Tuesday, January 01, 2013


I've finished reading what I think may be the last financial book I ever read: A Random Walk Down Wall Street, by Burton Malkiel. I suspect it may be the last for several reasons. First, it's a phenomenal book - well-written, funny, wise, and practical. It will be hard to find another book that can instruct better than this has. Second, it reinforces the investing principles that I've been following for the last decade and that have served me well during that time (while deepening my understanding of why they work). Finally, since the core advice for intelligently investing is so simple, there just isn't much more to learn after finishing this book. Oh, to be sure, times will change, and markets will be re-evaluated, and my personal allocations will gradually shift, but the basic principles Malkiel lays down should remain dependable.

Part of what's so wonderful about this book is seeing its track record. The book first came out in the early 1970s, a very different economic time than we face today. He has regularly revised the book every few years, and each edition helps explain what has happened in the past, but his core advice hasn't changed in the forty years since the book was first published. And, well, that means you can track the records of people who followed his advice, comparing them with those who didn't. As he makes clear in his book, that's the key component to any financial advice. Anyone can pore through past data and come up with a trading model that would have made money during that time period. The problem is that those models almost never work when you're working with "real money," into an uncertain future.

Malkiel is a wise person, and finds great, memorable ways to communicate important information. For example, he says that it's impossible to get rich quickly: you can only go poor quickly. Getting rich takes patience and time. Very pithy, and very true.

At the start of the book, Malkiel gives an overview of the madness of markets, taking a tour through massive bubbles in our history, all the way from the original Dutch tulip bulb craze through the American housing bubble that popped in 2008. He shows how many fortunes were destroyed in all of these crazes, laying a firm foundation of risk under all future discussions. There's a lot to get from this part of the book, but one of the most important is realizing that bubbles are obvious only in hindsight. When investors are surrounded by a crowd all pulling one way, it's very easy to get pulled along. Finishing this section should convince everyone that they need to take care while investing, or else they could be wiped out.

In the second section, he describes two of the primary approaches people take to stock-picking, and points out their flaws. This is probably the most combative part of the book, and also highly entertaining. He delivers particular scorn to technical analysts, who he calls "chartists." These are the people - he estimates that they represent about 10% of Wall Street investors - who ignore any information about a company's fundamentals (industry, size, dividends, price/earnings ratio, etc.), and instead focus on trends in the stock's price. They convince themselves that, by studying where a stock has been in the past, they can predict where it will go next, and can then profit by buying it or selling short. Malkiel gives example after example of how people have failed at this, and even lost fortunes trying. As he observes, someone will always claim that their method is different, so they will make money where everyone else has failed; but the problem always comes back to realizing that models which perfectly predict the historic movements of prices do a horrible job at predicting future movements.

He treats fundamental analysts with more respect. Fundamental analysts (who I will call "fundamentalists" just because it amuses me) rely on experts who know the company and the business well. They look at the key factors for a company: its dividend, the company's growth rate, its size, its book value, and so on. Based on this, they will try to determine what the value of the company "should" be. They compare this to the stock's market capitalization (the value per share times number of shares) to determine whether a stock is undervalued, and if so, they will purchase it, with the expectation that eventually the market will fix the "mistake" in the price up to its proper value, at which time they can sell it.

He sympathizes with fundamental analysts, but points out that historically, they have under-performed the benchmarks for the market as a whole, particularly when considering the fees charged by the analysts. He offers several reasons for this, some of which are quite amusing. Malkiel started his career in the finance world, and observed that most analysts are, frankly, not more bright than you or me, and the best analysts are quickly promoted to higher-level positions where they don't do much analyzing. Beyond that, though, fundamental analysis has a, well, fundamental problem. One of the key components in fundamental analysis is determining a company's growth rate, and the growth rate is inherently unknowable. Knowing the growth rate requires accurate prophecy of the future. Will the company discover a new mineral mine? Will a terrorist attack destroy their office? Will Congress create a subsidy? Will a drought occur next year? It's no wonder that we don't know what value a stock "should" be, since much of a stock's value is based on the earnings of the company in the future. Secondly, Malkiel contends that, with the modern regulatory regime (especially post-Sarbanes-Oxley) and with instant dissemination of information via the Internet, it's virtually impossible for fundamental analysts to gain access to "new" information that isn't already known by the market as a whole. There are some periods where the price of a stock may lag behind new information - like if a corporation announces better-than-expected earnings - but for the most part, everything that's known about a company is already reflected in its price. Thus, stocks mostly change value based on changes in the real world, and in response to the market as a whole. Fundamentalists may have once been able to give an edge in picking good stocks, but no longer can do so.

