In the late 1800s, Vilfredo Pareto observed that 20% of the peapods in his garden produced 80% of the peas — a lurid example of inequality among peas. Since then, this idea has been fleshed out into a principle, the Pareto principle, which states, roughly, that 20% of the effort will get you 80% of the way there.
Which is what I like about book summaries. You can spend 20% (or less) of the time it would take you to read the book by reading a summary, and as a result you can capture 80% of the value of a book.
For that reason, I’m planning on doing many more book summaries — this A Random Walk Down Wall Street summary should be the first of many.
So let’s get started.
A General Overview of A Random Walk Down Wall Street
Today’s book is Burton Malkiel’s A Random Walk Down Wall Street. The author, by the way, is an 82-year old Princeton economist, and the Chief Investment Officer of AlphaShares Investments. He also served as the director of the Vanguard group for some 28 years.
The book itself has proven to be one of the most popular investment books in existence. So popular that I’m reviewing the eleventh edition. It has sold 1.5 million copies and boasts more than 2000 citations, according to Google Scholar. Amazon calls it “the first book to purchase when starting a portfolio.”
So it comes recommended.
What the book is about
The book popularizes the random walk hypothesis. What is a random walk? The book says, “A random walk is one in which future steps or directions cannot be predicted on the basis of past history.” Here’s one way to think of it: imagine that you have an unbiased coin. You flip the coin. If it comes up as heads, that counts as +1. If tails, that’s -1.
Then, after each flip, you plot the current number. Here’s the outcome of one simulation of 10,000 flips:
This means that, at any time, the past performance of the stock gives you no information. Those juicy trends that your mind picks out, where the stock is going down so clearly you should sell (or vice versa)? Those don’t exist in this graph, by construction.
The random walk hypothesis says that this same thing is true (or nearly so) of the stock market — at any point in time, all the available information about a stock is priced in. If such is true, it’s impossible to construct a portfolio that beats the market in any skillful manner. You could construct such a portfolio only by chance.
This, Malkiel argues, is the case. Markets are nearly efficient — it’s not a perfect random walk, but any “momentum” is small enough that capitalizing on it won’t be worth the fees. So, practically speaking, you can’t (skillfully) beat the market.
How does this apply to investing? It implies that you should seek market wide returns by holding indexes, like one that tracks the S&P 500. These work by selling you, in effect, a small slice of every company, so that your portfolio is well diversified — the importance of which I’ll go into another day.
These, combined with their low fees (e.g. Vanguard’s ETFS), are unbeatable — or close enough. In theory, you could achieve the same thing with any well-diversified portfolio. In practice, brokerage fees will eat into your gains, such that it’s worthwhile to buy slices of already existing funds, which benefit from economies of scale.
That’s the main thesis that’s developed in the book, along with a lot of exposition of different things. The book has a history of speculation, discusses the correlation between risk and reward, the benefits of diversification, and how you ought to invest at different ages and under varying circumstances. Plus some example portfolios.
If any of this sounds interesting, it’s a great book. I recommend buying a copy. Remember: price is what you pay, value is what you get. The book is currently going for $9.48 on Amazon. Applying the same logic that I applied in “The True Cost of a Financial Advisor,” the extra returns you get by following the advice in this book could be worth a quarter of a million dollars or more.