Among the intellectual behemoths responsible for classic investment books, the author of A Random Walk Down Wall Street, Burton G. Malkiel, stands out as both a Wall Street financial advisor and a bona fide academic. Due to his unique background, Malkiel brings a fresh and valuable perspective into the time-honored debate between professional investors and academics about The Efficient Market Hypothesis. What is The Efficient Market Hypothesis and why should you care? Why is there so much discourse over whether or not it’s a legitimate way to approach the stock market?
The long and short of it:
On the Efficient Market Hypothesis
An important aspect of Malkiel’s philosophy is the Efficient Market Hypothesis. As the theory goes, the market will tend towards efficiency because due to the collective rational behavior of all market participants, all publicly available information will always be fully priced in. For this reason, if it is known that the stock price for a company will rise 20% tomorrow, it will rise 20% today. This is known in academic circles as the Efficient Market Hypothesis.
Due to this tendency, even incredibly insightful investors struggle to consistently beat the market. Even Graham’s legendary method of assessing stock value yields inconsistent results today. In an interview in 1976, shortly before his death, Graham was quoted in saying,
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when Graham and Dodd was first published; but the situation has changed… [Today] I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost… I’m on the side of the “efficient market” school of thought.
Malkiel doesn’t fully ascribe to the Efficient Market Hypothesis, but he is more on the side of Efficient Market than most other personal finance writers. When it comes to most investors in the short term, the market is fully priced in and it is functionally efficient. However, there are definitely notable exceptions to the Efficient Market Hypothesis, many of which Malkeil does acknowledge.
Exceptions to the Efficient Market Hypothesis
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- Some people do consistently beat the market
Investors who are truly capable of beating the market long term, the likes of Warren Buffett, Peter Lynch, and Howard Marks, don’t use short-term market-timing techniques. In trying to take advantage of pockets of market inefficiency, other observant investors will inevitably cotton on and render the technique ineffective. Investors who consistently beat the market are innovative and long-term thinkers. Because the vast majority of investors are unwittingly caught in the cycle of valuing short term gains over long-term profit (encouraged by the quarterly evaluation of professional money managers), there is a great deal of market inefficiency in long-term investments, the type of which Warren Buffett specializes in.
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- Bubbles
Bubbles are a type of market inefficiency that arises when people don’t know what they’re investing in. The moment that FOMO and hype overcomes research and caution is when stock prices soar to untenable levels. The moment the majority of investors stop paying attention to the solid foundational aspects of a business is the moment the market stops being efficient.
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- Commission free trading apps
This is not a point from Malkiel’s books but I would like to briefly address it nonetheless. Recently, commission free trading apps like Robinhood, WeBull, and Wealthsimple have been gaining in popularity. Without commission fees, active trading will undoubtedly become a far more viable method of investing than it used to be. New market inefficiencies may be introduced as uninformed decisions combine with overreactions to make massive price swings that don’t correspond to the stock’s actual value. However, this new method of trading is still in its infancy and thus far, no one truly knows the full ramifications of this new technology.
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- Retail investors > mutual fund managers
It used to be that regular people don’t have enough money saved up to buy stocks on their own. Therefore, the only way they could invest was by pooling their money together in a mutual fund for a professional to manage.
There are, however, many downsides to mutual funds.
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- Mutual funds frequently make trades on behalf of the investors and the cost of these trades really add up, eating into the investor’s profits
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- Mutual funds are expensive, there are management fees and frequently also loading fees, this can add up to a full 1% of earnings
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- The size of a mutual fund means managers frequently have to put money in subpar companies so they’re fully invested. It’s much easier to invest $500 million in excellent companies than $50 billion – there just aren’t enough investment opportunities
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- The size of investments also means investments will change the stock price. Mutual funds are forced to sell at a discount and buy at a premium
Today we have the ability to purchase fractional shares so we can invest on our own. Most trading apps support this, whether commission free or otherwise. No longer is investing prohibitively expensive for the new investor, anyone who wants to invest can now purchase fractional shares, buying a half or a quarter of a share when they lack funds. Due to all the downsides of mutual funds, fund managers actually have to beat the market by 2-3% just to match the market return. This is why most money managers fail to beat the market, despite being professionals. As an individual retail investor, you don’t have to contend with any of the additional fees or investing difficulties of large mutual funds, which means the extra 2-3% is fully yours to keep.
