Review: A Random Walk Down Wall Street

A Random Walk Down Wall Street, by Burton Malkiel, is a classic book on personal investing. The first edition was published in 1973, and there have since been twelve editions, with the most recent released in 2019. Considering how much the market has changed in that time, its continued relevance is a testament to the book’s quality and central message.

The book’s title is a reference to the Random Walk Hypothesis (RWH), the theory that prices of bonds and stocks can be viewed as random walks, a mathematical model in which prices increase or decrease randomly without regard to their historical value. If this model is accurate, then it’s impossible to predict whether a given stock’s price is about to rise or fall.

In light of that, the book argues that the most sensible strategy is to buy-and-hold. Over time, the value of one’s investment will grow as prices drift upward. Since any individual stock is still likely to behave somewhat erratically, it is prudent to diversify and purchase stocks from a wide range of companies. The simplest way to do so is to purchase shares of index funds, which buy stocks from all of the companies that belong to an index like the S&P 500. Many of these funds charge very low overheads and in exchange, they handle purchasing all the stocks at the appropriate weights, rebalancing as prices change, and distributing the dividends issued by each stock.

By now, this advice is widespread and popular, but it wasn’t always. When the first edition of A Random Walk Down Wall Street came out in 1973, there was no widely available index fund that one could invest in. The Vanguard Group, which is now one of the largest index fund managers, was founded the year after in 1974. Today, it manages over $5 trillion in assets, and many other large companies also provide funds tracking a wide range of indices.

Controversy surrounding the Random Walk Hypothesis

But are stock prices really random walks? A lot of research suggests that the answer is no. Andrew Lo and A. Craig MacKinley, who are finance professors at MIT and Wharton, have written several papers testing the random walk model and finding that it does not quite match historical data. They even published a book called A Non-Random Walk Down Wall Street which collects together their results in this area.

Does that mean the advice in the book is useless? Fortunately not. Even if prices are not in fact random walks, there is a related theory called the Efficient Market Hypothesis (EMH), which (roughly) states that it is not possible to beat the average returns in the market, since current prices accurately reflect available information about the value of stocks. There are different versions of the EMH, which state the above in various stronger or weaker ways. If the EMH is accurate, then the book’s advice of buying-and-holding index funds is still sound. The book conflates the RWH and EMH at many points, but they are not the same.¹ So the evidence against the RWH does not necessarily rule out the EMH, or its implications for investment strategy.

Nevertheless, the EMH is also the subject of much debate and analysis. Even Malkiel suggests that he is not entirely convinced of the strongest, boldest formulations of the EMH. Nevertheless, he argues convincingly that even if the hypothesis is not perfect, the average personal investor is unlikely to be able to beat the market. Moreover, the evidence presented suggests that most mutual funds managers can’t either, and even if they could, it would be impossible to figure out ahead of time which one to entrust with your money. So, practically speaking, most people saving for retirement should behave as if EMH were true and follow the book’s advice.

Outline of the Book

The book is divided into four parts.² Part one discusses two main theories behind how stocks are valued. The “firm foundations” view says that stocks are (or should be) valued based on the discounted value of all future dividends they will pay. The “castle in the sky” view says that stocks are worth… well, whatever an investor can hope to sell them for to someone else. Under this view, stocks are liable to be the subjects of manias, where the price is driven up by speculators hoping to sell to someone else down the line. After discussing these two points of view, the book recounts the history of some of the worst speculative bubbles of all time.

Part two describes two classic strategies that investors use to analyze and pick stocks, which are each rooted in the viewpoints from part one. Fundamental analysis involves calculating the value of stocks based on the firm foundations principles and then purchasing stocks that are under-priced. Technical analysis is instead based on castle in the sky view, and tries to guess trends in stock prices based on charts of past movements. Malkiel has a dim opinion of technical analysis, and seems to view fundamental analysis as too difficult to reliably profit from, in light of the EMH.

