Random Walk Down Wall Street

Forty-Two Years of a Random Walk Down Wall Street

Random Walk Down Wall Street

“If one of your New Year’s resolutions is to improve your personal finances, here’s a suggestion: Instead of picking up one of the scores of new works flooding into bookstores, reread an old one: A Random Walk Down Wall Street.” – Paul B. Brown, New York Times, Jan. 7, 2007

If asked to name the single most influential book in presenting the findings of modern finance to the investing public, our answer would unhesitatingly be Burton Malkiel’s A Random Walk Down Wall Street, now in its Eleventh Edition, which was published in early 2015. When the First Edition appeared in 1973, the investment landscape was a very bleak one indeed. The U.S. equity market had begun a tailspin that would last through the end of 1974 and would constitute the worst bear market since the Great Depression. The U.S. dollar was taken off the gold standard, and a nine-year period of high inflation had begun. Those who were alive during that period will recall the insanely long lines at gas stations when the U.S. suffered through the Arab Oil Embargo that was imposed in the aftermath of the Yom Kippur War. With the Watergate scandal, our nation faced a high degree of political uncertainty that would eventually culminate in the resignation of President Nixon, and we remained stuck in the quagmire of Vietnam.

The options available to investors were essentially limited to stock picking (which entailed high brokerage fees) and actively managed mutual funds which usually had high front-end loads and high annual management fees. The first index fund available to retail investors would not appear until 1976. Many investors had been caught up in the “Nifty Fifty” fad and were taking a beating in the bear market. These investors may have mistakenly thought that great companies are always great investments.

Malkiel took on the enormous job of re-educating investors, purging out all the nonsense they had picked up from their brokers and replacing it with the foundations of modern finance — the Efficient Market Hypothesis, Modern Portfolio Theory, and the Capital Asset Pricing Model. The “random walk” in the title of his work refers to the random nature of stock price movements as first set forth by French mathematician Louis Bachelier and later formalized by the Nobel Laureate economist, Paul Samuelson. The random walk theory implies that people who speculate on the short-term movements of stock prices have an expected return of zero before costs (see a random walker simulate monthly market returns). While the short-term movements of stock prices are random and thus unpredictable, the long-term movements are not. As Malkiel’s friend and co-author with Malkiel of The Elements of Investing, Charles Ellis (also see Investment Policy), put it: “The average long-term experience in investing is never surprising, but the short-term experience is always surprising. We now know to focus not on rate of return, but on the informed management of risk.” By the way, if you don’t have the time to read the 448 pages of A Random Walk Down Wall Street, please consider reading the 176 pages The Elements of Investing.

As we look through all the past editions, we see how Malkiel intelligently addressed the major events in the recent history of the financial markets. For example, beginning with the Eighth Edition in 2003, Malkiel added a section on conflicts of interest between research and investment banking departments. No doubt, this was his response to the egregious violations of investor trust that occurred during the dot com bubble when writers of research reports were encouraged to inflate their predicted prices for companies that were investment banking clients of the large brokerage firms. However, since Malkiel had already admonished investors that brokerage research was essentially worthless as a source of investment advice, this was just icing on the cake.

The Tenth Edition, with over 1.5 million copies of all editions sold, discusses the real estate bubble and crash of 2007-2009. Malkiel traces the problem to the fundamental change that occurred in the mortgage market where banks used to hold their loans (meaning that they had skin in the game) but now securitize them and sell them to the large Wall Street banks, which sell them to their clients. Once the banks became purely originators of mortgages, their only incentive was to write as many of them as possible, so lending standards went out the window. Regarding this and other past bubbles which some argue contradict the idea that financial markets are efficient, Malkiel opines,

“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…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.”

In the most recent edition. Malkiel tackles the topics of complex derivatives, Emerging Markets, “Smart Beta,” and exchange-traded funds, giving his insightful opinion on the latest trends that have cropped up in the investment landscape. 

As a director of The Vanguard Group from 1977 to 2005 and a close associate of John Bogle, Malkiel was in the vanguard of indexing, which he called the “no brainer step” beginning with the Third Edition in 1981. Malkiel’s job of re-educating investors continues to this day and has perhaps become even more difficult with investors being bombarded with misinformation from the financial media. We look forward to the Thirteenth Edition and many more editions beyond that. We do not expect Malkiel to ever retire from his vitally important job, and we are happy to lend whatever assistance we can in replacing speculation with education. 

Below we have assembled a timeline of various editions and important events in those years.  It is a great reminder of the random events that have driven the random outcomes in the market, yet in the chaos there was order brought about by the pricing of those events so that investors were properly rewarded for the risk they took. Over the 42 years and 7 months from Jan. 1973 to July 2015, $100,000 invested in IFA's Index Portfolio 100 grew to $15,986,641. Not bad, assuming you could stay invested and rebalance each year of the random walk down Wall Street (Disclosures: www.ifabt.com).