Book Review: A Random Walk Down Wall Street

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing 
By Burton Gordon Malkiel 

Money Lying on the Ground and an Ape Throwing Darts: two stories in A Random Walk Down Wall Street strike me the most. First, if you are walking on the street and see a $100 bill lying on the ground, you should not pick it up. Second, a blindfolded ape throwing darts at a newspapers financial pages could select a portfolio that would do just as well as one carefully selected by experts. And these two stories illustrate the main point of the book: the stock market is efficient and no one can earn above-average returns without accepting above-average risks. Therefore, an average person who invests in index funds can even do better than a professional who actively manages a fund. Besides this thesis, the book also introduces some investment vehicles and strategies. The question is: should I recommend this book as an introduction book to an intelligent friend with no investment experience?

The answer to this question depends on what my friend’s situation is. Specifically, it would concern my friend’s intended length of investment, market she chooses to invest in and her purpose of investing. In the following, I will mainly talk about situations where I won’t recommend the book to my friend. The book’s Efficient Market Hypothesis might not work well if my friend wants to invest short-term. If she sees a $100 bill on the street, why wouldn’t she pick it up just because it should or will disappear eventually? (The EMH says that the bill should or will disappear.) In other words, if my friend wants to invest in the short-term, why would she refuse to grab the short-term benefits just because it will disappear in the long run? Say that if my friend needs to send her children to college in four years, she can only invest the inheritance for the next four years. She might be better off by investing in an actively management fund. She probably will get much money by buying some tech stocks in 1995 and selling them in 1999, even though the internet bubble busted later on. If one is investing in a short period of time, the book’s theory will not necessarily apply since the thesis is based on long term. In this case, I won’t recommend the book to my friend. Instead, she will benefit more from a book that introduces different strategies on how to select stocks or fund managers.

The place the ape (average investor) is at also matters. "King Kong was a king and a god in the world he knew, but now he comes to civilization merely a captive", says Carl Denham in King Kong. Index funds might not outperform the actively managed ones at certain places. For example, if my friend is in China, she might be better off by hiring a good manager to manage her funds because the Chinese stock market is highly speculative and relatively opaque. According to the China Securities Regulatory Commission, as high as 65% to 70% of the investors in the Chinese stock market consists of private individuals. Partly because individuals tend to aim at the short-term rather than the long term compared to institutions, the Chinese stock market can swing dramatically and easily go out of norm. In the book, the market always adjusts itself to normal state. However, if abnormality is the rule, rather than the exception, like the Chinese stock market, the abnormal state becomes the new norm. Since it would be difficult to tell when the market will correct itself, one can do better by just following the trends or the new norm. Moreover, information from the public companies is not highly transparent, which prevents the market from performing efficiently. Since the Efficient Market Hypothesis is a condition for the superiority of index funds over actively managed funds, sticking with index funds, as promoted by the book, might not work well. Sometimes, the big mutual fund management companies have insider information that helps them take advantage of market inefficiencies and perform better than the index funds. (Note that the Chinese law system is not mature enough to prevent that from happening.) In fact, a recent research on S and P has shown that in some areas, stock picking outperforms passive investing. For example, more than half of actively managed large- and small-cap value funds beat the benchmarks in the past five-year period. Actively managed large-cap value funds did particularly well, returning 2.2% per year on average, versus 0.63% for the index; actively managed small value funds earned 3.79% per year, versus 2.96% for the index. The average actively managed international small-cap fund returned 4.91% per year over the last five years, more than triple the index. Index funds might be the King and God of stock market in some areas, but merely a captive to actively managed funds in other areas.

Moreover, the purpose of investing matters. If my friend is on the street to appreciate the spectacular architectures, a $100 bill lying on the ground will not be appealing to her. If my friend wants to invest to have fun, she would not derive much pleasure from just passively investing in index funds. Rather, I would recommend some other book that goes into the details of how to pick stocks to her. In another case, if my friend is investing to learn about companies or behavior of equities, she would not learn much with index funds. On the other hand, if my friend just wants to get rich slowly, the book by Malkiel is the right one. Lastly, you never know if your friend will be the next Warren Buffet. It is always worth a try. If I recommend the random walk book to my friend up front, she might become a passive investor and just give up picking her stocks and developing her own investment strategies.

A potential Warren Buffet might just get covered up in the mascot of a blindfolded ap.
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Editorial Staff