Beach Reading for this Summer: A Random Walk Down Wall Street: The Case for Passive Investment

Burton Malkiel is a renowned economist and writer, serving as both the Chief Investment Officer at Wealthfront and the Chemical Bank Chairman’s Professor of Economics at Princeton University. However, if you recognize his name, it’s likely due to his book A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. The book sold over 1.5 million copies before several updates and revisions, greatly increasing the popularity of several phenomena explained and endorsed by Malkiel in the book, including the random walk hypothesis and the success of passive investment principles. According to Malkiel, all that is needed to begin investing is “the interest and the desire to have your investments work for you.” 

The Random Walk Hypothesis 

In accordance with its title, one key element of A Random Walk Down Wall Street is the explanation of the random walk hypothesis of the market, or the financial theory that stock market prices cannot be predicted because the benefits of any perceived patterns are virtually nonexistent. Therefore, any fluctuations in economic value are simply due to the “random walk” of the market. As described by Burton Malkiel, “What are often called ‘persistent patterns’ in the stock market occur no more frequently than the runs of luck in the fortunes of any gambler. This is what economists mean when they say that stock prices behave very much like a random walk.” Some economists have gone so far as to claim that a monkey randomly throwing darts at a board full of stocks could potentially see returns as great as a team of investment managers meticulously determining each stock to include. Malkiel goes on to explain why these random fluctuations discredit the idea of attempting to beat the market through prediction and analysis. 

The Caveats of Fundamental Analysis 

While Malkiel admits that there do appear to be some recurring patterns within the stock market, he maintains that the adherence of the market to any analytical explanation at any given time is due to nothing more than sheer luck. Therefore, fundamental analysis, or the analysis of past economic trends in an attempt to predict future economic trends, is not actually a reliable 

indicator with which to determine the most fruitful investments. As Malkiel describes it, “the point is not to invest with a rearview mirror projecting double-digit returns from the past into the future.” To simplify his reasoning, Malkiel groups the flaws of fundamental analysis into three caveats: 

1. “Expectations about the future cannot be proven in the present.” This essentially means that it can be particularly difficult to remain objective about the state of the market in the present when much of the future is unknown, regardless of which formula one may be using to predict the future state of the market. 

2. “Precise figures cannot be calculated from undetermined data.” Financial analysts often use indefinite factors while attempting to calculate returns. Malkiel argues that this can be risky, as one can’t draw precise conclusions from data that hasn’t already been measured. 

3. “What’s growth for the goose is not always growth for the gander.” The value that the market puts on certain fundamentals, such as the ever-present value of growth, calls into question the real monetary value of these fundamentals. 

Relevance to Passive Investment 

Considering the random nature of market fluctuations and weaknesses in the principles of fundamental analysis, Malkiel invites investors to “bow to the wisdom of the market.” He compares the skill of investment management to that of a tennis player: “Just as the tennis amateur who simply tries to return the ball with no fancy moves is the one who usually wins, so does the investor who simply buys and holds a diversified portfolio.” This exemplifies a core principle of passive investment management: Investors are likely to be better off buying and holding a diversified portfolio with an asset allocation catered to their risk level than attempting to beat the market by constantly buying and selling different securities or mutual funds. 

“The point is that it is highly unlikely you can beat the market,” explains Malkiel, “It is so rare that it’s like looking for a needle in a haystack. A strategy far more likely to be optimal is to buy the haystack itself.” With this analogy, it’s explained that selecting an individual stock with the likelihood of greatly increasing returns is quite similar to the common adage of finding a needle in a haystack. Sure, you may hear about the odd person here and there who saw great 

returns after selecting a needle out of a haystack, but an investor would see far more consistent returns if they focused on the entire haystack. That is, if the investor focused on a long-term strategy including diversification among asset classes rather than picking individual stocks. 

Avoiding Emotional Investing 

Emotional investing is a phenomenon that many investors ultimately fall prey to. This can be partially explained by Malkiel’s explanation of the New Economy Mania, how “many business were managed not for the creation of long-run value but for the immediate gratification of speculators.” Many investors begin actively managing their finances searching for that immediate gratification of finding a needle in a haystack, or achieving great returns on an individually picked security. However, investors are likely to see a greater long-run value from saving money and properly diversifying their portfolio than from attempting to discover the “next big thing” in the stock market. 

In A Random Walk Down Wall Street, this is explained as a temptation that investors ought to try their hardest to avoid. “It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges. It is an obvious lesson, but one frequently ignored,” wrote Malkiel. The only surefire way to avoid emotional investing is to maintain a long-term financial plan, including a diversified portfolio with an asset allocation that meets the demands of your risk profile. Determine your individual risk profile and conduct a free assessment on the level of risk in your investment portfolio by clicking the button below: