A Random Walk Down Wall Street: Book Report

This book report examines the fundamental work in the field of economy and finance, the new eleventh edition of the book A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing by Burton G. Malkiel, published by the WW Norton & Company in January 2015. The current book contains 448 pages of helpful information, the density of which corresponds to the size of this edition. It is designed for a wide range of readers, ranging from people, who are not versed in any market operations, ending with the stockbrokers, who, for many years, work in the stock markets and apply different practices to improve management of financial operations. Also, it is important to mention that this book carries a significant value for students of economic departments, who only learn to understand all the multitude of economic theories and concepts that a variety of economic schools offer and some economists popularize.

The book was first published in 1973, and has withstood eleven editions, the last of which is the most comprehensive one. A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing has received numerous positive reviews not only from the reputable economists, but also from popular and relevant publications, such as The Wall Street Journal: “Talk to 10 money experts and you’re likely to hear 10 recommendations for Burton Malkiel’s classic investing book”; Forbes: “Not more than half a dozen really good books about investing have been written in the past fifty years. This one may well belong in the classics category“, and many others (Hamm, 2007).

The author of the current bestseller (more than 2 million copies sold) Burton Malkiel is a professor of Princeton University. During two years, he was an honorary member of the Council of Economic Advisers, held a post of dean of the Yale School of Economic and still remains the most reputable consultant and the member of many economic organizations and advisory councils.  

This edition is a guide among various economic theories, and shows the favorable sides and prospects for a single great concept that Burton Malkiel has developed a long time ago, but adheres to it till to now, which is for about 42 years. It is named ‘the random walk hypothesis’. Its essence lies in the fact that stock market prices do not change due to any laws or mathematical functions, but only lend themselves to randomly rise and fall, as in case with particles in the Brownian motion.

At first, the theory was proposed by the French explorer, named Jules Regnault in 1863, and then was developed by the set of economists, but it has become popular thanks to this book by Burton Malkiel. The author has tested the hypothesis on his students and has reached positive results. In addition, later this theory went beyond the usual boundaries of the economy, entering the sport, and more specifically - the Basketball Organization NBA, where the dozens of basketball shots have been exposed to the analysis, and a positive correlation between the successful and the next shorts was absent.

This theory has caused many controversies in economic circles and has become the starting point to the appearance of the opposite hypothesis, which is “non-random walk” of the prices, due to which, the prices can be predicted till the certain moment. Martin Weber, a well-known economist with a great experience in observing stock markets, is an admirer of that theory. In addition, two finance professors Andrew W. Lo and Archie Craig MacKinlay have written the book-refutation to the theory of Burton Malkiel, which is called A Non-Random Walk Down Wall Street. However, millions of people follow the theory of Burton Malkiel, including employees of Wall Street; therefore, it makes no sense to doubt the significant value of this book.

The eleventh edition consists of four parts, in each of which the author examines certain theories, provides practical examples and jokes that greatly facilitate the process of penetration into the life of stock markets.

The first part is called Stocks and Their Value and, generally, it meets to its title. The first chapter Firm Foundations and Castles in the Air focuses on the two interesting economic theories but before the author’s immersion there, he acquaints the readers with the “Random Walk”. Burton Malkiel considers the notion of investments as such, advising to not to be afraid to invest and do it as much as possible and more often, but to know where to invest. The author warns that investments imply a lot of painstaking work, but they will, at some point, provide enough carefree life “slowly but surely” (2015, p.32). Before making a decision to invest, it is worth to understand what theory is better. That is why, the author successively leads to two separate, but interrelated concepts – “Firm Foundations” and “Castles in the Air”. The first one states that the investment should be put in the real value of the product, based on the so-called “intrinsic values” (Malkiel, 2015, p. 41), i.e. the investor himself directly evaluates the status of the company or the property. The second theory tracks the flows of investments, which are made on the basis of the first theory by other people. That is, depending on the crowd movement, investments tend to move in one or another direction. Both of those directions are correct, and bring certain incomes, but operate in different ways.