At this point in the book, I was feeling pretty bleak about the stock market and investing in general. If nobody knows what's going to happen, then why bother investing at all? He then lays out his hypothesis, the random walk of the title.

A "random walk" is a concept used in mathematics and probability theory which means that the likelihood of an event occurring is independent of the events that have preceded it. The simplest example is flipping a coin. Any time you flip a coin, the odds of it coming up heads will be 50%, regardless of whether the last flip was heads or tails.

Interestingly, our brains rebel against the concept of a random walk. We know that, on average, when you flip a coin a bunch of times, it "should" come up heads 50% of the time. So, if we start flipping a coin, and it comes up tails the first four times, then we'll start to feel like it's "due" to come up heads. Maybe it comes up tails again. "Okay," we'll say. "This time, it's GOT to come up heads." Except, well, it doesn't. The odds of a series of coin flips ending up as TTTTTT is no less likely than the odds of it ending up as TTTTTH or even THTHTH.

With this in mind, it's very easy to see why people so easily convince themselves that they can predict where the market is going to go. Maybe they see a stock going down, down, down. "Aha," they think. "It's due to come back up!" Well... maybe. Or maybe it's Enron. Malkiel's point is that, in the short term, the movement of individual stocks and the market as a whole is essentially random. We can try to explain it, and convince ourselves where it's going, but we're just telling stories to make the world seem more reasonable. We don't actually have any control.

Gosh... that sounds pretty dire, too, doesn't it? If the market moves randomly, then why invest instead of going to Vegas? Well, Malkiel argues, in the short run the market is a voting mechanism: it follows the madness of crowds, mis-values hot stocks, and overlooks mis-priced equities. In the long run, though, the market is a weighing mechanism. Every time that a market is brought too far out of whack, it has eventually swung back to a more realistic level. That process can take years, which is why nobody should get into the stock market unless they can stomach a long downturn. Over the long haul, though, nothing can make you as much money as reliably as the common stock market.

This leads into the third part of the book, where he discusses modern schools of thought on investing. First up is a strategy for investing dubbed modern portfolio theory, or MPT. Previous generations of investors saw investment as a matter of picking the right stocks at the right time and holding them for the right duration of time. MPT, which has been significantly influenced by Malkiel's own theories on efficient markets, and is championed by many today, provides a practical way to achieve fairly high returns on investment with fairly low risk by diversifying your holdings. This means both diversifying across different asset classes (stocks and bonds) as well as diversifying within an asset class (holding at least twenty different assets that are not strongly correlated).  The goal is not to make sure your portfolio will always go up - in bad markets, nearly every portfolio will decline, reflecting the real loss in economic activity. Rather, the goal is to help a portfolio weather the downturns, while continuing to take advantage of the long-term superior earnings available from the stock market. Interestingly, MPT has demonstrated that, by mixing together assets from two different risky investments, your combined investment can both perform better and have less risk than either investment alone.

Malkiel includes a lot of graphs and charts in this book, and they do wonders at communicating his points. One of my favorites shows the returns that you could get by purchasing a stock market index fund and holding it for a certain number of years. For each period, he shows the most it could earn, the least it could earn, and the average it would have earned. For example, if you purchased the market in 2007 and held it for one year, it would fall enormously; if you purchased in 2009 and held for one year, it would gain enormously. If you purchased in 2007 and held for three years, you would fall a little; if you purchased in 2009 and held for three years, it would rise a lot. What's remarkable is that, for every holding period, from one year to thirty years, the average expected profit remains consistent. However, as the holding period grows longer, the best- and worst-case outcomes retreat, with the worst-case shrinking most dramatically. Beyond ten years, no time period has ever lost money (assuming dividends are re-invested); at twenty-five years, even the worst-case return looks quite good. That's the magic of compound interest: the dividends keep working for you, even in down markets, and accumulating over time, eventually working the alchemy of lowering risk without lowering profit. One can get rich. It just takes time and patience.