Although Malkiel remains adamant that the wisest investment is always in index funds, he does allow that many people are insatiably drawn to the idea of stockpicking and beating the market. To that end, Malkiel offers a series of rules and steps to help the average investor manage risk and maximize returns.
Malkiel’s Rules of Thumb
Keep up-to-date with the market. Malkiel recommends the following sources:
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- The New York Times and Wall Street Journal for general news
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- Barron’s, an American weekly business newspaper/magazine published by Dow Jones & Company
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- BusinessWeek, Fortune, and Forbes for investment ideas
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- Investment advisory services like Standard & Poor’s Outlook and the Value Line Investment Survey
Of these sources, only Value Line Investment places all its content behind a pay-wall. Most other services offer free videos, articles, and analysis in addition to subscriber-only services. Other good sources for business news that Malkiel did not mention include:
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- MarketWatch, also a subsidiary of Dow Jones & Company
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- BusinessInsider, a New York based international news outlet founded in 2007
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- CNBC, a TV news program specializing in business, politics, investing, and finance
Rule 1: “Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years”
Here Malkiel straddles the line between growth investing and value investing. This advice is a double-edged sword, because while it avoids the potential of buying a value stock that never goes up (value trap), it also runs a greater risk of being overpriced than sticking purely to the fundamentals. Thus it’s important to follow all of Malkiel’s rules, not just this one in isolation.
Rule 2: “Never pay more for a stock than can reasonably be justified by a firm foundation of value”
Malkiel mentioned previously that ascertaining the precise intrinsic value of a stock is akin to trying to catch a wil’o’wasp. This is because a key part of value assessment is projecting future earnings. Unfortunately any effort to forecast the future is more subject to randomness than analysis. Due to the unshakeable opacity, Malkiel suggests erring on the side of caution, to always go with the more modest estimate and not get carried away by faith and enthusiasm.
Rule 3: “It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air”
Malkiel makes a good suggestion here to combine Graham’s emphasis of cheapness with the vast growth potential of stocks with good stories. According to Malkiel, it’s not enough to find a cheap unloved stock. It must be a cheap unloved stock with the potential to become well loved. This is a criteria few stocks are able to satisfy, so this rule is more suggestive than mandatory. Of course it certainly helps to find an attractive stock selling at a fair price before the public finds it, but it’s a very infrequent occurrence and requires a degree of dedicated research most retail investors are not ready to commit to.
Rule 4: “Trade as little as possible”
Malkiel recommends this for a variety of reasons; more trading means more commission fees, more tax you have to pay for realized gains, and diminished the long term benefits of compounding. For some, the first two points are non-issues, due to using a commissions free trading app and being in a lower tax bracket. However, the last point applies to us all. Compounding works wonders for the patient and it’s always a good idea to hold companies with strong fundamentals for a long term.
Rule 5: Diversify in industries with negative covariance
Diversification is the common rule of thumb familiar to almost every investor worth their salt, but diversify how? And in what industries? Here Malkiel introduces the concept of positive and negative covariance.
Say for example there are 2 companies. Company A sells sunscreen. Company B sells raincoats. When it rains, the stock price of Company A goes down -25% and the stock price of Company B goes up 50%. However, sometimes it’s sunny, and in that case, Company A gains 50% while Company B loses -25%.
Because one company makes money while another loses money, this is a negative covariance. Why is this important for investors? Well, let’s look at Josh and Mary, who each decided to invest $1,000 on Monday.
Josh invests his entire $1,000 in Company B on Monday because he thinks it will rain. Over the week, it rains on Monday, Tuesday, Thursday, and Saturday. By the end of the week, Josh will have a total of $1,067.87. That’s a profit of $67.87 or 6.7%.
Meanwhile, Mary invests $500 in Company B and $500 in Company A because she doesn’t know if it will rain or not. By the end of that same week, Mary will have a total of $2,565.78, for a profit of $1,565.78, or 156.578%.
