A
Random
Walk
Down
Wall Street
THE TIME-TESTED STRATEGY FOR
SUCCESSFUL INVESTING
Burton G. Malkiel
W. W. Norton & Company
NEW YORK • LONDONContents
Preface 15
Acknowledgments from Earlier Editions 19
PART ONE STOCKS AND THEIR VALUE
1. Firm Foundations and Castles in the Air 23 What Is a Random Walk? 24
Investing as a Way of Life Today 26 Investing in Theory 28
The Firm-Foundation Theory 28 The Castle-in-the-Air Theory 30
How the Random Walk Is to Be Conducted 33
2. The Madness of Crowds 34 The Tulip-Bulb Craze 35 The South Sea Bubble 38 Wall Street Lays an Egg 44 An Afterword 51
3. Stock Valuation from the Sixties through the Nineties 52 The Sanity of Institutions 52
The Soaring Sixties 53
The New "New Era": The Growth-StocklNew-Issue Craze 53 Synergy Generates Energy: The Conglomerate Boom 56
Performance Comes to the Market: The Bubble in Concept Stocks 63
The Sour Seventies 66
The Nifty Fifty 66
The Roaring Eighties 68
The Triumphant Return of New Issues 68
Concepts Conquer Again: The Biotechnology Bubble 70 ZZZZ Best Bubble of All 71
8 CONTENTS
The Nervy Nineties 74
The Japanese Yen for Land and Stocks 74
4. The Biggest Bubble of All: Surfing on the Internet 78
How Bubbles Arise 78
A Broad-Scale High-Tech Bubble 80 An Unprecedented New-Issue Craze 82 TheGlobe.com 84
Security Analysts $peak Up 86 New Valuation Metrics 87 The Writes of the Media 89
Fraud Slithers In and Strangles the Market 92 Should We Have Known the Dangers? 94 A Final Word 96
PART TWO HOW THE PROS PLAY THE BIGGEST GAME IN TOWN
5. Technical and Fundamental Analysis 99 Technical versus Fundamental Analysis 100 What Can Charts Tell You? 102
The Rationale for the Charting Method 105 Why Might Charting Fail to Work? 107 From Chartist to Technician 108
The Technique of Fundamental Analysis 109 Three Important Caveats 117
Why Might Fundamental Analysis Fail to Work? 120 Using Fundamental and Technical Analysis Together 121
6. Technical Analysis and the Random-Walk Theory 126 Holes in Their Shoes and Ambiguity in Their Forecasts 126 Is There Momentum in the Stock Market? 128
Just What Exactly Is a Random Walk? 129 Some More Elaborate Technical Systems 133
The Filter System 133 The Dow Theory 134
The Relative-Strength System 134 Price-Volume Systems 135 Reading Chart Patterns 135 Randomness Is Hard to Accept 136
A Gaggle of Other Technical Theories to Help You Lose Money 138
The Hemline Indicator 138 The Super Bowl Indicator 140 The Odd-Lot Theory 140 A Few More Systems 141
Technical Market Gurus 142
Why Are Technicians Still Hired? 144 Appraising the Counterattack 145 Implications for Investors 148
7. How Good Is Fundamental Analysis? 150
The Views from Wall Street and Academia 151
Are Security Analysts Fundamentally Clairvoyant? 152 Why the Crystal Ball Is Clouded 155
1. The Influence of Random Events 156
2. The Production of Dubious Reported Earnings through "Creative" Accoun ting Procedures 156
3. The Basic Incompetence of Many of the Analysts Themselves 159 4. The Loss of the Best Analysts to the Sales Desk, to Portfolio
Man-agement, or to Hedge Funds 160
5. The Conflicts of Interest between Research and Investment Bank-ing Departmen ts 161
Do Security Analysts Pick Winners?—The Performance of the Mutual Funds 164
Can Any Fundamental System Pick Winners? 170 The Verdict on Market Timing 171
The Semi-strong and Strong Forms of the Efficient-Market Theory 172
The Middle of the Road: A Personal Viewpoint 174
PART THREE THE NEW INVESTMENT TECHNOLOGY
8. A New Walking Shoe: Modern Portfolio Theory 179 The Role of Risk 180
Defining Risk: The Dispersion of Returns 181
Illustration: Expected Return and Variance Measures of Reward and Risk 181
Documenting Risk: A Long-Run Study 184
Reducing Risk: Modern Portfolio Theory (MPT) 186 Diversification in Practice 190
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9. Reaping Reward by Increasing Risk 197 Beta and Systematic Risk 198
The Capital-Asset Pricing Model (CAPM) 201 Let's Look at the Record 206
An Appraisal of the Evidence 209
The Quant Quest for Better Measures of Risk: Arbitrage Pricing Theory 211
A Summing Up 214
10. Behavioral Finance 216
The Irrational Behavior of Individual Investors 219 Overconfidence 219
Biased Judgments 222 Herding 225
Loss Aversion 229
The Limits to Arbitrage 233
What Are the Lessons for Investors from Behavioral Finance? 237
1. Avoid Herd Behavior 238 2. Avoid Overtrading 240
3. If You Do Trade: Sell Losers, Not Winners 241 4. Other Stupid Investor Tricks 242
Does Behavioral Finance Teach Ways to Beat the Market? 243
11. Potshots at the Efficient-Market Theory
and Why They Miss 244
