A RANDOM WALK

DOWN WALL STREET

The Time-Tested Strategy for

Successful Investing

BURTON G. MALKIEL

W. W. NORTON & COMPANY

New York London
 CONTENTS

Preface 17
Acknowledgments from Earlier Editions 21

Part One
STOCKS AND THEIR VALUE

1. FIRM FOUNDATIONS AND CASTLES IN THE AIR

Whatlsa Random Walk? 26
Investing as a Way of Life Today 28
InvestinginTheory 30
The Firm-Foundation Theory 31
The Castle-in-the-Air Theory 33
Howthe Random Walk Is to Be Conducted 35

2. THE MADNESS OF CROWDS 37

The Tulip-Bulb Craze 38
The South Sea Bubble 41
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Wall Street Lays an Egg 48

An Afterword ss

3. SPECULATIVE BUBBLES FROM THE SIXTIES INTO THE

NINETIES 56
The Sanity of Institutions 56
The Soaring Sixties 57
The New "New Era": The Growth-Stock/New-Issue Craze 57
Synergy Generates Energy: The Conglomerate Boom 60
Performance Comes to the Market: The Bubble in Concept Stocks 65
The Nifty Fifty 68
The Roaring Eighties 70
The Return ofNew Issues 70
Concepts Conquer Again: The Biotechnology Bubble 71
ZZZZBest Bubble ofAll 73
What Does It All Mean? 75
The Japanese Yen for Land and Stocks 76

4. THE EXPLOSIVE BUBBLES OF THE EARLY 2000s 79

The Internet Bubble 79
A Broad-Scale High-Tech Bubble 81
YetAnother New-Issue Craze 84
TheGlobe.com 86
Security Analysts $peak Up 88
New Valuation Metrics 89
The Writes ofthe Media 91
Fraud Slithers In and Strangles the Market 93
Should We Have Known the Dangers? 96
The U.S. Housing Bubble and Crash ofthe Early 2000s 97
The New System of Banking 98
Looser Lending Standards 100
The Housing Bubble 101
Bubbles and Economic Activity 104
Does This Mean That Markets Are Inefficient? 104
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Part Two
HOW THE PROS PLAY THE BIGGEST GAME IN TOWN

5. TECHNICAL AND FUNDAMENTAL ANALYSIS 109

Technical versus Fundamental Analysis 110
What Can Charts Teil You? in
The Rationale for the Charting Method Iis
Why Might Charting Fail to Work? 116
From Chartist to Technician 117
The Technique of Fundamental Analysis 118
Three Important Caveats 126
Why Might Fundamental Analysis Fail to Work? 128
Using Fundamental and Technical Analysis Together 130

6. TECHNICAL ANALYSIS AND THE RANDOM-WALK THEORY 134

Holes in Their Shoes and Ambiguity in Their Forecasts 134
Is There Momentum in the Stock Market? 136
Just What Exactly Is a Random Walk? 137
Some More Elaborate Technical Systems 141
The Filter System 141
The Dow Theory 142
The Relative-StrengthSystem 143
Price-Volume Systems 143
Reading Chart Patterns 144
Randomness Is Hard to Accept 145
A Gaggle of Other Technical Theories to Help You Lose Money 146
The Hemline Indicator 146
The Super Bowl Indicator 148
The Odd-Lot Theory 149
Dogs ofthe Dow 149
January Effect iso
AFew More Systems isi
Technical Market Gurus isi
Why Are Technicians Still Hired? 154
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AppraisingtheCounterattack 154
Implications for Investors 157

