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Review: A Random Walk Down Wall Street by Burton G. Malkiel

A Random Walk Down Wall Street: Completely Revised and Updated EditionA Random Walk Down Wall Street: Completely Revised and Updated Edition by Burton G. Malkiel

My rating: 3 of 5 stars

Investors are bound to have heard about this classic and it’s author, economist Burton Malkiel. In this book, he explains that the market is highly efficient, and no one can accurately predict its ups and downs; it’s a “random walk”. So, the best approach is passive, “buy and hold” investing using diversified index funds held long term. I recommend this book to investors of any level, especially those attracted to active, speculative investing.

The book begins with a fairly boring recount of several financial bubbles throughout history, to prove the “irrational exuberance” of investors. Malkiel shows that despite short-term trends, the market always corrects itself; “value will out”, as he puts it. Crazed investors rush into “revolutionary” new companies and technologies, but the key to investing is not how much an industry will affect society or how fast it will grow, but its ability to sustain profits. In truth, most IPOs underperform.

Several investing techniques and theories are evaluated, including technical analysis, fundamental analysis, firm foundation theory, the “castle in the air” theory, efficient market theory, and modern portfolio theory. Malkiel uses the efficient market theory to explain the markets’ efficiencies, and modern portfolio theory in advising how to construct a diversified portfolio.

Malkiel makes a compelling case that active investing is a losing game. Active investors generally underperform passive investors because they fail to time their purchases and sales correctly, and they incur transaction fees and taxes on their short term gains. Only 1/3 of active investors (individual traders and fund managers) beat the S&P 500 in the short term, and almost none beat it over the long term. In this section and throughout the book, Malkiel often refers to John Bogle, champion of indexing and founder of the Vanguard Group. I’m something of a Bogle disciple, and highly recommend his book The Little Book of Common Sense Investing.

After providing a lot of background information, Malkiel finally gets to the part I was looking for: specific financial advice. He explains asset allocation and diversification, and how to build a portfolio based on your age and risk tolerance. I was hoping for example portfolios showing asset allocations for various age ranges, but Malkiel shies away from such detailed recommendations. For people in their 20s, like me, he suggests investing aggressively in stocks, including international and emerging markets. See my notes below for more of his advice.

One of the main themes is the relationship between risk and reward. Malkiel puts it this way: you must decide whether you’d rather eat well or sleep well. Higher risk is more likely to yield higher returns, allowing you to eat well, but the stress may cost you your sleep. Only you know the risk you’re willing to take for the potential reward.

The book ends with an explanation of hedging with derivatives such as futures, put options, and call options. I didn’t pay much attention, and plan to stick with his simpler advice on diversified indexing.

Ignore short term volatility; buy and hold for the long term.
It’s financially wise to own your home. It’s an inflation hedge, provides tax breaks, and forces saving.
The market trends upward, so it’s better to invest a lump sum today than to dollar cost average. For investors without lump sums, however, dollar cost averaging is the most common and reasonable approach.
Save for financial goals using vehicles that mature at the goal date (CDs, treasuries, bonds, etc.).

Portfolio construction
Diversify to reduce risk. Choose assets with low or no correlation. Include US stocks, international stocks, emerging market stocks, REITs, bonds, TIPs, and cash.
Hold bonds and bond funds in tax sheltered accounts.
Small cap stocks tend to outperform large cap. This may be due to higher risk, or survivorship bias.
Value stocks tend to outperform growth, because investors tend to overpay for growth.
REITs add diversity and have returns similar to stocks. They also provide an inflation hedge.

Selecting funds
Choose no load, total stock market index funds.
If you buy active funds, choose no load, low turnover, low expense funds with little unrealized appreciation.
Look for expense ratios less than 0.5% and turnover less than 50%.

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