Can A Random Walk Down Wall Street Make You Money?His LifeProfessor Burton Malkiel’s famous book, A Random Walk Down Wall Street has an interesting thesis. Simply stated, its no one can predict the stock market. That’s it. We can all go home folks. Don’t forget to tip your bartender.Burton Malkiel is a professor of economics at Princeton University and has authored many influential articles on Wall Street. His book A Random Walk Down Wall Street was written in 1973 and is currently in its ninth edition. This enlightening book offers a different way to look at the stock market and the holy grails of trading.
His LessonsBurton Malkiel proposes that short term stock prices can not be predicted. The short term market is generally inefficient. Due to manias & emotion, stocks may become extremely overvalued. Then, hit with a bit of bad news, stocks will experience a sharp drop in price. It's crazy and unpredictable. Just like falling in love. Traders who try to profit from short term market moves don’t do very well. Why? Becaust the prices are not based on fact, but the hopes of the crowd. Let’s think about this. A stock’s price movement is based on how many investors are buying or selling the stock on that day. The decision to buy or sell, is based on that investor’s inclination on what stock will do in the future.
So, if Acme International had 1 million shares traded today….a mix of buy and sells….whose inclination of how the stock will do in the future is correct? This is what short term traders base their future decisions on; the stock's recent activity. A Random Walk Down Wall Street proposes that most stocks will reach their “correct” value eventually. Some stocks sooner than others, depending on how quickly the information flows into the market. In the long term, buy & hold investors will always do better. Burton Malkiel believes most investing books are not worth much. The authors are sales people trying to sell their "Wanna get rich trading stocks?" pitch. A Random Walk Down Wall Street goes on to give examples on how the market or should I say the crowds, tends to behave irrationally. This irrational behavior leads to crazy markets that no one can predict. Tulipmania Holland in the early 1600’s, had a mad rush of 'going long' on tulips. This madness sent the prices of tulips so high that people were actually mortgaging their homes to buy them. The market crashed in 1637 leaving many people living in flower beds. South Sea Company London, England early 1700’s. The South Sea Company promoted itself as the company on the road to riches. The main business of South Sea was the transportation of slaves from West Africa to America. Although profits were slim to none, London went on a stock buying rampage. Eventually the stock price crashed, bankrupting many.
The Internet Bubble Who can forget Kozmo.com? People wanted to buy internet stocks. Wall Street was happy to sell them. Stock analysts wrote rave reports on such companies whose business was the home delivery of ice cream cones. There was no revenue, but the analysts said a good idea is worth more than money in the bank. Suuuure. This was a painful time for me so I’ll skip the rant. To sum it up, market bubbles exist as long as investors keep plowing in the cash and bidding up the prices. When the buying peaks and slows down, investors look to sell. There's no one around who wants to buy at those prices. Which leads us to the inevitable drop in prices. Also known as crash.
What does A Random Walk Down Wall Street say about stock picking schools of thought? Technical Analysis Chartists attempt to predict a stock’s future movement based on what prices have done in the past. Professor Malkiel claims this is hogwash. The up and down movement of stock prices are random. One of his supporting cases is, if you flip a coin 100 times and chart the results, the graph will look like a stock chart. If you flipped 4 heads in a row, a chartist would say you have a trend. These techniques don’t beat a ‘buy & hold’ strategy. The only thing short term traders ring up is commission charges. Fundamental Analysis Examining a company’s balance sheets will determine its future earnings. Which in turn will tell you if the market has over- or undervalued the stock.
A Random Walk Down Wall Street believes past earnings performance offers no prediction of the future. Why? • Wall Street analysts are not experts in anyone else’s industry but their own. • Forecasts do not take into account unpredictable events. These include terrorism, regulation changes, and increases in the price of raw material. • Accounting fraud. Are those financial records accurate or an extra helping of number flavored fudge? • Conflict of interest? If Global Bank of Finance had a huge troubled pharmaceutical client in their corporate finance practice…do you think the analyst would write a “sell” recommendation on the stock? Not if he wanted a Managing Director to come downstairs and smack him over the head. Ok. So how do you make money on Wall Street? It’s easier than it looks. You just have to keep it simple. Following Professor Malkiel’s research, he believes more money is made when you increase your exposure to risk. Stocks are instruments that bring about the highest returns. So, how do you get the high returns but minimize your exposure to risk?  Modern Portfolio Theory states the way to achieve relatively high returns with low risk is diversification. Spread your money over a basket of risky securities. So what I’m trying to say is, buy an index mutual fund. Benjamin Graham, Warren Buffett and Peter Lynch say trying to beat the market is awfully tough. You're better off purchasing an S&P indexed mutual fund, make your monthly contributions and relax. Purchasing REITS (discussed separately within this site) and inflation-protected bonds are other areas of diversification. That was easy. Will any of us abide by this advice? Of course not.
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