7. HOW GOOD IS FUNDAMENTAL ANALYSIS? THE EFFICIENT-

MARKET HYPOTHESIS 159
The Views from Wall Street and Aeademia ieo
Are Security Analysts Fundamentally Clairvoyant? ieo
Why the Crystal Ball Is Clouded 163
1. The Influence ofRandom Events 164
2. The Produktion ofDubious Reported Earnings through"Creative"
Accounting Procedures 165
3. Errors Made by the Analysts Themselves 168
4. The Loss ofthe Best Analysts to the Sales Desk, to Portfolio
Management, or to Hedge Funds 170
5. The Conflicts oflnterest between Research and Investment Banking
Departments 170
Do Security Analysts Pick Winners? The Performance of the Mutual
Funds 174
The Semi-Strong and Strong Forms of the Efficient-Market Hypothesis
(EMH) 182
A Note on High-Frequency Trading (HFT) 184

Part Three
THE NEW INVESTMENT TECHNOLOGY

8. A NEW WALKING SHOE: MODERN PORTFOLIO THEORY 189

The Role of Risk 190
Defining Risk: The Dispersion of Returns 191
Illustration: Expected Return and Variance Measures of Reward and
Risk 191
Documenting Risk: A Long-Run Study 194
Reducing Risk: Modern Portfolio Theory (MPT) 196
Diversification in Practice 201
 CONTENTS 11

9. REAPING REWARD BY INCREASING RISK 209

Beta and Systematic Risk 210
The Capital-Asset Pricing Model (CAPM) 213
Let's Look at the Record 219
AnAppraisaloftheEvidence 221
The Quant Quest for Better Measures of Risk: Arbitrage Pricing
Theory 223
The Fama-French Three-Factor Model 225
ASummingUp 226

10. BEHAVIORAL FINANCE 229

The Irrational Behavior of Individual Investors 232
Overconfidence 232
Biased Judgments 235
Herding 239
Loss Aversion 243
Pride and Regret 245
Behavioral Finance and Savings 246
The Limits to Arbitrage 248
What Are the Lessons for Investors from Behavioral Finance? 252
1. Avoid Herd Behavior 253
2. Avoid Overtrading 255
3. If You Do Trade: Seil Losers, Not Winners 256
4. Other Stupid Investor Tricks 257
Does Behavioral Finance Teach Ways to Beat the Market? 259

11. IS "SMART BETA" REALLY SMART? 260

What Is "Smart Beta"? 260
Four Tasty Flavors: Their Pros and Cons 262
1. Value Wins 262
2. Smaller Is Better 265
3. Momentum and Reversion to the Mean 266
4. Low Volatility CanProduce High Returns 268
Blended Flavors and Strategies 270
 CONTENTS

"Smart Beta"Funds Flunk the Risk Test 271

Appraisal of "Smart Beta" 271
How Well Have Factor Tilts Worked in Practice? 274
Value and Size Tilts 274
Blended Hybrid Strategies 277
Research Afflliates Fundamental Index (RAFI) 278
Equally Weighted Portfolio Strategies 280
Other Factor Tilts 281
Low-Beta (Low-Volatility) Strategies 281
Momentum Strategies 281
Implications for Investors 282
Implications for Believers in Efficient Markets 284
Capitalization-Weighted Indexing Remains at the Top ofthe
Class 287

Part Four
A PRACTICA! GUIDE FOR RANDOM WALKERS
AND OTHERINVESTORS

A FITNESS MANUAL FOR RANDOM WALKERS AND OTHER

INVESTORS 291
Exercise 1: Gather the Necessary Supplies 292
Exercise 2: Don't Be Caught Empty-Handed: Cover Yourself with Cash
Reserves and Insurance 294
Cash Reserves 294
Insurance 295
Deferred Variable Annuities 297
Exercise 3: Be CompetitiveLet the Yield on Your Cash Reserve Keep Pace
with Inflation 297
Money-Market Mutual Funds (Money Funds) 298
Bank Certificates of Deposit (CDs) 298
Internet Banks 299
Treasury Bills 299
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Tax-Exempt Money-Market Funds 300

