Updated on 04.13.07

Review: A Random Walk Down Wall Street

Trent Hamm

A Random Walk Down Wall StreetThis week, I sat down with one of the modern classics on stock investing, Burton Malkiel’s A Random Walk Down Wall Street. I was already aware of the premise behind the book – the stock market is pretty efficient and most everyone is wasting their time trying to find inefficiencies to exploit – but I was interested in finding out what information inside could really help me as an individual, both as an investor and as a person interested in improving my personal finances. Did the book succeed? I’ll let you in on that at the end, but let’s walk through the book and see what we can learn from it.

Walking Through A Random Walk Down Wall Street

This book has a lot of information in it. I wrote a paragraph summary of each chapter below so you can get an idea of some of the finer points, but I could go on for weeks analyzing this book. Please note that I’m reviewing the ninth edition of the book, the latest one in hardback; some earlier editions may be missing some chapters and points.

Chapter 1: Firm Foundations and Castles in the Air
The book starts off by defining two basic investment ideologies, the firm foundation theory and the “castle in the air” theory. The firm foundation theory basically says that you should invest based on the actual real value of what you’re investing in; for example, if you buy a stock of Coke, it should be based on what the value of the Coca-Cola Corporation is. The “castle in the air” theory basically says that you should invest in response to what the crowds are doing and that you can make more money by riding the waves of people who are either following trends or trying to invest based on a firm foundation. Which one is right? The truth is that they both are, but at different times.

Chapter 2: The Madness of Crowds
This chapter is quite entertaining: it discusses financial “crazes” throughout history, including my personal favorite craze of all, tulipomania. In all three examples (tulipomania, the South Sea bubble, and the Wall Street crash of 1929), a market grew like gangbusters until everything was overvalued, then the values rapidly returned to normal. Graphs of prices in all three examples bear this out; within a year or two of the end of the craze, the prices had returned to roughly the same value as they were before the big run-up.

Chapter 3: Stock Valuation from the Sixties through the Nineties
Even more amusing, Malkiel continues this theme of markets that go crazy and then level off again by using several examples of cross-sections of the stock market where this occurred throughout the last fifty years. I was aware of the overvaluation of food stocks in the 1980s, for example, but to see that it has just repeated over and over again is an eye-opener. Take the Nifty Fifty from the early 1970s – people were basically speculating in blue chips, and by the end of the decade, the speculation had gone away and the stocks returned to normal blue chip levels.

Chapter 4: The Biggest Bubble of All: Surfing on the Internet
This all of course leads to the dot-com boom of the late 1990s and the bust in the early 2000s. Malkiel basically argues that this huge bubble was the result of a confluence of the same bubbles as before, all working in concert: the IPO mania that fueled the early 1960s stock market, the “smoke and mirrors” businesses of the South Sea bubble, and the chasing of future efficiencies that happened in the 1850s with railroad stocks all happened again with the dot-com businesses. And, again, it peaked and crashed and everything returned to roughly as they were before. Coincidence? Malkiel’s main point in the whole book is that it’s not a coincidence. Markets are efficient and time and time again, when inefficiencies occur, it won’t take long for the market to weed them out.

Chapter 5: Technical and Fundamental Analysis
Given this central idea of market efficiency that’s been pounded in with dozens of examples, Malkiel moves on to look at the two most common forms of analysis that occur on Wall Street: technical analysis and fundamental analysis. Technical analysis is the study of the behavior of prices on the market, using past performance to speculate on future performance, often using complex charts and trend lines. On the other hand, fundamental analysis revolves around analyzing the health of a business by carefully dissecting its financial statements, the market the business competes in, and its competitors. This chapter mostly serves as a detailed introduction to both, though it’s already clear that Malkiel has somewhat more respect for fundamental analysis than technical analysis.

Chapter 6: Technical Analysis and the Random-Walk Theory
This chapter is basically a complete decimation of technical analysis; there’s no other way to really put it. Perhaps the most devastating part is when he compares the stock market to the average length of a hemline in women’s fashion and finds a correlation. In other words, technical analysis spends all of its time looking for correlations – but most of these correlations are spurious at best. By spending all of your time looking at charts, you’re essentially cutting yourself off from a broader picture, making the spurious correlations even worse.

