“A Random Walk Down Wall Street” by Burton G. Malkiel

random_walk

Here’s the secret to making money in the stock market: buy low-cost index funds which cover the whole market.  There, not so hard, right?  Burton Malkiel has been espousing this for 40 years, when the first edition of this book was published and index funds didn’t even exist yet.  The data, as he presents in the book, shows him out well.  Sure, some years some active fund managers score big, but they are no more likely than any other manager to outperform the market the following year(s).  The only consistent winner is a properly-weighted portfolio of index funds.

That said, Malkiel gives lots of bits of advice on manual methods of picking stocks.  After all, if you see a $100 bill on the street, don’t be like the finance professor who said “it must not be real; otherwise someone would have already picked it up.”  Really you should respond “I must pick it up quickly, otherwise someone else will come and pick it up very soon.”  There still are market inefficiencies to be exploited … it is just very hard to do so consistently.  Keep your core in index funds, but keep a small pool of funds ready to pick up the $100 bills when you find them…

Stock Picking

As far as stock picking goes, Malkiel sees all technical indicators as junk.  Well, besides maybe some short term value to a relative strength strategy.  But…if any indicator really did work well, the discoverer is surely not telling anyone about it.  Too many people doing the same thing would change the market dynamics such that the indicator no longer works.

Fundamental analysis doesn’t bear much fruit either.  And we must avoid bubbles, even though they are hard to spot.  Here’s a tip: be very wary of buying into something touted as “the future” if it isn’t making solid profits now.

Malkiel does give a “secret formula” for picking stocks late in the book:  Long-run equity return = Initial dividend yield + growth rate (of earnings and dividends combined).  The trick is knowing what the expected growth rate will be.  The typical stand-in here is the P/E ratio — if it is high, then this (might) signify the expectation of growth.  But then again, value investors like to buy low P/E stocks…

There is a pretty strong correlation of overall market P/E ratio to forthcoming returns.  The lower the P/E ratio of the market, the higher the returns.  Based on historical data, a market P/E ratio of < 10.6 has yielded on average 16.4% returns over the next decade while a P/E ratio of > 25.1 yields on average 3.7% returns over the next decade.  The returns vs. P/E curve is generally linear between these two points.  (Malkiel’s chart on pg. 347)  As of this writing, current market P/E is 24.89…we are unfortunately in for a decade or so of single digit returns.  (Note: MMM has this point covered as well.)

Smart Beta

There are a couple of strategies that Malkiel mentions may have some potential to beating the market.  Maybe.  (He’s is oh so careful about admitting that anything could ever beat the market long-term!)

1) Value wins.  Tilt towards low price-earnings ratios.  VVIAX

2) Tilt towards smaller cap companies – they have more room to grow.  (IWM – Russell 2000; or IWN, DFSVX – combo of 1 & 2)

3) Momentum and reversion to the mean (AMOMX)

4) Low volatility bought on margin (SPLV)

And a final bit of advice: buy closed-end funds which are selling at discount vs NAV.  The WSJ maintains a listing where they already have the discount computed.

Diversification

There’s a chart on almost the final page of the book which kind of blew me away.  The 2000’s decade is called the “lost decade” because overall market returns ended up pretty much where they started.  But … a diversified portfolio of 5 different funds (using the “age 55” mix), rather than just total market, was up ~100%.

diversification

(Note: Malkiel gives the exact same weights for International and Emerging Markets, so on this plot they are right on top of each other.)

In an individual stock portfolio, diversification is also very important in lowering risk.  The beneficial effect seems to diminish after about 50 stocks or so.  Should also make sure to get about 20% exposure to international stocks.

Advertisements

What do you think?

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: