A Random Walk Down Wall Street

Bonds, like stocks, are tradeable securities, but they are more like a form of debt than ownership. Rather than owning a portion of the government or company that issued the stock, bonds represent a kind of loan, in which the investor is loaning the company or government a fixed sum in exchange for that sum and interest later. Bonds are considerably less risky than stocks, though Malkiel notes that changes in interest rates and inflation may damage the overall realized return of the bond for the investor. Malkiel suggests investing more heavily in bonds as investors age, as they are easier to predict and rely on over time.

An investor’s portfolio is a collection of all their current investments. A portfolio can include any tradeable asset, including stocks, bonds, real estate, or cash, and Malkiel suggests diversifying one’s portfolio to avoid situations in which all assets might be challenged simultaneously. As an example, Malkiel provides suggested spreads of portfolios, in which an investor should maintain the core of their portfolio in index funds, but they may also invest in REITs, bonds, and physical assets like gold or diamonds to offset possible downturns in any given asset category.

Leveraging, or buying on margin, is the process of borrowing money to purchases a greater number of securities than could otherwise be purchased. By leveraging to buy an excess of stocks, for example, the investor hopes that the stocks outperform the loan, allowing them to sell the stock, pay off the loan, and retain a profit. Malkiel notes that leveraging can be dangerous, as, if the stocks underperform the loan, the investor will still need to liquidate, or sell, the stock, pay off as much of the loan as possible, then use their own assets to cover the remainder of the debt. Nonetheless, in a risk parity strategy, leveraging allows the increase in risk to provide greater returns.

A bubble, or bubble company, is any situation in which investors have artificially inflated the value of a company or product. The earliest example in Random Walk is of the Dutch tulip boom, in which the value of tulips continually rose until investors began to sell off their assets. During the bubble, investors perceive tulips, as an example, as an infallible investment, and, as prices rise, they depend on a “greater fool” who will hypothetically purchase the tulips at an even higher price. Eventually, as Malkiel says, the system runs out of “greater fools,” and those left holding the tulips lose their value. Other examples in the text include the South Sea Company, the tronics boom, the dotcom boom, and the more recent GameStop bubble.

The premise of an index fund is that it is a portfolio of stocks or bonds that tries to encompass the entirety of the market to reflect the average performance of that market. One might invest in an index fund like the S&P 500, which tracks the largest 500 companies in the US, or the Russell 3000, which tracks the 3000 largest companies. By tracking a large portion of the market, the fund can match the returns of the market as a whole, though it cannot beat the market. Malkiel advocates for index funds as a low-cost, low-risk method of passive investing, wherein the investor essentially just puts money into the index fund and receives returns equivalent to the value of the market over time.

Dividends are the sums paid out by companies to shareholders, or people that own stock in that company. The dividend is cited in Random Walk as one indicator of whether a stock is worth purchasing, as Malkiel notes that investors should buy stocks with high dividends and expected growth. However, Malkiel predominantly recommends, in the case of an index fund, that investors choose to reinvest dividends, which is essentially using the dividend to purchase even more stock in the company. In an index fund, however, dividends are gathered from multiple stocks and then reapplied to the fund as a whole, increasing ownership across the fun.

The price-earnings multiple or ratio is a comparison between a company’s market value, or stock price, and earnings. Essentially, if a company’s stock is selling for 10 times the amount that they are earning per share, then it has a P/E multiple of 10. Stocks with high P/E multiples are seen as overvalued, while low P/E multiples indicate undervaluing. Malkiel generally recommends buying stocks with low P/E multiples, as they tend to show greater returns over time, while high P/E multiples, like those seen during bubbles, are often risky.