(Note: that image is from the 2007 edition of the book. The averages have all slipped down slightly since then, thanks to the latest bear market, but the overall shape is the same.)

This section of the book also includes a fair discussion of several modern schools of thought that seem to challenge Malkiel's random walk hypothesis and accompanying theory about efficient markets. The most interesting of these is a chapter devoted to the insights of behavioral psychologists. Malkiel is, at heart, clearly an academic, and he certainly respects the scholarship behind behavioral economics. He concedes the point that traditional economic theories tend to assume that investors are rational, when clearly they are not. Behavioral economists posit that, because investors aren't rational, markets can't be truly efficient. Malkiel engages with this concept, pointing out that while this is true during a bubble (even if a canny investor does figure out that assets are overvalued, it can be extremely risky to conduct arbitrage and profit if the bubble continues for years), over long runs of time there's a consistent reversion to normalcy. Movements are chaotic and unpredictable in the short term, and have upward momentum over the long run, and have been ever since we started keeping records hundreds of years ago. Now, as to whether that upward momentum is the result of market efficiency, or behavioral psychology, really doesn't matter much in practice: the demonstrated safest and best way to invest is to buy a broad, diversified portfolio, and hold it forever.

The last section of the book is devoted to application: practical advice on how an individual should construct their portfolio. This was the part that felt most familiar to me, thanks to the way Malkiel's teachings have seeped into mainstream personal finance education. He shows several pie charts showing different hypothetical allocations for different people at different ages: a young businesswoman in her mid-20's; a parent in their late 30's; an adult in their mid 50's after putting children through college; and someone approaching or in retirement. As expected, the earlier allocations focus more on stocks, while still holding respectably portions in bonds and other holdings like real estate investment trusts (REITs); the later allocations shift to more conservative allocations, although it's interesting to note that in his view, stock equities should still stay at around 40% even in retirement, and the allocation for cash doesn't grow past 10%.

Throughout the book, he gives good guidance on the importance of recognizing one's own temperament and capacity for risk, repeatedly returning to the mantra of not investing past your "sleeping point" - the level of risk that would make it difficult for you to sleep at night in a bear market. So, with this as with all things, an individual might do well to forego his suggestions and invest in a more conservative allocation. In that case, one would probably want to save even more to help make up for what will likely be a lower return over the long haul (but a much higher quality of life thanks to lower stress!).

The book closes out with some very pointed and specific suggestions: particular funds to consider buying, the ideal allocations between US, international, and emerging markets. This is probably the part that will get dated most quickly, but for now it remains very useful, since it's just a few years since the book came out. (Though I think the Vanguard international fund options, at least, have changed a little since publication.)

For me, personally, I'm considering three tweaks to my investments. Two were largely inspired by this book, and the third is something I've been mulling for a while.

First, Malkiel is pretty explicit about the importance of giving large exposure to international markets: he recommends an even split between US and international equities, and within international, a strong exposure to emerging markets (basically, countries other than Europe, Australia, and Japan). When I first started investing back in 2004, the general consensus seemed to be around 20% exposure to international markets: enough to offer some diversification from problems in the US market, while leaving the bulk of your holdings in US companies. There were several good-sounding arguments for this approach: the US stock markets tend to be better regulated and more investor-friendly than foreign markets; many US-traded companies (like Coca-Cola) are global companies, and thus you get international exposure anyways from your US stocks; and investing in shares that are not priced in dollars exposes you to currency risk, so even if an investment does well your gains could be wiped out if the dollar fell in value.

Since then, though, the pendulum has definitely shifted, and most guidance I read now is pushing international stocks into a higher position. Malkiel's 50/50 split is the most I've seen recommended, but 20% is now the floor instead of the average. I'm currently sticking to making international stocks 20% of my total portfolio, which equates to just 25% of my stock holdings.

There are many good reasons to consider making this higher. The big one that Malkiel emphasizes is that most growth, not just now but that's likely in the future, will be in emerging countries. He thinks that the long run of roughly 10% growth in America is likely coming to an end, and we'll be seeing returns closer to 8% in the decades to come. Other countries, though, have much more potential to grow their economies, and investing in them will help raise one's portfolio. Beyond Malkiel's predictions, there are some other arguments to be made as well. For example, the global economy is so strongly interconnected now that it may not be useful to view international funds as really protecting against risk in the US market any more; after all, in 2008 the US housing market collapsed, and took the world economy down with it. So, it makes more sense to view international stocks as a means to help your portfolio grow at a rate similar to the whole world's economy, rather than as a counterweight to the US markets.

