54 pages • 1 hour read
Burton G. MalkielA Random Walk Down Wall Street
Nonfiction | Reference/Text Book | Adult | Published in 1973A modern alternative to SparkNotes and CliffsNotes, SuperSummary offers high-quality Study Guides with detailed chapter summaries and analysis of major themes, characters, and more.
Summary
Background
Chapter Summaries & Analyses
Key Figures
Themes
Index of Terms
Important Quotes
Essay Topics
Tools
BetaThemes
Balancing Risk with Reward
A primary focus of Malkiel’s advice centers on balancing risk and reward as an investor. Generally, Malkiel agrees with the common perception that increased risk results in increased reward, but this “reward” is better phrased as “returns,” which can be either positive or negative. Essentially, a highly volatile stock, which could be a stock with a high beta, has the potential to yield massive positive returns or massive negative returns. Even a loss of 50% would be considered a large return, in the sense that it is a large negative value resulting from what was likely a risky stock. However, quality can also function in a similar way to risk, and Malkiel notes: “The more respectable a stock is—that is, the less risk it has—the higher its quality” (131), which, in turn, “are said to deserve a quality premium,” much as risky stocks have a risk premium. However, with the advent of beta and the removal of unsystematic risk from this equation, higher risk does not always mean higher reward, though Malkiel comments that higher risk is needed to achieve extraordinary returns.
Malkiel describes a “speculator” as someone who “buys stocks hoping for short-term gain,” while an “investor” is someone who “buys stocks likely to produce a dependable future stream of cash returns and capital gains over years and decades” (36). Though participating in the same market, speculators and investors are adopting a different set of risks. For the speculator, risk is realized almost immediately, as a stock rises or falls in price over the course of a day or week, while the investor measures risk over years, minimizing the effects of short-term losses and gains. As such, the investor is much more likely to have a stable return, but the speculator has a chance to make a large sum of gains in a single sitting. As Malkiel notes, different rewards are granted “for assuming a different set of risks” (272), which is exemplified in such funds as risk parity and smart beta funds.
The premise of risk parity is to increase risk by leveraging purchases, which means buying stocks with borrowed money to purchase more of a stock than one could have otherwise. If the increase in the price of the stock is greater than the cost of the loan, then the investor receives a greater gain than they would have without leveraging. If the stock underperforms, they lose even more. However, Malkiel asserts that “leverage is one investment technique that needs to be in the investor’s toolbox” (281), largely because it is one way to increase risk and reward outside of systematic risk. Overall, Malkiel suggests that risky investments are more for investors who have already established the core of their portfolio in more reliable products like index funds, implying that risk, while potentially leading to greater returns, is only worth maintaining if the investor has the means to recover from potential losses.
Comparing Long-Term and Short-Term Goals
Malkiel references Warren Buffett when he notes: “Lethargy bordering on sloth remains the best investment style. The correct holding period for the stock market is forever” (252). This advice characterizes most of Malkiel’s work. Investing in an index fund indefinitely, and even leaving those funds as inheritance after death, reduces risk, fees, and taxation, while also allowing the investor to see returns accumulate along with the market. Buying and selling shares frequently usually results in higher risk, greater losses, and many fees and taxes that could be avoided by buying and holding. Though many investors have short-term goals that require short-term solutions, Malkiel suggests more secure products for those goals, like CDs and bonds, which have comparatively lower risk and provide a predictable return on a specific date. Depending on whether the investor has long- or short-term goals, Malkiel suggests different courses of action that reflect the needs and risks appropriate for each investor.
In discussing different needs, Malkiel uses the example of a young couple that expects they will need a down payment for a home soon. Malkiel suggests that the couple invest the amount of the down payment in a CD, or certificate of deposit, which will mature around the time they anticipate needing the down payment. For matters like educational expenses, Malkiel adds the possibility of zero-coupon securities, or bonds, which can mature in the correct time ranges of the expected expenses (361). The caveat of these methods is a reduced rate of return, as CDs and bonds are not likely to outperform the stock market but present considerably less volatility, meaning that, unlike in the stock market, the investment will return the predicted amount at the predicted time. Crucially, Malkiel does not recommend investing in the stock market, as the volatility of the stock market prevents an accurate prediction of what the return will be in a specific period. This reason is also behind Malkiel’s assertion that older investors should invest more heavily in bonds, while younger investors, who have the time needed to endure downturns in the market, should invest more heavily in stocks.
The longer an investor can hold their portfolio of stocks, the lower their risk of suffering intense losses and the less they will need to pay in taxes and transactions costs. Malkiel states: “In general, you are reasonable sure of earning the generous rates of return available from common stocks only if you can hold them for relatively long periods of time” (352), noting that 20- or 30-year periods have stocks as the “clear winners” in terms of returns. Granted, Malkiel acknowledges that these buy-and-hold strategies do not aim to beat the market but to follow it, providing a return consistent with the overall performance of the market. Short-term investing, involving multiple purchases and sales, could, in theory, outperform the market, but such tactics are rarely successful and are never successful consistently over time. As such, long-term goals require long-term plans, and investment for decades in a broad-based index fund is the best plan to suit goals like retirement.
The Psychology of Crowds and Markets
In the Introduction to the text, Malkiel comments: “What is hard is having the discipline to save small amounts on a regular basis and to keep it up regardless of the inevitable crisis of the moment” (28), and a large part of Malkiel’s discussion of the psychology of crowds and markets is predicated on what investors should avoid, rather than on how to capitalize on that psychology. Discipline, in this case, encompasses a variety of ways in which the investor needs to resist temptation, as Malkiel notes the dangers of succumbing to peer pressure to buy a specific stock, market trends that build castles-in-the-air, and pessimism in the face of a downturn. In each case, Malkiel looks at how investors behaved in the past, and the conclusion is almost always the same: the smart investor understands the psychology of the market and resists the urge to participate in irrational fluctuations.
In Part 2, Malkiel covers a variety of bubbles, of which the tulip boom becomes a representation of bubble stocks. He asserts that “those who are unable to resist being swept up in some kind of tulip-bulb craze” are the “consistent losers” (62), noting how timing the market is almost impossible, leading most investors hoping to capitalize on a bubble suffering crippling losses. In the age of modern media, the temptation is greater, as news outlets, magazines, and social media can promote a product or stock in ways that were inconceivable during the tulip boom. Using a modern example like GameStop, Malkiel shows how investors were often too late to invest and too late to sell, leading most investors suffering losses, with Malkiel asking: “Why are memories so short?” (62). The book asks the reader to remember the booms of the past to warn them against such speculative investing, but Malkiel understands the urge to participate in such bubbles. The offer of fast wealth is difficult to resist, and much of the book discusses the methods of fraud and deception that play into the patterns of bubble companies in the past.
A direct example of Malkiel telling the reader to reject their intuition in investing is in his discussion of pride and regret. Investors that suffer losses “find it difficult to admit,” especially “to friends or a spouse” (242), and regret from their losses leads them to hold onto poor-performing stocks in the hope that they will eventually realize a return. However, Malkiel suggests selling poor-performing stocks, ignoring the urges of regret to avoid further losses. Similarly, investors “are usually quite proud to tell the world about their successful investments” (242), which they do by selling high-performing stocks to realize a gain. Again, Malkiel suggests ignoring that prideful urge, as holding onto a high-performing stock can lead to greater gains in the future, and selling stocks leads to taxation. Overall, the message of the book is that investors behave in predictable patterns, and the market is efficient, in part, because of these irrationalities. Nonetheless, the individual investor can resist these psychological pulls to avoid losses and sustain a greater performance in the market.
