A Random Walk Down Wall Street

“During many occasions over the last 45-year period, it looked like the end of the world as we knew it. In 1987, the stock market lost 20 percent of its value in a single day. When the dot.com bubble burst in 2000, some of the best-known growth companies lost most of their value. Apple fell by more than 80 percent, and Amazon lost more than 90 percent of its value. During the financial crisis of 2007-2008, obituaries were written about the capitalist system itself. And as the COVID-19 pandemic worsened in 2020, many press reports assured us that the world had fundamentally and irreparably changed. But enough of all this. The important point is that an investor saving $100 a month and putting it into an equity mutual fund became a millionaire.”

The examples Malkiel provides in this passage illustrate the lows the market can reach in times of crisis. However, his comment at the end of the passage asserts the soundness of long-term, balanced investing, in which the investor saving $100 a month in an equity mutual fund survives the catastrophes by avoiding the pitfalls of greed and crowd psychology.

“It was his opinion that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.”

Keynes’s idea of castles in the air capitalizes on crowd psychology, while firm-foundation theory rests on an equilibrium reached over time. Essentially, Keynes’s method only works in short-term buying and selling, in which a new issue might be overpriced shortly after the IPO, and investors who buy an initial offering can sell at a higher price for a profit. However, if an investor buys too late, they risk selling at the lower price following a crash, making the investment risky.

“The directors were, however, wise in the art of public appearance. An impressive house in London was rented, and the boardroom was furnished with thirty black Spanish upholstered chairs whose beechwood frames and gilt nails made them handsome to look at but uncomfortable to sit in. In the meantime, a shipload of company wool that was desperately needed in Vera Cruz was sent instead to Cartagena, where it rotted on the wharf for lack of buyers.”

This passage highlights how public perception warps crowd psychology. The contradiction in the passage, that the chairs look good but are not comfortable, and that the boardroom is luxurious while the company loses money in Cartagena, highlights how a company can appear to be successful without actually bringing in any profits. During the South Sea bubble, as with the other bubbles, appearances are deceiving, but they draw in “greater fools” to buy stocks at inflated prices.

“Why are memories so short? Why do such speculative crazes seem so isolated from the lessons of history? I have no apt answer, but I am convinced that Bernard Baruch was correct in suggesting that a study of these events can help equip investors for survival. The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze. It is an obvious danger, but one frequently ignored.”

Throughout the first part of the book, Malkiel repeats his central idea that the “losers” get caught in crowd psychology, investing in bubbles like the tulip boom only to lose their money. He laments that memory is so short because, after the tulip boom, more and more bubbles continue to happen across history, with bubbles noted as recently as 2022. Malkiel’s advice, here, is to use this history as a way to prepare for a future in investing, not as an analysis of what went wrong for the market as a whole.

“A bubble starts when any group of stocks, in this case those associated with the excitement of the Internet, begin to rise. The updraft encourages more people to buy the stocks, which causes more TV and print coverage, which causes even more people to buy, which creates big profits for early Internet stockholders. The successful investors tell you how easy it is to get rich, which causes the stocks to rise further, which pulls in larger and larger groups of investors. But the whole mechanism is a kind of Ponzi scheme where more and more credulous investors must be found to buy the stock from the earlier investors. Eventually, one runs out of greater fools.”

In this description of a bubble, it is important to note how advances in technology increase the dangers of investing in risky stocks. During the tulip boom, there may have been reports in newspapers, but the world has since developed television, radio, magazines, and social media, all of which increase the spread of offers to “get rich.” Likewise, investing is continually becoming easier for the average person, which increases the number of “greater fools” who will lose in the end.

“The lesson, however, is not that markets occasionally can be irrational and that we should therefore abandon the firm-foundation theory of the pricing of financial assets. Rather, the clear conclusion is that, in every case, the market did correct itself. The market eventually corrects any irrationality—albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic, and often they attract unwary investors. But, eventually, true value is recognized by the market, and this is the main lesson investors must heed.”

Though Malkiel does not explicitly endorse either firm-foundation or castle-in-the-sky theory, he does note their effects. Here, he comments on how the market is ultimately efficient and rational, as booms and busts are not permanent across the market. Though crises like the tronics or dotcom boom may occur, he argues they always balance out over time, making diverse, long-term investments practical and profitable.

“The attempt to predict the future course of stock prices and thus the appropriate time to buy or sell a stock ranks as one of investors’ most persistent endeavors. This search for the golden egg has spawned a variety of methods, ranging from the scientific to the occult. There are people today who forecast future stock prices by measuring sun spots, looking at the phases of the moon, or measuring the vibrations along the San Andreas Fault. Most, however, opt for one of two methods: technical or fundamental analysis.”