Part three describes some of the academic theories about stocks and investing. Readers will learn more about EMH and terms like CAPM, beta, and modern portfolio theory. There is also some discussion about studies that contradict aspects of efficient market theory. However, the book suggests that in the balance, the EMH is still a good guiding principle for most investors.

Part four is a guide to how to apply all of these ideas to personal investing. It explains things like tax-advantaged accounts, investing in index funds, and so on. Readers who have read a bit about personal finance will probably have seen all of this material in one form or another, but it’s still a well presented review.

Does Malkiel have a conflict of interest?

Malkiel joined Vanguard as a Director in the late 70s. As mentioned above, Vanguard is one of the largest providers of index funds. So, is his advice to invest in index funds biased by this affiliation? I think not. The first edition of the book was published before Vanguard was founded. Index funds did not exist in a form available to the average investor at that time, and the book advocated for their creation, arguing that they would help people avoid the high costs and poor performance of actively managed mutual funds. Therefore, the fundamental suggestion of the book does not seem to have changed as a result of Malkiel joining Vanguard.

After nearly thirty years, Malkiel left Vanguard. Around 2012, he became Chief Investment officer of Wealthfront, a “roboadviser”. One of the main services that Roboadvisers like Wealthfront and Betterment offered from the start was automated “tax-loss harvesting”. The idea is to sell a stock that has declined, thereby realizing a loss that can be used to offset taxes from capital gains or other income. Then, one buys back a stock that is similar in order to maintain a target allocation.³ Investors have always been able to implement this process manually, but most people following low maintenance passive strategies like index investing would probably be unlikely to do so regularly. Wealthfront and Betterment made the process automatic, in exchange for an expense ratio that is higher than many of the low-cost index funds provided by Vanguard.

This is not out of line with what the book has always advocated, as long as the expense ratio stays low enough. As part of the “harvesting” step, one is still keeping a broadly diversified portfolio.

However, in recent years, Wealthfront has begun new “smart-beta” offerings. Very briefly, smart-beta tries to improve returns by tilting the portfolio toward certain classes of companies, such as those with lower volatility, smaller capitalization, or low price to earnings ratios. Some research has suggested that these stocks out-perform the market on average.

The trouble is that in the 2015 version of A Random Walk, chapter 11 is titled “Is ‘Smart Beta’ Really Smart?”. As one might guess from the phrasing, the answer Malkiel more-or-less gives is no. He suggests that many of the academic analyses underlying smart-beta strategies have failed to live up to their predictions when applied, and some observed excess returns may just be the result of increased risk taking. This chapter replaces a version from the 2003 edition that was called “Potshots at the Efficient-Market Theory and Why They Miss”, which focused on the academic theory underlying smart-beta approaches.

But now, as Wealthfront is offering smart-beta, Malkiel says he has changed his mind, as described in this New York Times article. The justification he gives in the article is that part of his objection to earlier smart-beta offerings was higher expenses and poor tax consequences, which he believes are not an issue with Wealthfront’s version. That may be true, but my reading of the chapters mentioned above is that he was also critical of the whole premise, even setting aside costs. I have not read the 2019 edition of the book, but the title of chapter 11 has been changed to “New Methods of Portfolio Construction: Smart Beta and Risk Parity”, which has a decidedly less skeptical tone.

Of course, people change their minds, and smart beta is perhaps not that large of a departure from the underlying message of the book. Tilting toward a certain class of smaller capitalization stocks still means one is broadly invested in many stocks and not constantly trying to trade one stock for another. (After all, many people would not have a huge problem with using an S&P 500 index rather than total stock market, but that too has a form of tilt.)

Conclusion

A Random Walk Down Wall Street has stayed popular for a long time for a reason: the basic advice is sound, and the explanations are clearly written. Although the book has changed throughout the editions, the key principles have not. It remains a good introduction for a reader who wants to learn some of the basics about investing.