January 11, 2009

A Random Walk Down Wall Street

Filed under: Book Reviews — Robert John Ed @ 5:25 am

After asking my brilliant finance prof where an imbecile should go to learn about personal finance and strategy, he gave me five words:  Random Walk Down Wall Street.  Although I’ve read extremely small amount on finance and investment, this book covered such a huge amount of ground in such a logical way, I feel as though investing is actually very simple now.  That’s saying a lot.

Written by Burton Malkiel, the thesis of the book is essentially that the market is incredibly efficient.   So efficient, in fact, that it is nearly impossible to consistently beat the market by attempting to hold a portfolio that out performs.  Why is it so difficult?  What about all those professionals that DO outperform the market?  The first question can be answered simply by the fact that stock prices (or any medium of investment) are effected by a series of random events that can’t be predicted by anyone.  Since the market is so incredibly efficient as mentioned, the ability to be ahead of the markets is very hard.  The reason that portfolio managers do beat the market averages is also pretty simple.  They beat the market in the short term, not the long term.  The rub, of course, is that no one consistently beats the market in the short term.  There are winners and losers every quarter, but most of the guys who get the big paychecks don’t out perform the market over a series of years.  In fact, a great many actually do far worse.  What does all this mean?  You can’t beat the market.  By all means you can’t consistently do it.  You can try, it’s fun, but it is a gamble no matter who you are.  Like all gambling, it’s very easy to get caught up in a gambler’s fallacy and over play your hand.

Now that we’ve seen that you can’t win (btw this is statistically backed up in the book, my word for it is hardly enough verification) we have to examine the extraneous pressures caused by attempting to beat the market.  Trading costs money.  So do all of the agents you employ to help you trade.  Brokerage fees cost an investor a great deal and the humorous aspect is that (as noted) the professionals are no more likely to succeed in out performing the market than your average joe.  So why exactly do these professional analysts get paid so much?  Why do people line up for those services?  There is no rule or law that states that efficient market theory is true.  It’s just statistically relevant and proven over the time periods where stocks have been employed.  So people assume that these professionals know what they’re doing, they assume that a suit and tie will get them a good return.  They don’t think about the fact that excess trades and fees are decimating their returns.

The book has a very simple strategy.  It’s so simple that it’s boring.  Buy and hold.  Buy a diversified portfolio of stocks, bonds and real estate while reinvesting the dividends into the portfolio.  Hold it and reap long term rewards.  Diversification is a large aspect of the investment as it dilutes the potential for large holdings of a few stocks to swing the value of your investment one way or the other.  Diversify internationally with variances in types of investment, risk of investment and maturity of investment.  All while considering the age and needs of the portfolio manager (you.)

There were so many great things in this book to learn.  It is a long read, although it’s written in a way that is often interesting despite the rather dry material.  The introductory chapters that delineate why bubbles begin and burst is especially interesting.  The tulip crash of 1637 really points out the problem of groupthink and why it’s bound to happen again…and did with the internet bubble. 

Bottom line:  this is THE book to read on personal finance.  It is completely worth while, despite the amount of time it will probably take.  At 400+ pages, it wasn’t the easiest title in my library, but it may well prove to be the most valuable.



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