The second chapter The Madness of Crowds is a historical review, which is able to convince each person in the danger of investing, according to the second theory. In the pursuit of the rapid income, people oftentimes fail to see the obvious things and creates the collapses, damaging not only own lives, but also placing the entire country into the state of stagnation. The four historic economic crashes of various countries, which took place in a completely different time, clearly demonstrate the same unpredictable behavior, as well as the changes in prices of stock markets. The Tulip-Bulb Craze remains the classic example, which led the Netherlands in the middle of the seventeenth century to the deep depression, by influencing each of its inhabitants without exception. The system of the “word of mouth” (Malkiel, 2015, p. 57) has allowed the tulip bulbs to achieve a fabulous value and took over the minds of Dutch, from the ordinary sailors to the members of government. After reaching its peak, the system has failed and later collapsed terribly. It would seem that lessons of history are evident, but a little more than fifty years after, “The South Sea Bubble” has appeared in England and has caused the same consequences. Both cases do not give any grounds for comparing the eighteenth century with the present time, however, a strange increase in the cost of real estate on Palm Beach land from $ 800,000 in 1923 to $4 mln in 1925 (Malkiel, 2015, p. 78), has forced to recall the Dutch tulip bulbs. Later, in 1929, the collapse of the stock exchange on Wall Street will lead U.S.A. to a state of deep depression. All these cases clearly illustrate the necessity of properly selecting investment strategies and the caution with “Castles in the Air” theory.

The third “Speculative Bubbles from the sixties into the nineties” and the fourth “The Explosive Bubbles of early 2000’s” chapters continue to amaze by the numbers of bubbles in the history of the United States. Thus, in the mid-fifties, such companies as General Electric began to speculate with their products for the sake of increasing the company’s shares. Speculative movements were picked up by other corporations. In 1959, IBM has gained extreme popularity and the so-called “tronics boom” too, which has caused a new wave of recessions on the stock exchange. At that time, any company that was not even related to the electronic equipment, and was selling, for example, toothbrushes, could rename itself at something consonant with “tronics”, and to sell the company’s shares for a significant sum. People were investing in anything that could relate to electronics (Malkiel, 2015, p.94). The same thing has happened with the word “tone” later, when computer games have become popular, with the main heroes of these games, like Astron, Vulcatron or Dutron (Malkiel, 2015, p.102). The economists-tricksters have played with words and, thereby, have earned a lot of money, ruining the state in general.

In the mid-60s, these words took the shape of the new one – “synergy” (Malkiel, 2015, p.112). The conglomerate wave swept the entire stock market. Seventies have blazed by already legendary names, such as Polaroid, Kodak, Avon, Xerox or Disney. The eighties were marked by new “tronics”, but there was the biotechnology, as gene modifications, which failed in 1982. The similar actions took place in China and its Lycoris Fragrances flower that resembles the story with Dutch bulbs.

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With the rapid development of technologies, the machinations have become even more accessible and more refined. Japanese Stock Market Bubble, Minkow with his ZZZZ Best or Alfin Fragrances are some of the striking examples. Such cases can cause the absolute distrust on the part of depositors, about what Burton Malkiel reminds. However, such situations are aimed at prevention and awareness of all people, who wish to receive any profit. The main lesson of the bubbles is that the person should understand where to invest his/her money, he/she should not succumb to machinations of cheaters and do not go on about the crowd.

The second part of the book called How the Pros Play the Biggest Game in Town is devoted to the analysis of the market, and starting with the fifth chapter Technical and Fundamental Analysis, the author considers both strategies separately. The technical analysis is orientated on operations with all sorts of data, and, therefore, includes numerous tables, charts, graphs, and, in total, a large number of digits. The disadvantage of such an analysis is that the person only sees a specific and narrow part, which deals only with finances. Furthermore, these figures may be described only as events, which have already happened and, therefore, the questionable probability of forecasts is not able to help somehow in future.

Burton Malkiel also examines the fundamental analysis, and, due to its broader nature, the author gives it the preference. The fundamental approach allows one to consider the business from the perspective of current situation of other companies, not only competitors, but also the entire market. It expands the investor awareness and, thereby, reduces possible losses in future. This type of analysis, as opposed to technical one, is able to predict the immediate future. However, despite the obvious advantages, both analyses work fully only together, as giving the priority to any one of them, the investor will not be able to see the full picture of the stock market.