Critically, Malkiel conflates technical and fundamental analysis in this passage, as he is criticizing each of them. The examples he provides, like sun spots, refer to technical analysis, but, by the end of Part 2, sun spots are neither better nor worse than fundamental analysis. The overarching point, illustrated here, is that any attempt to accurately predict the future of the stock market is futile.

“Most people don’t recognize the implications of compound growth for financial decisions. Albert Einstein once described compound interest as the ‘greatest mathematical discover of all time.’ It is often said that the Native American who sold Manhattan Island in 1626 for $24 was rooked by the white man. In fact, he may have been an extremely sharp salesman. Had he put his $24 away at 6 percent interest, compounded semiannually, it would now be worth more than $100 billion, and with it his descendants could buy back much of the now improved land. Such is the magic of compound growth.”

Part of Malkiel’s advocacy for index funds relies on compounding returns by re-investing dividends. This passage shows how investing money is most valuable over large periods of time, in which any returns are simply re-invested to increase the pool of money on which further returns can be gained. In his example, he simply uses an account accruing interest, but the example mirrors the hypothetical man investing $500 plus $100 each month into an index fund.

“The results reveal that past movements in stock prices cannot be used reliably to foretell future movements. The stock market has little, if any, memory. While the market does exhibit momentum, it does not occur dependably, and there are frequent momentum crashes. There is not enough persistence in stock prices to make trend-following strategies consistently profitable. Although momentum exists in the stock market, described more fully in chapter 11, any investor who pays transactions costs and taxes is unlikely to employ a trading strategy to benefit from it.”

This passage highlights the primary issue with risk and reward in the stock market. Because momentum exists, people inevitably perceive it as a reliable method to predict good stocks to buy and sell, but with crashes and a lack of “memory” in the stock market, these instances of momentum seem more like easy ways to lose a lot of money. Adding transactions fees and taxes also come up frequently as reasons to adopt a buy-and-hold strategy.

“I do not mean to imply that Wall Street analysts are incompetent and simply parrot back what managements tell them. But I do imply that the average analyst is just that—a well-paid and usually highly intelligent person who has an extraordinarily difficult job and does it in a rather mediocre fashion. Analysts are often misguided, sometimes sloppy, and susceptible to the same pressures as other people. In short, they are very human beings.”

The humanity of investment professionals is a key component of the second section, as Malkiel emphasizes how these professionals are prone to the same errors and issues that the average person encounters. While not all professionals are “misguided” or “sloppy,” they all have the potential to make mistakes that could cost investors significant dollar amounts. Crucially, Malkiel is not criticizing these people for their flaws, but he is acknowledging that investors should be aware that professionals are not superhuman.

“How can this be? Every year one can read the performance rankings of mutual funds. These always show many funds beating the averages—some by significant amounts. The problem is that there is no consistency to performance. Just as past earnings growth cannot predict future earnings, neither can past fund performance predict future results. Fund managements are also subject to random events: They may grow fat, become lazy, or break up. An investment approach that works very well for one period can easily turn sour the next. One is tempted to conclude that a very important factor in determining performance ranking is our old friend Lady Luck.”

In the comparison between long-term and short-term decisions, Malkiel often mentions how the past does not guarantee the present or the future. In this passage, Malkiel steps back from the market to look at the performance of mutual funds, which invest in the market, and, unsurprisingly, the result is the same. A good year for one mutual fund does not ensure a good following year, or a good decade, and those funds that do achieve lasting performance are lucky, unless they are capitalizing on illegally gained information.

“It is, of course, quite true that only the possibility of downward disappointments constitutes risk. Nevertheless, as a practical matter, as long as the distribution of returns is symmetric—that is, as long as the chances of extraordinary gain are roughly the same as the probabilities for disappointing returns and losses—a dispersion or variance measure will suffice as a risk measure. The greater the dispersion or variance, the greater the possibilities for disappointment.”

This passage highlights how risk in investing may seem different from risk in regular life. Usually, readers think of risk as the possibility of something bad happening, whereas investors see risk as the possibility of a good or bad outcome. In a risky investment, risk is often paired with the possibility of a greater return, though the traditional meaning of a possible loss is still true.

“As an individual takes on more risk, however, the return should increase. If the investor holds a portfolio with a beta of 1 (as, for example, holding a share in a broad stock-market index fund), her return will equal the general return from common stocks. This return has over long periods of time exceeded the risk-free rate of interest, but the investment is a risky one. In certain periods, the return is much less than the risk-free rate and involves taking substantial losses. This is precisely what is meant by risk.”