How is it possible that Mary made so much money while Josh made so little?
The reason is compounding. While Josh lost money whenever it didn’t rain, Mary was able to make money on both sunny and rainy days. Over the course of the week, Mary was able to gain a steady 12.5% every day, which allowed compounding to take effect and lead to massive profits. Josh on the other hand, had to essentially start over his compounding every time it was sunny. Additionally, losing 25% took an enormous bite out of not just his accumulated profits, but also his principle. Of course, this is an unrealistic situation, no company’s stock price would be so volatile or so predictable. However, if we expand our example out to months and years (stock price of Company A increases by 50% in April, May, June, July, and August, then goes down by -25% every other month of the year), we can see that there is merit in accounting for negative covariance in stock selection.
Through this example, Malkiel demonstrates the importance of diversifying in industries with negative covariance. Of course, no industry will be 100% negatively covariant. If there were a recession, the stock price of both the sunscreen sellers and raincoat sellers would go down. However, even then, it’s wise to make preparations for what you can control instead of bemoaning what you can’t.
For such diversification, Malkiel recommends the following sectors in addition to a standard diversified common stock portfolio:
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- REITs (real estate investment trusts) that allow you to buy a share of real estate. Pays historically high dividends, which can supplement income for those who need it
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- International Index Funds, as a bad run in the US economy doesn’t automatically translate to a global recession (usually)
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- Gold/Art Pieces/Collections, although these holdings are not productive assets and therefore can’t generate additional fundamental value the way stocks, bonds, and real estate can and often costs money to maintain, they are excellent hedging for times of economic crisis and rampant inflation. Malkiel recommends no more than 5% of your portfolio be invested in gold and similar holdings
What makes A Random Walk unique?
Perhaps it’s because Malkiel is an academic, perhaps it’s because he had a history in Vanguard, the mutual fund provider that brought us index funds, regardless of the reason, A Random Walk is perhaps the most thorough book on capital allocation I have read thus far. Although I disagree with Malkiel’s assessment that beating the market is impossible for the average investor, he is able to clearly lay out actionable steps, backed up by a wealth of historical and statistical evidence, the reader can take to become a competent personal wealth manager. He also offers a formulaic way for passive investors to reliably achieve average market returns.
I have only the highest respect for the legendary investors who are able to consistently beat the market, but I also deeply appreciate Malkiel’s more grounded approach, especially as an average (okay, below average) retail investor. Beating the stock market is not easy, yet investors like Graham, Buffett, Lynch, and Marks make it sound (and look) so simple that the rest of us are left scratching our heads. Malkiel is not a genius investor, but he does have a deep understanding of the economy and Wall Street, so he takes a more realistic stance and clearly says, “Look, the market is inefficient in some ways, but don’t underestimate the forces that do in fact make it efficient. You must first understand what makes the market efficient before you can take advantage of the times it is inefficient.”
Final thoughts:
As I said, A Random Walk differs from most other finance books not in the uniqueness of its ideas, but in the depth Malkiel goes to explore these ideas. A Random Walk is like a textbook in this way, taking a generally objective stance in the world of investing, recounting past events and present theories from a birds-eye-view Also unlike many other writers of investment books, Malkiel is not a value investor. He has far greater respect for fundamental analysis than technical analysis, but he’s ultimately of the opinion that neither method will let you beat the market consistently (although fundamental analysis paired with a growth mindset will get you much closer).
Should you read A Random Walk Down Wall Street?
Maybe.
Malkiel goes in depth in his assessments on various investment approaches but his analysis is the sort you’ll get if you took an economics course at your local college or university. It’s very well-documented and academic, and therefore unlikely to make you much money. Perhaps the most useful concept I got out of the book is a newfound understanding of negative covariance, something that I previously only had very vague knowledge of. Aside from that, A Random Walk was mostly good for solidifying things that I already kind of knew with clear explanation and a deluge of facts and figures.
I personally enjoyed A Random Walk, but it’s fairly lengthy (456 pages), and at times over explained. For those who enjoy reading finance books, A Random Walk is very enlightening. For those who don’t feel the need, they will be well served by a condensed overview.
