Book Review: A Random Walk Down Wall Street

Filed in archive Book Reviews on January 14, 2008

A Random Walk Down Wall Street, originally published in 1973, just hit the shelves with its ninth edition. While many years have passed, and this classic has had many updates to avoid becoming dated, its basic premise hasn't changed: the stock market is a "random walk" that can't be predicted with any consistency, and trying to do so will only lead to worse performance than simply owning a complete index of funds, such as an S&P 500 mutual fund.

A Random Walk's author, Burton Malkiel, takes a chapter-by-chapter approach to knocking down any theories that might suggest beating the market consistently can be accomplished, especially once capital gains taxes and transaction charges are taken into account. (Since most index mutual funds do very little trading and have low fees, investors avoid paying taxes on an ongoing basis and don't have the transaction charges inherent in individual stock buys.)

Malkiel lays out the two stock theories that might be used to justify individual stock purchases ("Firm Foundation" investing that looks for intrinsic value, and "Castles In the Air" that suggests riding the wave of a good story that other investors will buy in to), and then shows that no technical analysis or fundamental analysis can consistently predict future returns. Malkiel's theory is that stocks are a "random walk," meaning it is impossible to know which way the next step will be taken. (Think of a drunk stumbling along and try to predict which way he/she will go next.) While the trend may be consistently up, the next step is unpredictable.

Why is predicting so hard? Why can so few mutual fund managers consistently beat the market? Why is it foolhardy to try? After all, looking at a set of stocks, it does seem like it would be easy to say that some are destined to rise while others are destined to fall. And maybe it is easy to separate sure winners from the clear losers, but that doesn't mean it is easy to predict which stocks will rise more than others when you're looking at shades of gray. Malkiel makes the case that many random (and un-random) things affect the market in a way that sometimes causes sure things to go south while longshots pay off. Wars, fuel costs, new governmental regulations, the use of creative accounting by certain companies (think Enron), poor analysis by so-called experts, conflicts of interest at large investment banks, and other factors can all result in the future looking a lot different than the present day would suggest.

It's difficult to do the book justice, but I would say this in recommendation: Investors are unlikely to read it and not immediately want to put all of their money into index funds to get decent returns while avoiding the higher fees of managed mutual funds (or to avoid the transaction charges if they're making they're own stock purchases). Malkiel is very convincing in showing that your chances of consistently beating the overall stock market is so small that to do anything but use index funds is asking to underperform the market.

Note that Malkiel is not saying you'll lose money; he's saying you'll make less than you would by buying a complete index. He also does offer some suggestions on multiple indexes you might purchase to ensure diversity in your holdings while still holding down costs.

If you haven't read A Random Walk Down Wall Street before, getting this info with the ninth edition is better than never getting it at all.