Tag Archives: Random Walk on Wall Street

Malkiel Understates the Risk of Long Term Investing

Malkiel’s “Random Walk down Wall Street” offers very practical advice for household investors, but is dangerously misleading on the risks of long term investing.

The book starts out with a behavioral bent, pointing out all the times in which markets have gone crazy. I personally found the coverage of how simple name changes during the dot com bubble would cause certain stocks to zoom higher in value — a smoking gun for irrationality. Yet in spite of this behavioral bent, Malkiel is very down to earth about how many opportunities are available for people to beat the market. In the end of the first part of the book, Malkiel notes:

Markets are not always or even usually correct. But NO ONE PERSON OR INSTITUTION CONSISTENTLY KNOWS MORE THAN THE MARKET.

But even if people can’t beat the market, that doesn’t mean that there aren’t a lot of ways to underperform dramatically. I view his chapters on diversification in this light. He does a good job of introducing what can be very difficult mean-variance theory. Instead of using matrix algebra, he goes through an toy example of umbrella manufacturers and a resort owner and shows how it can be valuable to spread a nest egg across investments that, as a collective portfolio, can perform well come rain or shine.

When it comes to implementing investment advice, I also wholeheartedly agree with his argument for sticking with indexed funds. I enjoyed his statistical treatment of why reported mutual fund returns over-predict the actual investment opportunities available to investors due to survivorship bias. And whenever he brought up market “anomalies” such as the January effect or waiting for low price to earnings ratios to get higher returns, he was sure to note the uncertainty behind these signals, and to push people towards a passive investment strategy.

However, while I agree with the general message that households should be investing more into the stock market, both domestic and international, I think Malkiel substantially understates the true risks of investing in the stock market. In particular, he engages in the fallacy of time diversification when he tries to convince the reader that stocks are safer in the long run. The core of his argument centers around this chart:

Based on this chart, he argues that “A substantial amount (but not all) of the risk of common-stock investment can be eliminated by adopting a program of long-term ownership and sticking to it through thick and thin (the buy-and-hold strategy discussed in earlier chapters).”

But this relies on an empty notion of risk. The risk that is relevant for retirement investors is not the risk that their investment earns an average return above some other investment, for example long term bonds, but rather whether, at retirement, there is enough wealth left over to carry them through their golden years. As such, it’s not the average return that matters, but rather the total return over an entire working life!

And when it comes to this, the longer your investment horizon the larger the variance of the total return! If returns are independent over time, variance scales linearly. While there may be some mean reversion in the long run, as Malkiel notes in his discussion on PE ratios, this mean reversion can be very slow and doesn’t change the thrust of the analysis.

The risk from stock investment might be better visualized by thinking about what are the range of possible outcomes after 40 years in the stock market. Suppose each year stocks return 8% on average with a standard deviation of 20%, and that returns are independent (adding plausible levels of dependence does quantitatively little to the results). Suppose further that the investor’s utility is log, so that negative outcomes hurt a lot and extremely positive events aren’t that positive. Then the potential life paths for utility are summarized in the chart below. Each black line represents one potential history of an investor going 40 years in the stock market.

From this diagram it’s clear that risk rises over time. Sure, you have a tendency to drift up, but the bad outcomes get very bad. So even if the variance of the average return goes down, the variance of that average return multiplied by the investment timescale keeps on going up.

A Random Walk Down Wall Street

Burton G. Malkiel’s best seller, A Random Walk Down Wall Street, makes an argument for the efficient market hypothesis and argues that individual investors have no better chance of beating the stock market than a monkey throwing darts at a dart board. His advice is for investors to just buy into funds that replicate the overall markets returns. This advice will ensure an individual of moderate returns over an extended period of time, which Malkiel claims is the best on average that individuals can do.

Burton Malkiel defends his claims by providing evidence that no other strategy has, nor will ever consistently beat these index funds that track the overall stock market as a whole. While I agree with this assertion, because as he stated, “that any truly repetitive and exploitable pattern that can be discovered in the stock market and be arbitraged away will self-destruct.” This is because as more and more people find out about this technique, such as the Dogs of the Dow, the January effect, or the Monday Afternoon pattern, then the gains will be wiped away as more people try to exploit these patterns. This will lead to investors bidding up the prices until there is no gain to be made from these trading techniques.

One point that I contest with of Malkiel’s is that all of the studies he uses to support his data incorporate trading fees which essentially wipe out the possible gains for individual investors. With the creation of websites such as Robinhood that offer $0 trades, it would be very interesting to conduct these same studies, but without the trading fees to see if his theory about individual investor never (or hardly ever) being able to beat the market as a whole. Removing these expenses will save the users tons of money and may change the results of some studies claiming that beating the market is all luck.

The main premise behind Malkiel’s book is to help individual investors maximize their potential returns of saving their money, and there is some very good advice that should be followed by all investors (such as diversification and determining appropriate risk allocation), but I do believe that there are ways in which individuals can beat the market. Investing is a gamble, and all investors must understand that they could lose some or all of their money, but by following some of the techniques Malkiel outlines, anyone can start adequately preparing for their retirement. This book is one that I recommend anyone interested in investing reads before doing so.

A discussion on Why Choosing Index Funds (Blog 23)

Malkiel’s A Random Walk Down Wall Street is a good book regarding to introduction on investment. Based on his own rich experience, Malkiel combines investment theories such as firm-foundation theory, the castle-in-the-air theory and the random walk theory and practice as a flawless whole. Using lively humor and easily understood language he pours out the secret of true meaning of investment: a method of purchasing assets to gain profit in the form of reasonably predictable income and/or appreciation over the long term. As a highly practical investment guide, though it provides its readers a variety of investment strategy as well as financial tools, the highly praise for holding index funds constitutes the core of the book.

There are many assumptions or facts that makes holding index funds over long time a good strategy. Some of them Malkiel pointed out clearly while some others Malkiel did not. What I’d like to do now is digging them out and talk about my understanding of them.

The first one, as well as one of the most important and basic one: The random walk of the market. That is to say, the short-run changes in stock prices are unpredictable, which makes earnings forecasts useless. Thus from investment aspect, buying stocks and holding it only a short time is a clumsy action. However, though I buy this assumption, there are exceptions. Warren Buffet is a following of firm-foundation theory. Because he own many inner information of a company, which makes his team could estimate the ‘real value’ a firm, he could predict the trend of the stock in relatively short time. Thus my point is, the lack of information causes the impossible of predicting short-term stock price. If one own inner information, take your action quickly. But of course, for most individual investors, Random walk assumption is reasonable.

Second assumption: the more stocks in different fields (index fund) you buy, the less unsystematic risk it is. Thus one should invest in a variety fields. I have no disagreement with this one. Just one thing, while the unsystematic risk could be diluted by splitting investment in different field, there is not much thing we can do on systematic risk.

The above two assumptions tells why we should hold index fund over long time instead of single stocks——–we could minimize risk. However, it does not necessary mean that we could make profit. But the fact is that Malkiel succeed. Because, I believed, there is an hiding assumption that Malkiel did not point out loudly.

Third assumption: Financial market, as a whole, is increasing its wealth. This is true, whether we back track the history or present days or even looking forward to the future, the society is improving and will continue improving, and the economic is developing and will continue developing. Thus as long as you hold the index fund for long time enough, you will find the increasing pattern of the wealth. However, almost everything has exceptions. If someone bought an index fund of some China’s company before 1949 (when New China established), I will highly doubt whether he made profit. In fact, whether the index fund still exists is a question. And my point is that: whether holding index funds long time could make earnings also depends on the stability of a society. For a country like U.S, Choosing Index funds and holding them long is a wise idea.