Honestly, a big part of my reluctance to increase exposure is tied to my reluctance to mess with my allocation. One piece of advice I absorbed early in my investing career is to be as inactive as possible: don't chase the hot sectors, don't get scared and dump stocks when the market takes a dive. I felt comfortable with my 60/20/20 plan when I first created it, and doubling the amount of international stocks in it feels like a big shift. Knowing that today I would make a 40/40/20 portfolio doesn't make it much easier to make a major change in my existing portfolio.

Malkiel has some detailed explanations for what he does in his own portfolio, including a slightly unusual step he takes to increase his exposure to the Chinese stock market. I don't think I'll go that far, and I won't change my 25% to 50% overnight. But, I think it might be prudent to start working my international exposure higher. I won't be selling any of my US total stock market index fund; I think I'll set a goal to direct new investments so they're weighted a bit more towards international markets, with the objective of reaching 30% by the end of 2013. If that feels good, I'll keep moving in 5% increments over the coming years until I reach a point that feels comfortable to me.

The second major idea this book has made me consider is holding an REIT for more exposure to real estate. This plays a fairly modest role in his portfolio of just around 10%; nonetheless, he demonstrates how, in most markets (not the 2008 recession), real estate has shown a very low correlation with the stock market; furthermore, it also tends to do well in inflationary periods. Keeping an REIT would allow a portfolio to weather a bear market more easily. And, since we seem to be past the worst years of the housing crash, they aren't likely to be overvalued.

I've avoided REITs up until now for a couple of reasons. First, as a homeowner, a decent chunk of my wealth is already invested in real estate (albeit a highly undiversified investment!). Second, it's hard to get excited about the long-term returns of REITs, which lag noticeably behind those of stock funds. (Granted, though, that's also the reason I resisted investing in bonds for years, which I now realize was shooting myself in the foot - in small amounts, diversifying from an all-stock portfolio both reduces risk AND increases yields.) REITs are also more complicated than equity mutual funds, which adds some small hassles to tax planning and preparation. Finally, I'm attracted to simple portfolios, and am tempted to just eliminate something which would only hold a sliver of my total assets.

The book has made me seriously consider REITs for the first time. I still don't think I'll necessarily rush to buy an REIT, but it's on my radar now. Once I pass a certain threshold where a small 10% investment in an REIT wouldn't feel like chump change, I might dip my toes in those waters.

The third change I'm considering making to my portfolio isn't something that Malkiel directly addresses, but is a thought that's been percolating in my head for a while, and that his discussions of tax-efficient planning have triggered yet again. I'm lucky enough to be able to max out my tax-advantaged retirement accounts, and have some left over to hold in taxable accounts. Which is awesome, but I increasingly feel like I'm not taking the best advantage of my retirement accounts.

Currently, all of my retirement accounts (401(k)s and Roth IRA) are in Target Retirement Date funds. I love these funds - they are super-simple, and largely match the allocations I would want anyways. Internally, the Target Retirement fund holds its money in a Total Stock Market, a Total International Stock Market, and a Total Bond Market index fund.

In my non-retirement account, I have pretty much exactly the same holdings (total stock market, total international, total bond, and some CDs), albeit in slightly different allocations. The "problem", such as it is, is that the interest I earn from bonds and from CDs gets taxed at my regular income tax rate. It would be better if I held those investments inside my Roth or my 401(k), since that way I wouldn't have to pay tax on the earnings each year. I also pay tax on dividends and (theoretically) capital gains on my stock funds, but those tend to be really small and don't add much to my bill.

To give a contrived example: suppose I had $1000 in my 401(k) and $1000 in my non-retirement account. Suppose each was divided up with $600 in US stocks, $200 in international stocks, and $200 in bonds. Every year, I would pay tax on the interest I earned from the $200 of bonds in my non-retirement account. However, suppose I decided to shift around my investments. Instead, I would have the $1000 in my 401(k) divided up with $400 in US stocks, $200 in international stocks, and $400 in bonds. In my non-retirement account, I could then have $800 in US stocks, $200 in international stocks, and nothing in bonds. Then, I wouldn't need to pay any taxes at all on the money earned from my bond funds, and I would still own exactly as much of each fund as I did in the first example.

