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A Random Dance Down Wall Street

In the last few weeks, I’ve been reading A Random Walk Down Wall Street by Burton Malkiel.  Definitely an investment classic, required reading for anyone with more than a few months expenses in their savings.  The very simple conclusion of the book can be summed up as follows:

The strategy for the average investor with the highest expected value is to invest in broad-based low-cost index funds.  Though that’s obviously not the strategy with the optimum return, but it’s impossible to reliably identify a better strategy in advance.

(If you think you’re an above-average investor, the advice still applies to you if: You want some of your investments to be relatively low-risk, you don’t want to put substantial time and effort into researching investments (you’d rather spend it increasing and/or enjoying your income), or you’re willing to consider that your assessment of your investment abilities may be incorrectly high.) 

This book suggests that markets approximate the effect of the efficient market hypothesis (the disclaimer is important, since it’s unlikely that even the weak form of that hypothesis is precisely true, that would, among other things, imply P=NP).  Prices may not reflect all public information right away.  But there’s an incentive for prices to match public information eventually, so in the long-enough term there’s no easy augury that can profit reliably.  (And in practice that term is fairly short, if you want easy money, it’s probably shorter than you like.)  Not to say there’s nothing you can do to accurately predict the future.  It’s just really hard.

There are strong logical arguments in favor of both components of the book’s theory.  As to why the average institutional investor fails to beat the market:

  1. Every time someone chooses to buy an asset that beats the market, someone else chooses to sell it.  (It takes two to tango.)
  2. Generally, both the buyer and the seller are institutional investors because institutional investors do basically all of the buying and selling.
  3. Thus any time an institutional investor gains a relative advantage, another is likely to gain a relative disadvantage.  Taken together, they’d do as well as the market average, excluding the cost of all this buying and selling.
  4. The cost of all this buying and selling is substantial, so on average they do worse.
  5. Thus, buying an index fund also gets you a pre-expenses expected performance of the market average, but with substantially lower expenses.

As to why you (probably) can’t easily beat the market:

  1. If something is predictably under-valued, people will buy it until it isn’t.  (Even if only some people realize it’s undervalued, so there’s little time lag on this component.)
  2. If something is predictably over-valued, at some point people will start to sell it.  (There’s more of a time-lag on this component because they might expect to be able to sell it at an even higher price to a “greater fool”, but savers want to spend eventually and fools have finite money.)
  3. If some investor is predictably good, people will copy them until they no longer beat the market.  (Also, past performance doesn’t guarantee future results.)

So, good stuff.  The book focuses on presenting empirical evidence to back up those arguments, along with a lot of interesting history and a critical look at competing theories.

One weakness of the book is that, for an economics book, it seems to underestimate the effects of supply and demand.  It notes that the value that the market places on earnings and dividends varies during different “eras” of the market, that it was particularly low during the “Age of Angst”, 1969-1981.  During that era, stocks failed to keep up with inflation not because earnings failed to keep up with inflation, but because the P/E multiple fell sharply.  It mentions that the era was characterized by “demand-pull inflation” (demand for spending, not for saving!) suggests that investors were rationally “scared” and thus demanded higher risk premiums, which the market provided with lower P/E multiples.  But that sounds like an ultra-roundabout way to say that lower demand for savings and lower demand for having savings in stocks relative to other (perceived as less “risky”) things caused the P/E multiple to drop.

Which is odd, if you’ve accepted the author’s frame of referring to that earnings times market-average P/E multiple as a “firm foundation of value”, when that multiple is not nearly so firm, and may have as much to do with aggregate demand for stocks (in general) as opposed to anything about the specific companies being priced.  Something like gold, which Malkiel describes as “impossible to predict” has no dividends or earnings, only that unpredictable multiple.

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