The Random Walk Guide to Investing

The Random Walk Guide to Investing: Ten Rules for Financial Success
Burton G. Malkiel
W.W. Norton & Company, 2003

The title of this book derives from the author’s famous book A Random Walk Down Wall Street, published in 1973. That book, and this too, refer to the theory of efficient markets. In the author’s words: “The main premise of the theory is that the stock market is an extraordinarily efficient institution for reflecting without delay any information that arises. When news arises, an army of profit-seeking Wall Street professionals pounces on it rapidly, driving stock prices up or down. As a result, stock prices reflect whatever good or bad news there is about each individual company or about the economy as a whole.”

News is unpredictable. If not predictable and random, it wouldn’t be news, and today’s prices would reflect that information. So the price of a stock tomorrow is based on unpredictable — and therefore random — events. There is nothing contained in the past prices of a stock that has any value in predicting tomorrow’s price.

This is quite a powerful theory. It has many implications. For example, have you seen the stock analysts on television known as “technical analysts?” They look at charts of past prices, and spotting things like “support,” “resistance,” or “head and shoulders,” they predict what will happen in the future. But according to the efficient markets theory, there is not a single thing in those charts that is useful in predicting future prices.

It also means that in the long run, there is no hope of beating the market as a whole. That means that a huge chunk of the financial services industry is engaged in selling services that don’t work in the long run or even the short run, and, in fact, are harmful to the average person.

Consider “actively managed” mutual funds. These are funds where the managers, by using various strategies, attempt to earn large returns. These managers are among the smartest people on Wall Street. Yet each year about 80% fail to “beat the market,” which is to say they didn’t perform as well as broad market indexes such as the S&P 500 index. In fact, for the 10 years ending December 31, 2002, the S&P 500 index beat the average equity mutual fund by 2.09%, and for the 20 years before the same date, by 2.42%.

Of course, each year there are some funds that do very well, and some that are able to maintain high performance for a few years in a row. These are the funds that everyone talks about, and many people buy. But on page 129 there is a sobering table of figures. It shows the 20 best-performing funds (out of the 851 funds with more than $100 million in assets) from 1997 to 1999. These funds averaged annual returns of 44% to 66% during those years. Their managers were hailed as geniuses and treated as celebrities.

The next columns of the table report the funds’ rank for the period 2000-2002. The highest rated of these was at position 500 (out of 851 funds). Most were ranked worse than 750, and there are quite a few ranked worse than 830. Their returns averaged negative 32% per year. (In three years at -32% per year, $100 turns into $31.) Patterns like this were found in earlier time periods, too.

We might think that we would be smart enough to get out of these high-flying funds as they start to tumble. But the managers of most of these funds have wide latitude as to the strategies they can use, and they weren’t smart enough to switch to some other investment. How can the average person expect to know more than these managers?

Some people believe that they can do well by purchasing last year’s best funds. Professor Malkiel reports on a study where he took the funds with best recent performance, and these portfolios produced below-average returns. He also took Morningstar’s best-rated funds, and found that a portfolio of them produced much lower returns than an index fund. From 1990 to 2002, the Morningstar best rated funds grew in value by about 110% (judging from a graph), while the Wilshire 5,000 Index grew by about 300%. Over a lifetime of investing, that’s the difference in being relieved there’s Social Security and being independently wealthy.

One of the reasons why actively-managed funds fail to beat the market in the long run is that the actively-managed funds have large costs. Index funds are very inexpensive to operate. Costs like this are very important in investing. Small differences, even just 1% per year, make a lot of difference when subjected to compounding over a lifetime. That’s why Malkiel strongly recommends reducing the costs of investing. Still, many people purchase “load” funds where perhaps as much as 6% of your investment goes to sales charges, and funds that have large ongoing management fees to pay every year (including marketing fees). Now there are “wrap” accounts that many people are lured into using, where the investor pays an annual fee, usually 1% to 3%, for the services of a professional money manager. I recently had experience with someone who had a wrap account from a very large investment company, one whose advertisements on television are commonplace. The advisor charged 1.5% per year, and the investor’s portfolio consisted of a variety of mutual funds, all actively managed, and all of which had high sales charges and high annual fees. This investor had absolutely no hope of earning anything near what an index fund would return.

It’s no surprise that Malkiel is not well-liked by Wall Street and investment professionals, as the efficient market theory tells us there’s no way to beat the market in the long run. Yet a huge industry tries to sell us products we are led to believe will beat the market. As the advisor I mentioned a moment ago said to me in an effort to get my business after I told him I was a self-directed investor, “You pay a little more, and you earn a lot more.” He may even believe that. The sad fact is that most people have no idea how well their investments are performing. Calculating returns, especially when investment is made periodically, is difficult. Do you remember the Beardstown Ladies, an investment club that produced fabulous reported returns for several years running? It turned out that their calculations treated their contributions as though they were returns that their investments earned. Mistakes like that are easy to make. A few years ago a well-known website had a portfolio-tracking service that I used for a while to track the returns of my 401(k) plan. I thought I was doing really well, until I realized that it treated my twice-monthly contributions as through they were investment returns. I inquired about this, but the service admitted no error. Since then, they have discontinued this “service.”

The first chapter of this book, titled “Fire Your Investment Advisor,” is quite blunt about its topic. If people are willing to study a little, perhaps by reading a short book like this, and then to trust themselves, I agree. Otherwise, you may want to use the services of an investment professional. In this case, people would do well to use a fee-based planner instead of one who is paid by sales commissions or annual fees.

The next two chapters explain the four investment categories (cash, bonds, stocks, and real estate), and the important relationship between risk and returns.

Then the rules start: Start saving and investing now, in order to take advantage of the powerful effect of compounding over time. (“The most powerful force in the universe,” Einstein reportedly said.) Save and invest regularly. Have proper insurance and cash reserves. Invest with an eye towards minimizing taxes. Allocate assets amongst the four categories according to your time horizon and your capacity and temperament towards risk. Diversify appropriately. Bow to the wisdom of the market (this is where the efficient market theory is important). Invest in index funds. Don’t be your own worst enemy: avoid stupid investor tricks.

This is a valuable book for anyone who is interested in their financial security. Please don’t think that because you may not have a lot of money to invest that it isn’t important for you to take investing seriously. The less money you have, the more important it is to start saving and investing now, and to invest wisely. This book will show you how.

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