So, I'm a bit tempted to start shifting more of my less tax-efficient investments into my tax-sheltered account; but doing this would require getting rid of my beloved Target Retirement fund, and paying more attention to my overall investment picture. Frankly, I'd rather not do this: while you would never know it from this blog post, I like to forget that I have any money invested at all and actively ignore how each investment is doing. (I have annual automatic rebalancing enabled in my retirement funds; for non-retirement, I use a Google Docs spreadsheet I created to direct future contributions to maintain a balanced portfolio without ever needing to sell any funds. In both cases, I never need to learn how much a fund has won or lost over any time period.) Also, while I definitely won't be tapping my retirement accounts before age 65, it's certainly possible that I might want to use my non-retirement funds for something else, and I'd like to have some sort of mix of funds available there so, if I need to make any withdrawals, I can do so without being forced to sell stocks, possibly at a significant loss.

I'll probably revisit this question after filing this year's taxes. If my investment income is fairly minor, then I'll maintain the status quo for at least another year. If I start feeling the pain of interest taxes, though, I might bite the bullet and start shifting my funds to be more tax-efficient.

Moving on from my personal response to the book: I think this book would be a perfect read for anyone who is interested in investing. Note that I didn't say "anyone who invests" or "anyone who wants to invest." Rather, I'd recommend this book to people who actually enjoy the topic of investing, and want to learn more about how it works and different strategies that have been tried over the years.

For people who are looking for more of a basic financial primer, I'd still recommend one of Jane Bryant Quinn's books: either Smart and Simple Financial Strategies for Busy People or Making the Most of Your Money Now. When it comes to investing, her recommendations are very much in keeping with Malkiel's suggestions and those of modern portfolio theory. However, Quinn takes more of a holistic view towards finances, spending time on the subjects that most consumers will face: budgeting, credit card debt, direct deposit, student loans, 401(k) plans. S&SFS4BP gives good advice on investing for retirement without diving too deeply into the details about how markets work. MtMoYMN gives really good and lucid explanations of the mechanics of different investments - that book did more than anything else to help me really "get" bonds - and, somewhat similar to Malkiel's final chapter, has some sections that operate along the lines of, "I don't think you should buy individual stocks, but if you do, here's how." Malkiel's book, while very practical, is ultimately a more academic work, that's more concerned with the how and the why of market behaviors, whereas Quinn's is more focused on what you should do about the market.

In other words, A Random Walk Down Wall Street is primarily a tome for investment nerds like myself. (It may also be of interest to math and statistics nerds.) It's one of the only proven investing books that has withstood the test of time, through markets both good and bad, and remains at least as vital today as when it was first written.

EDIT 1/19/13: Man, I love Vanguard.  This post gives a really thoughtful perspective on the use of REITs. The immediate effect is to cool my enthusiasm for buying into an REIT - it could still have some use as a portfolio diversifier, but looking at that graph definitely cools any sense of urgency I had about adding one.


  1. I found this book in the back of my parents' car and read it when I was a teenager. It made a huge impression on me. Because of it, I never considered going into a finance-related career.

  2. I'm impressed that it made an impression! It seems a little esoteric for a teen. That's a great time of life to absorb its lessons, though.

    Oddly enough, one of the lessons I took away from the book is that you can get wealthy in the finance career, but not necessarily by doing well... all the fees people pay for actively-managed funds, brokerage fees, and advisement fees end up in someone's pockets, regardless of how well your clients end up!

  3. Absolutely. Finance careers actually seem more safe than if they were based on performance. Take venture capital or hedge funds. You're basically gambling with other people's money, but it's better than gambling because the expected return is positive (assuming the stock market is generally goin up). Even when you lose, you get 2% of all your clients money (you make a million bucks even in a bad year). And if you win, you get 20% of the winnings. That is a _very_ sweet racket.

    But...it's definitely a racket. I'm sure that the people who do it actually _believe_ that they're able to pick the winners. But, since I don't, if I did it then I'd just be cheating people. And I'm not sure I could cheat people for living.