Exercise 4: Learn How to Dodge the Tax Collector 300
Individual Retirement Accounts 301
RothlRAs 303
Pension Plans 303
Savingfor College:As Easy as 529 304
Exercise 5: Make Sure the Shoe Fits: Understand Your Investment
Objectives 306
Exercise 6: Begin Your Walk at Your Own HomeRenting Leads to
Flabby Investment Muscles 313
Exercise 7: How to Investigate a Promenade through Bond
Country 315
Zero-Coupon Bonds Can Be Useful to Fund Future Liabilities 316
No-Load Bond Funds Can Be Appropriate Vehicles for Individual
Investors 317
Tax-Exempt Bonds Are Useful for High-Bracket Investors 317
Hot TIPS: Inflation-Indexed Bonds 319
Should You Be a Bond-Market Junkie? 320
Foreign Bonds 321
Exercise 7A: Use Bond Substitutes for Part of the Aggregate Bond
Portfolio during Eras of Financial Repression 321
Exercise 8: Tiptoe through the Fields of Gold, Collectibles, and Other
Investments 322
Exercise 9: Remember That Investment Costs Are Not Random; Some
Are Lower Than Others 325
Exercise 10: Avoid Sinkholes and Stumbling Blocks: Diversify Your
Investment Steps 326
A Final Checkup 327

HANDICAPPING THE FINANCIAL RAGE: A PRIMER IN

UNDERSTANDING AND PROJECTING RETURNS FROM STOCKS AND
BONDS 329
What Determines the Returns from Stocks and Bonds? 329
Four Historical Eras of Financial Market Returns 334
 CONTENTS

Era I: The Age of Comfort 335

Era II: The Age of Angst 337
Era III: The Age of Exuberance 341
Era IV: The Age of Disenchantment 343
The Markets from 2009 through 2014 344
Handicapping Future Returns 345

14. ALIFE-CYCLE GUIDE TO INVESTING 349

Five Asset-Allocation Principles 350
1. Risk and Reward Are Related 351
2. YourActual Risk in Stock and Bond Investing Depends on the Length of
Time You Hold Your Investment 352
3. Dollar-Cost Averaging Can Reduce the Risks of Investing in Stocks
and Bonds 355
4. Rebalancing Can Reduce Investment Risk and Possibly Increase
Returns 359
5. Distinguishing between Your Attitde toward and Your Capacity
for Risk 361
Three Guidelines to Tailoring a Life-Cycle Investment Plan 363
1. Specific Needs Require Dedicated Specific Assets 363
2. Recognize Your Tolerance for Risk 364
3. Persistent Saving in Regulr Amounts, No Matter How Small,
Pays Off 364
The Life-Cycle Investment Guide 366
Life-Cycle Funds 370
Investment Management Once You Have Retired 370
Inadequate Preparationfor Retirement 371
Investing a Retirement Nest Egg 372
Annuities 372
The Do-It-Yourself Method 375

15. THREE GIANT STEPS DOWN WALL STREET 379

The No-Brainer Step: Investing in Index Funds 380
The Index-Fund Solution: A Summary 382
 CONTENTS IS

A Broader Definitionoflndexing 385

A Specific Index-Fund Portfolio 388
ETFs and Taxes 390
The Do-It-Yourself Step: Potentially Useful Stock-Picking Rules 393
Rule 1: Confine stock purchases to companies that appear able to sustain
above-average earnings growthfor at leastfive years 394
Rule 2:Neverpay more for a stock than can reasonably bejustified by a
firmfoundation ofvalue 394
Rule 3:It helps to buy stocks with the kinds ofstories ofanticipated growth
on which investors can build Castles in the air 395
Rule 4: Trade as little as possible 395
The Substitute-Player Step: Hiring a Professional Wall Street
Walker 398
The Morningstar Mutual-Fund Information Service 400
The Malkiel Step 401
A Paradox 405
Investment Advisers 407
Some Last Reflections on Our Walk 408
A Final Word 410

A Random Walker's Address Book and Reference Guide to Mutual Funds and
ETFs 413

Index 423