In this passage, time and risk are set against one another as balancing measures in investing. Malkiel comments that the investor in question, even though they are investing in the kind of broad-based index fund that Malkiel advises, may suffer short-term losses. However, the returns over a long enough period should still result in a reasonable gain, which offsets the losses, making the “risk” a measurement of both gains and losses for the investor.

“Efficient-market theory, modern portfolio theory, and various asset-pricing relationships between risk and return all are built on the premise that stock-market investors are rational. As a whole, they make reasonable estimates of the present value of stocks, and their buying and selling ensures that the prices of stocks fairly represent their future prospects. By now, it should be obvious that the phrase ‘as a whole’ represents the economists’ escape hatch. That means they can admit that some individual market participants may be less than rational. But they quickly wriggle out by declaring that the trades of irrational investors will be random and therefor cancel each other out without affecting prices. And even if investors are irrational in a similar way, efficient-market theory believers assert that smart rational traders will correct any mispricings that might arise from the presence of irrational traders.”

Here, Malkiel highlights how investors use generalities to cover gaps in the functioning of the market, but these gaps do not refute the EMH. Through arbitrage and the presence of multiple rational and irrational actors in the market, these forces balance out to create an efficient market. Note the similarity between the phrasing “as a whole” and the frequent caveat of long-term and short-term. Just as the market “as a whole” functions rationally, individual investments are best judged “as a whole,” meaning over a sufficient time period.

“How easy it was in early 2000, when the tech stock you bought moved persistently higher, to convince yourself that you were an investment genius. How easy it was then to convince yourself that chasing the last period’s best-performing mutual fund was a sure strategy for success. And for the few who gave up their jobs during the bubble to engage in day-trading, how exhilarating it was to buy a stock at 10:00 a.m. and find that it had risen 10 percent by noon. All of these strategies ended in disaster. Frequent traders invariably earn lower returns than steady buy-and-hold investors.”

Malkiel’s example combines the forces of overconfidence, biased judgment, pride, and regret, showing how a single investor can succumb to an irrational mindset, leading to ruin. The investor in question perceives a degree of control over the market that they do not possess, and they act on “foolproof” schemes that are not supported by empirical evidence. Added to these pitfalls of psychology, the investor is losing money in taxes and fees through frequent trading, which decreases any gains they may have earned in the process.

“The evidence-based principle on which it rests is that relatively safe assets often provide higher returns than are appropriate for their level of risk, while riskier assets can be relatively overpriced and return less than they should. Investors can therefore improve their results by leveraging low-risk assets, buying them with some borrowed money, so as to increase their risk and return.”

This passage seemingly contradicts the overall message of risk and reward, in which greater risk should yield greater reward. However, whenever risk can be mitigated, it is not a factor in determining returns, since mitigation removes the risk and the reward. However, risk can be generated through methods like leveraging, or buying on margin, which then increases gains by buying more than the investor can with their own capital, betting that the purchased securities will outperform the loan used to purchase them. This constitutes a self-imposed risk, but it does increase returns when it is successful.

“And I continue to believe that a broad-based total stock market index fund should be the core of everyone’s portfolio. Investors also need to be completely realistic in their expectations about what returns such funds will produce and what pitfalls are involved. None will substitute for a broad-based, well diversified, indexed core. Certainly, for investors who are starting to build an equity portfolio in planning for retirement, standard capitalization-weighted index funds are the appropriate first investments they should make.”

Part 3 includes funds like risk parity, smart beta, and ESG funds, all of which Malkiel admits could outperform the market on occasion. However, these funds are riskier than the broad-based index fund that Malkiel advocates, marking these other funds as additional options to build up an existing portfolio. Malkiel says to invest primarily in a broad-based index fund. If the investor finds themselves with an excess of capital and a desire for riskier investments that may yield higher returns, they can invest in risk parity or ESG funds with that additional capital, maintaining their base investment in the index fund.

“If you want a get-rich-quick investment strategy, this is not the book for you. I’ll leave that for the snake oil salesmen. You can only get poor quickly. To get rich, you will have to do it slowly, and you have to start now. What if you did not save when you were younger and find yourself in your fifties with no savings, no retirement plan, and burdensome credit card debt? It’s going to be a lot harder to plan for a comfortable retirement. But it’s never too late. There is no other way to make up for lost time than to downsize your lifestyle and start a rigorous program of savings.”

