". Thus the central proposition of charting is blown out of the water without really any compelling statistical evidence, which I'm sure technical analysts would poke holes into. Malkiel does admit that charting can make money, but there's been no evidence presented to him that the strategy and the increased trading costs it involves can outperform an index tracker.

There is one very amusing anecdote related to charting, and the effect that randomness can have on technical analysis. Malkiel, flipping a coin to plot the movements, drew a graph of an imaginary share price. Depending on whether the coin landed on heads or tails, the share price moved up or down a dollar that day. After so many flips, he showed the graph to his chartist friend. "We've got to buy immediately. The pattern's a classic. There's no question the stock will go up 15 points next week" was the reply...

The topics of stock market valuations and the merits of charting and fundamental analysis cover the first two of the book's four chapters. Unfortunately, after what is a good but at times questionable read, the second half of the book deteriorates into a very long-winded review of subjects that the typical Foolish reader can largely ignore.

Thus, there is a huge amount of Wise twaddle in the book, covering such theories as "The role of risk", modern portfolio theory, beta and the Capital Asset Pricing Model. The author goes into significant detail to explain the underlying basis for these concepts, and it certainly leads to much chapter-skipping for the Foolish investor.

After ploughing through a quagmire of "risk versus reward" gobbledegook, Malkiel concludes that "as neither technical nor fundamental analysis seem to yield consistent benefits, it appears that the only way to obtain higher long-run investment returns is to accept greater risks". But then it is conceded that "a perfect risk measure does not exist". To summarise, similar to fundamental and technical investing, there is acceptance that the very Wise "beta" alternative can work, but no real concrete proof that it does provide superior results over the long term.

Then follows a "fitness manual" for Random Walkers. With its American bias, UK Fools can quickly jump the parts covering IRAs, Keogh Plans and REITs. In fact, with our own Foolish Ten Steps outlining the same basic financial principles with far greater clarity, the whole chapter can be skipped. With such revelations as pound cost averaging and commission costs, there's nothing in the book that can't be discovered on this Motley Fool site.

Thumbing through yet another dubious chapter, detailing the theoretical returns from bonds and stocks, thankfully leads to Malkiel's summary.

After lengthy statistical evidence, "the no-brainer" is to invest in index trackers. Sound advice indeed for those wanting the rewards of the stock market without having the time, inclination or ability to select individual companies. Although Malkiel does offer some stock selection advice, he recognises that there'll always be those who can't resist the allure of attempting to beat the markets:

"Investing (in individual stocks) is a bit like lovemaking. Ultimately, it is really an art requiring a certain talent and the presence of a mysterious force called luck. And another important similarity... it's much too fun to give up."

Conclusions

As mentioned earlier, the first half of the book is by far the better. Very readable, the tales of investment fads and fashions lead to strong parallels with the current investment scene. I have misgivings over various assumptions made about some of the theories put forward, casting aside fundamentalist Warren Buffett and the lack of charting data. But at the end of the day, it all boils down to Malkiel's statistics and his subjective opinion.

After those good bits, the reader will find Random Walk falling into that trap of most investment books -- fast becoming a boring, statistical, number-crunching read. The trouble with this overall Foolish book is that it takes forever to conclude something that is already widely known in Fooldom. Quite simply, you don't have to read a 400-page epic to recognise that index trackers are a better bet than underperforming and over-charging unit trusts, or perhaps trying your hand at your own stock picking.

If you're interested in 20th Century investment crazes, and surprisingly there aren't too many books that cover this subject, then the first couple of chapters could be for you. But the relevant information and conclusions contained within the rest of the book, concerning the benefits of index trackers, can easily be found on the Motley Fool.

Ratings (out of five Jesters caps):
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