The next chapter Technical analysis and The Random Walk Theory makes strong cases for the fact that technical analysis is powerless just by itself. It aims at finding a correlation, that is, the relationship between the prices of previous day and the next one, which is similar to the search of difference between patterns on the walls. The author calls it “the wallpaper principle” (Malkiel, 2015, p.135). An example of such technicians as Joseph Granville demonstrates the strategies’ ineffectiveness. Moreover, the derived, by the author and his students, probability of the appearance of the downturn or take-off in the percentage ratio of 50 to 50 shows the chaotic movement of the market, which is the basis for the random walk theory. That is why, the author advices to use the strategy “buy-and-hold”, in connection with which, he refers to the Dow Theory. It says that it is better to buy shares, when they are growing, and sell them, when they are falling. The relative-strength and price-volume systems operate according to the Dow Theory, but have different approaches, where indicators like Hemline or Super Bowl can help deal with the necessary one. The technicians look like fanatics, and do not believe in the randomness. Therefore, in order to not lose the capital, the author recommends understanding the nature of randomness and to just take it as it is.

However, the author does not recommend to put all the power in fundamental analysis, to which the seventh chapter of the book How Good is Fundamental Analysis? The Efficient-Market Hypothesis is devoted. He describes at least four main reasons, why this strategy can be extremely inefficient. The first of the reasons is the effect of random events. Even if the analysts can predict future, they are not able to prevent the sudden intervention of the force majeure or any ordinary accidents. The so-called “Money Games”, which have taken place, for example, in Motorola company in the seventies, reflect the effect of “The Creation of Dubious Reported Earnings through Creative Accounting Procedures”. In addition, the simple incompetence of analysts is a serious obstacle to the full and qualitative analysis of the markets. The main mistake is the generalization, or summarizing all the figures to one big common denominator, that is the averaging that does not allow to understand the true state of affairs. The final factor in the danger of the fundamental analysis is the loss of the best employees that leave the analytical work and go to the next level of their career. Thus, the author keeps sending the same message across through all the chapters of this book: “Analyze everything by yourself and think before you trust your capital to any system or the analyst”.  

The uncertainty in the choice between the two main strategies, the third one solves, which is represented by Burton Malkiel in the third part of the book The New Investment Technology. “Modern Portfolio Theory” minimizes the risks and increases revenue by adding more investments. It also causes the process of diversification. In 1950, Harry Markowitz, who later received a Nobel Prize, has offered this theory. Thus, the author indicates that the possession of at least a half of a variety of US stocks can reduce the risks by 60%, which is quite an impressive amount. In addition, holding the international stocks increases this percentage by another few dozen items.

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However, as the history shows, any strategy has its drawbacks, so the inattentive management can cause regular expenses and losses, that is described by Malkiel in the ninth chapter Reaping Reward by Increasing Risk. Even in this seemingly perfect strategy, reducing the risks to zero figures is impossible. Furthermore the author insists that the investors should not do it but, on the contrary, try to redirect the forces to studying the risks and controlling them. The chaotic nature, which they possess, has a huge potential, and the proper management will bring the additional income. Malkiel categorizes the risks into two basic groups, such as the systematic risks and the unsystematic risks. The first ones arise within the borders of the whole market, and reflect the average tendency in particular niches and groups. That is why, it is harder to prevent them without globalist influence on the economy of the country. The second ones refer to the internal condition of the company, its deals and last news. For example, it can be the production start of new line of goods or, on the contrary, the waves of the strikes through the entire corporation. Unfortunately, the Portfolio Theory can cope only with the unsystematic risks, but it does so perfectly.

In the tenth chapter of Behavioral Finance, the author examines in detail the different types of behavior of financial institutions. First of all, the overconfidence may be the main cause of risk. The investor, having, as he seems, the solid ground under his feet, ceases to see the obvious traps and machinations. In this case, most of the investors simply forget to turn to the analysis or figures, and do everything by force of habit, without its share of critical thinking. Another deceptive feeling that overtakes the investor is an illusion of control or bias. The power seems truly huge, as well as the impact one makes on the stock market. In this delusion, the person is able to make hasty conclusions and take the sudden decisions that lead to another type of behavior – “follow the crowd”. Malkiel has discussed it earlier in the book, but here he sharpens his attention to the similar mistake. Trends, developed by a crowd, do not become a proper decision automatically, which is successfully shown in the history. The panic state can embrace the person if the things suddenly go wrong, and he starts to make a thousand of accompanying mistakes, which place the business in an even worst state. Without a doubt, holding bad shares may be the cause of poor income. The last eleventh chapter in the part is “Smart Beta” Really Smart? focuses on the indicator beta. Without using market capitalization, it operates by such fundamental data as cash-flow, absolute size or book value.

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