Chapter 7: How Good Is Fundamental Analysis?
Malkiel has at least some respect for fundamental analysis because it is based on foundational logic and is open to accepting wide varieties of data. However, he finds fundamental analysis to be deeply flawed as well. There are many reasons why fundamental analysis can be completely off base: random events (like 9/11), dubious financial data from companies (like Enron), human failings (emotional attachments and incompetence), the loss of good analysts to better positions, and so on. Basically, Malkiel concludes that professional analysts may have a slight leg up on individual investors, but this is mostly due to having more ready access to information and other materials and the advantage is minimal.

Chapter 8: A New Walking Shoe: Modern Portfolio Theory
From there, we move on to portfolio theory, which is basically the idea that people should have a diverse selection of investments and that these investments should maximize the rewards while minimizing the risk. Malkiel basically argues that it doesn’t matter how much you diversify your stocks (and other assets), you are still exposed to some risk. In general, he has some respect for modern portfolio theory, but he goes on in the next chapter to point out why minimizing risk isn’t always the best strategy.

Chapter 9: Reaping Reward By Increasing Risk
This was easily the most complicated chapter in the book and left me taking some lengthy breaks in the middle to digest the information. This chapter basically takes the ideas from the previous chapter and introduces a new factor: beta. Basically, beta is a number that expresses how closely an individual stock matches the behavior of the overall stock market in the past. Thus, in theory, stocks with a high beta should jump like crazy during a bull market and then dive like Greg Louganis during a downturn. With a very wide scope, this is true, but in specifics, it rarely turns out to be highly accurate.

Chapter 10: Behavioral Finance
This chapter takes a close look at behavioral finance, which applies human cognitive and emotional biases to their investment choices and thus how these biases affect overall markets. From behavioral finance, Malkiel concludes that the only parts that really work are the ones that are common sense: don’t invest long term in what’s hot right now, don’t overtrade, and only sell stocks that are losers.

Chapter 11: Potshots at the Efficient-Market Theory and Why They Miss
Here, Malkiel walks through a series of criticisms of the overall idea of the book, which is that the market is generally very efficient and always reverts to the mean. He starts off by discarding some poor arguments and gradually moves onto better and better arguments, ending with evaluating Benjamin Graham’s idea that one should identify and invest in value stocks for the long term. He easily deconstructs most of them and only has significant trouble with Graham’s argument. I felt he slightly missed the boat on what Graham has to say, which is that value stocks will always have value. Malkiel points out that over a long period, both growth and value stocks do match up with the overall market, but value stocks do not have the monstrous dips that growth stocks have.

Chapter 12: A Fitness Manual for Random Walkers
This chapter is rather ordinary, as it is a basic chapter on how to build a healthy investment foundation, similar to ones that appear in most investment books. Get an emergency fund, make sure you’re well insured, put as much investment as you can into accounts that are tax-sheltered (like Roth IRAs and 401(k)s), and so on – standard personal finance advice. He does strongly encourage home ownership, though. As for the question of what exactly to invest in, the next two chapters handle that.

Chapter 13: Handicapping the Financial Race: A Primer in Understanding and Projecting Returns from Stocks and Bonds
Ever heard the phrase “past performance is no guarantee of future results”? That’s what this chapter is about: you can only use past performance as a very, very broad indicator of the future. In short, Malkiel believes that over a very long period, stocks will beat bonds and inflation, but with any period shorter than a decade, it’s basically random and it’s all about the risk you can stomach.

Chapter 14: A Life-Cycle Guide to Investing
Given that, the next chapter is basically a detailed guide on how to invest for yourself. In short, when your goal is more than a decade off, you should be heavily into stocks for the long haul, but if your goal is in the shorter term, you should be widely diversified, tending towards investments with lower risk (bonds and cash) as the big day approaches. In other words, Malkiel believes that investing in a target retirement fund is a really good idea.

Chapter 15: Three Giant Steps Down Wall Street
The book concludes with some more specific investment tips. In short, if you don’t have the time to micromanage things, invest in an index fund. If you want to chase individual stocks, minimize your trading, only buy stocks that have numbers that are reasonable, and look for ones that have stories upon which people can build the “castles in the sky” mentioned in the first chapter. As for other options, like managed funds? He basically says no, or gives a very hesitant yes with a ton of caveats.

Buy Or Don’t Buy

We know one thing for sure: there’s a ton of information packed away in this book concerning how the stock market – or any market – works. Most of the book focuses on different ways of analyzing the market to find an edge – and concludes that they’re largely junk; the end of the book takes what was learned from this and applies it to investing in general.