What Do We Mean by Saying Markets Are Efficient? 246 Potshots That Completely Miss the Target 247
Dogs of the Dow 247 January Effect 248
"Thank God It's Monday Afternoon" Pattern 249 Hot News Response 249
Why the Aim Is So Bad 250
Potshots That Get Close but Still Miss the Target 251
The Trend Is Your Friend (Otherwise Known as Short-Term Momentum) 251
The Dividend Jackpot Approach 253 The Initial PIE Predictor 255
The "Back We Go Again" Strategy (Otherwise Known as Long-Run Return Reversals) 256
The "Smaller Is Better" Effect 259 The "Value Will Win" Record 261
Stocks with Low Price-Earnings Multiples Outperform Those with High Multiples 262
Stocks That Sell at Low Multiples of Their Book Values Tend to Produce Higher Subsequent Returns 263
But Does "Value" Really Trump Growth on a Consistent Basis? 264 Why Even Close Shots Miss 265
And the Winner Is . . . 267
The Performance of Professional Investors 267
A Summing Up 271
PART FOUR A PRACTICAL GUIDE FOR RANDOM WALKERS AND OTHER INVESTORS
12. A Fitness Manual for Random Walkers 277
Exercise 1: Gather the Necessary Supplies 278
Exercise 2: Don't Be Caught Empty-Handed: Cover Yourself with Cash Resources and Insurance 280
Cash Reserves 280 Insurance 280
Deferred Variable Annuities 282
Exercise 3: Be Competitive—Let the Yield on Your Cash Reserve Keep Pace with Inflation 283
Money-Market Mutual Funds 283 Bank Certificates of Deposit (CDs) 283 Internet Banks 284
Treasury Bills 285
Tax-Exempt Money-Market Funds 285
Exercise 4: Learn How to Dodge the Tax Collector 286
Individual Retirement Accounts 286 Roth IRAs 288
Pension Plans 289
Saving for College: As Easy as 529 290
Exercise 5: Make Sure the Shoe Fits: Understand Your Investment Objectives 291
Exercise 6: Begin Your Walk at Your Own Home—Renting Leads to Flabby Investment Muscles 298
Exercise 7: Investigate a Promenade through Bond Country 300
12 CONTENTS
Zero-Coupon Bonds Can Generate Large Future Returns 301 No-Load Bond Funds Are Appropriate Vehicles for Individual
Investors 302
Tax-Exempt Bonds Are Useful for High-Bracket Investors 302 Hot TIPS: Inflation-Indexed Bonds 304
Should You Be a Bond-Market Junkie? 305
Exercise 8: Tiptoe through the Fields of Gold, Collectibles, and Other Investments 306
Exercise 9: Remember That Commission Costs Are Not Random; Some Are Cheaper than Others 308
Exercise 10: Avoid Sinkholes and Stumbling Blocks: Diversify Your Investment Steps 309
A Final Checkup 310
13. Handicapping the Financial Race: A Primer in Understanding and Projecting Returns from Stocks and Bonds 312
What Determines the Returns from Stocks and Bonds? 312 Three Eras of Financial Market Returns 316
Era I: The Age of Comfort 317 Era II: The Age of Angst 319 Era III: The Age of Exuberance 323 The Age of the Millennium 325
14. A Life-Cycle Guide to Investing 329 Five Asset-Allocation Principles 330
1. Risk and Reward Are Related 330
2. Your Actual Risk in Stock and Bond Investing Depends on the Length of Time You Hold Your Investment 331
3. Dollar-Cost Averaging Can Reduce the Risks of Investing in Stocks and Bonds 334
4. Rebalancing Can Reduce Investment Risk and Possibly Increase Returns 338
5. Distinguishing between Your Attitude toward and Your Capacity for Risk 340
Three Guidelines to Tailoring a Life-Cycle Investment Plan 342 1. Specific Needs Require Dedicated Specific Assets 342
2. Recognize Your Tolerance for Risk 343
3. Persistent Saving in Regular Amounts, No Matter How Small, Pays Off 343
The Life-Cycle Investment Guide 345 Life-Cycle Funds 348
Investment Management Once You Have Retired 349
Inadequate Preparation for Retirement 349
Investing a Retirement Nest Egg 350
Annuities 351
The Do-It-Yourself Method 354
15. Three Giant Steps Down Wall Street 357 The No-Brainer Step: Investing in Index Funds 358
The Index-Fund Solution: A Summary 360 A Broader Definition of Indexing 363 A Specific Index-Fund Portfolio 366
ETFs and the Tax-Managed Index Fund 367
The Do-It-Yourself Step: Potentially Useful Stock-Picking Rules 369
Rule 1: Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years 370 Rule 2: Never pay more for a stock than can reasonably be justified
by a firm foundation of value 370
Rule 3: It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air 371 Rule 4: Trade as little as possible 372
The Substitute-Player Step: Hiring a Professional Wall Street Walker 373
The Morningstar Mutual-Fund Information Service 375 A Primer on Mutual-Fund Costs 376
Loading Fees 377 Expense Charges 377 Turnover Costs 378 The 50-50 Rule 379
The Malkiel Step 379 A Paradox 383
Some Last Reflections on Our Walk 384
A Random Walker's Address Book and Reference Guide to Mutual Funds 387