This passage highlights Malkiel’s longstanding claim in the book that investing is best done over a long period of time with relatively safe and broad investments. By connecting the idea of fast riches to “snake oil,” meaning useless tonics sold as cure-alls, Malkiel is disparaging the many investors who claim they can play the market and win consistently. The realism of the passage shows how anyone can invest, but it requires dedication and frugality to succeed.

“J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, ‘What should I do about my stocks?’ Morgan replied, ‘Sell down to the sleeping point.’ He wasn’t kidding. Every investor must decide the trade-off he or she is willing to make between eating well and sleeping well. The decision is up to you. High investment rewards can only be achieved by accepting substantial risk. Finding your sleeping point is one of the most important investment steps you must take.”

Malkiel’s comparison of sleeping to eating is essentially the balance between risk and reward, in which high risk might interfere with sleeping, but it is required for high reward, which allows greater eating. For each investor, the degree to which they are willing to accept risk will dictate the degree to which they are able to gather rewards. For the investor who does not like risk, they have to accept slow returns, while the investor who is comfortable accepting large amounts of risk has the chance to reap large rewards. Malkiel’s advice is to only invest with an amount of risk that allows the investor to be comfortable, avoiding stress over potential losses.

“But although I do not believe the market is always perfectly rational, if forced to choose between the stock market and the economics profession, I’d put my money on the stock market every time. I suspect that stock investors weren’t irrational when they caused a sharp drop in price-dividend and price-earnings multiples—they were just scared. In the mid-1960s, inflation was so modest as to be almost unnoticeable, and investors were convinced that economists had found the cure for serious recessions—even mild downturns could be ‘fine-tuned’ away. No one would have imagined in the 1960s that the economy could experience either double-digit unemployment or double-digit inflation, let alone that both could appear simultaneously.”

There are two big points in this passage, as Malkiel is both noting how the economy can take turns that are entirely unforeseen, much as the double-digit unemployment and inflation were unimaginable to investors in the 1960s, and that even seemingly irrational actions in the market often have rational explanations. While some might consider fear to be irrational, Malkiel notes that fear is entirely rational, as the market’s unpredictability encourages caution. Such actions, then, are predictable, and can even be used as a cautionary tale to avoid disrupting the market in the future.

“It is this fundamental truth that makes a life-cycle view of investing so important. The longer the time period over which you can hold on to your investments, the greater should be the share of common stock in your portfolio. In general, you are reasonably sure of earning the generous rates of return available from common stocks only if you can hold them for relatively long periods of time.”

The entirety of the book encourages long-term investing, in which the investor invests in an index fund, then leaves their investment, reinvesting any dividends, until retirement. However, Malkiel recommends that older investors shift their focus more toward bonds and REITs. The reason for this strategy is that older investors cannot invest as much time in stocks as younger investors. Because an investor in their twenties can invest for 40 or more years, they stand to suffer the least risk, whereas an older investor that may only be able to invest for 10-20 years is at a higher risk of losses without the time to recover from downturns.

“For most people, I recommend starting with a broad-based, total stock market index fund rather than individual stocks for portfolio formation. I do so for two reasons. First, most people do not have sufficient capital to buy properly diversified portfolios themselves. Second, I recognize that most young people will not have substantial assets and will be accumulating portfolios by monthly investments. This makes mutual funds a very good choice. As your assets grow, a U.S. stock-market fund should be augmented with a total international stock (index) fund that includes stock from fast-growing emerging markets.”

This passage describes the first steps each new investor should take on their journey. First, investing in an index fund can form the core of a portfolio, from which additional indexes can be added to increase diversification. Especially for younger investors, the ability to add funds monthly makes this portfolio akin to a savings account. Even as Malkiel recommends other investment techniques and strategies, he always relies on a base, core portfolio of index funds for safe and reliable investing.

“Having been smitten with the gambling urge since childhood, I can well understand why many investors have a compulsion to try to pick the big winners on their own and a total lack of interest in a system that promises results merely equivalent to those in the market as a whole. The problem is that it takes a lot of work to do it yourself, and consistent winners are very rare. For those who regard investing as play, however, here is a sensible strategy that, at the very least, minimizes your risk.”

This passage points out the similarities between investing as an individual in the stock market and outright gambling. Because consistent winning is so rare, attempting to tackle the stock market alone is extremely risky. Even Malkiel is not willing to claim that he can eliminate that risk, saying instead that his tips will “minimize” that risk. Overall, the message of the book is not to immediately attempt to purchase winning stocks, but to invest in an index fund and hold that investment as long as possible.