This might sound really weighty, but it’s not. This book was very easy to read, much easier than I expected before I opened the cover. There’s a solid sense of humor behind it, nestled in with all the information, and the information itself is presented in a way that’s easily digestible.

If you have any interest in how the stock market works, you should definitely read A Random Walk Down Wall Street. It gives a very critical look at what most people are saying about the stock market – and why a lot of it is potentially rubbish. It also clues you in on how to invest if you take that view of the world.

Of course, there are many other perspectives on the market, and the truth is that the stock market can be exploited by individuals, but that exploitation requires a lot of work, work that is simply not feasible for most people (or even for most investment professionals). While I recommend buying this book, I also recommend pairing it with a solid book on individual stock investing to get another perspective. I’ve enjoyed both Phil Town’s Rule #1 and Jim Cramer’s Real Money. Taking both viewpoints together will give you a very good understanding of how Wall Street – and pretty much any market – really works, and how you can either try to beat it or ride with it.

A Random Walk Down Wall Street is the twenty-third of fifty-two books in The Simple Dollar’s series 52 Personal Finance Books in 52 Weeks.

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  1. JAK says:

    I dig this new format of book review. Thanks.

  2. Trent Hamm Trent says:

    JAK: Over time, I’m going to go back and combine the older reviews into a single post like this for easier reference for my readers.

  3. Rebecca says:

    Saved the best for last. Even aside from the new format, which is great, the information was so concise that it is worthy in and of itself. I do plan to get the book, but I am e-mailing this post to everyone I know who is interested in investing.

    You have a real gift for summary, Trent, choosing the most important info and relating it in an interesting, easy to understand manner. I hope you succeed in making a living by writing, because you certainly have a talent for it. Since you also happen to enjoy research and writing, I’d say it was a perfect match. Best of luck with everything and thank you very much for a truly excellent post. One of your best, for sure.

  4. TOK says:

    Trent, I just finished this book last night and uit is one of my favorites. I read an older version a few years back. This is a great investment book for all levels of investors. I hold most of my assets in index funds but I do hold a few individual stocks as well. I like your one stop book review format as well. Keep up the good work!

  5. lorax says:

    A Random Walk Down Wall Street is one of my favorite financial books. I haven’t read the new edition yet, but I’m curious about the take on the post 2003 rise in the grand scheme of things.

    Suggestions for other book reviews: _Irrational Exuberance_, _Unconventional Success_, _The Intelligent Asset Allocator_, and _Risk Free Investing_. (I think you did a Bogle book already, right?)

  6. js says:

    I currently have that book on loan from the library. It’s a good book, a very mainstream approach to investing, made very understandable.

  7. hibryd says:

    One day I will write Mr. Malkiel a thank-you letter. When I was finally out of college (and thinking that maybe not *all* of my surplus money should be paying off my student loans) I decided to dive into investing. My parents knew nothing. No high school or college class ever covered the subject. The book shelves were flooded with utter crap (“Rich Dad Poor Dad”) and advertisements for mutual funds were all over the place. I had no idea what to do or where to go. Thank god the first book I ever picked up was “Random Walk Guide to Investing.”

    While that volume could have used some more careful editing, it basically took a huge load of worry off my shoulders by saying “Investing is easy, it’s simple, and you don’t need outside help. In fact, ignore anyone trying to ‘help’ you. They want a cut.” Three years later, well, I don’t have a ton of money saved up, but I’m doing a lot better than anyone I know of in my age range, and probably better than my boomer parents.

  8. Allan says:

    I am a real believer in this book. I read this book when I majored in economics in college (we used the 1975 update). I have used the concepts from this book ever since, both professionally (I have spent most of my life managing investments for pension funds/life insurance companies)and personally.

    I am always shocked at how much crap is available to mislead investors and just how little most professionals (my peers included) know about the fundamentals of investing.

    Take one piece of advice from me: read this book and treat it like the bible and regard everthing else with great suspicion.

  9. TDK says:

    Thanks for your detailed review of Malkiel’s “Random Walk down Wall Street”. I am doing a book report on this book for a graduate finance class, and your review helps to reinforce the ideas I also took from the book.

  10. sayjack says:

    I read this book a while back and it has shaped the way I invest. I just recently found this post and love reading it because Trent does such a great job at summarizing the main points. Also, if the ideas are so fundamental and basic, then why are they not required reading in high school? I think young people could greatly benefit from reading this book at an early age.

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