Dr. Burton Malkiel, author of A Random Walk Down Wall Street, joins the show to talk about the 50th anniversary of his investment classic.
Listen now and learn:
- The two biggest mistakes investors make
- Lessons from market bubbles of the past
- Practical ideas for achieving investment success
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Show Notes
Dr. Burton Malkiel joins me to discuss the newly released 50th-anniversary edition of A Random Walk Down Wall Street.
In addition to authoring this investment classic, Dr. Malkiel is currently the Chemical Bank Chairman’s Professor of Economics Emeritus at Princeton University. He is a former member of the Council of Economic Advisers and also formerly served as dean of the Yale School of Management.
We cover a lot of ground from the book in which he draws on his experience as an economist, financial adviser, and successful investor.
Here are my notes from our conversation…..
What Efficient Market Hypothesis Means for Investors (1:00)
Efficient Market Hypothesis is the idea that the information gets recorded quickly into stock prices.
For example, imagine a drug company trading at $20 per share. If it invents a new cure for cancer that makes the stock price worth $40, the price doesn’t go to $40 slowly over time, it goes to $40 right away. In this example, it may be that the market might underreact or overreact to the news, but it’s not clear to anybody that this under – or overreaction implies an opportunity to make excess profits.
Efficient Market Hypothesis suggests that the market is pretty darn good at reflecting new and existing information such that there aren’t going to be opportunities for unusual profits.
It doesn’t mean prices are always right. Even if everybody is completely rational and prices stocks as the discounted present value of all future cash flows, the future can only be estimated – and no one can perfectly get those estimates right. In some sense, prices are always wrong – but nobody knows for sure whether they’re too high or too low.
In the first edition of A Random Walk Down Wall Street, Dr. Malkiel suggests that a blindfolded chimpanzee throwing darts could choose a portfolio that could do as well as the experts. Although he points out that you don’t really want to throw darts or pick individual stocks; you really want to own the market and hold everything.
The “random walk” idea is a spinoff of efficient market hypothesis – all past and present information is quickly incorporated into price, and nobody can know what the next piece of information will be. Dr. Malkiel acknowledges that there is definitely some momentum in past prices, but the unpredictability of future events makes price movements mostly random.
Dr. Malkiel emphasizes that markets aren’t 100% efficient and random, but it’s awfully close to being so and most people that try to beat the market (by exploiting perceived inefficiencies) fail to do so. As a result, he thinks you’re better off passively owning index funds than trying to actively manage your portfolio.
See EP.74: The Failure of Active Management
I completely agree. Investors get easily distracted and forget how powerful the market return can be. That’s why I often say an investor’s success mostly comes down to minimizing mistakes. There have been all sorts of innovations since A Random Walk Down Wall Street was published in 1973, but I find it fascinating that good investment advice hasn’t changed much.
Dr. Malkiel agrees. Regularly investing in a simple index fund and remaining disciplined over time can produce extraordinary returns. (Interestingly enough, index funds didn’t exist when he first recommended them in 1973.)
The two biggest mistakes people make are…
- (1) selling stocks in a crisis and
- (2) following others into hot investments simply because they’ve gone up in price a lot
Lessons Learned from The History and Bubbles (17:15)
I frequently talk about the normalcy of market losses because it’s incredibly important to be prepared for your portfolio to experience downturns with a similar frequency and magnitude as what has occurred in the past.
In my experience, being prepared for inevitable portfolio losses makes it easier to stay the course during those periods that might otherwise feel surprising or scary.
But re-reading A Random Walk Down Wall Street and speaking with Dr. Malkiel has made me realize that familiarity with the statistical side of history isn’t enough. Understanding the narratives that stirred animal spirits and fueled past bubbles provides useful context for thinking about investment fads today.
For me, reading Dr. Malkiel’s summation of the South Sea Bubble felt like I was reading about the last three years in the cryptocurrency space. Out of the many periods described in the book, he spoke specifically in our conversation about lessons from the Dutch Tulip bubble of the 1630s to the Dot Com bubble of the late 1990s.
As Dr. Malkiel points out, these bubbles happen because there’s nothing that bothers people more than seeing their neighbor get rich from something and thinking, “I want to do that as well.” He spends a meaningful portion of the book focused on these points in history to help equip investors to avoid these disastrous situations.
How Interest Rates Are Impacting Stock Prices (27:00)
There isn’t any question that low interest rates played a key role in boosting stock price valuations, which in turn boosted stock market returns.
At the same time, low rates made bonds a lousy investment, particularly for older investors who need to live off their accumulated savings.
But circumstances have flipped now that interest rates have risen to more normal levels – stock price valuation metrics are lower and bonds now offer a meaningful rate of return.
That might mean ideal allocations for a retiree may be different, but Dr. Malkiel doesn’t think it would make much of a difference for investors still saving for retirement who ought to be heavy in equities.
Talking about different allocations was a nice transition for us into Modern Portfolio Theory and the case for diversification.
The Case for Diversification (30:30)
The basic idea from Modern Portfolio Theory is that diversification generally reduces risk.
Imagine a simple island economy with two businesses: a resort and an umbrella manufacturer. In a year that is terribly rainy, the resort does terribly and the umbrella manufacturer does well. In a year that is sunny, the resort does well and the umbrella manufacturer does poorly. If you own both, it gives you a much more stable set of returns.
Diversification gives you more stable returns. That’s important because people have a hard time dealing with too much volatility. Also, all else equal, more stable returns lead to higher compound returns.
With Modern Portfolio Theory, it’s all about adding assets that don’t move in perfect tandem – you want to combine assets that zig with others that zag.
There are occasional periods (2022 being a good example) when all assets seem to move together and the benefits of diversification don’t seem to pay off, but in the long run, spreading your investments across all asset classes has paid off.
See EP.76: Is The 60/40 Portfolio Dead?
But even when diversification is working well, that often means there will be a part of your portfolio that disappoints. After all, if you own everything, then you own the losers. The relative laggard for diversified investors since the Great Financial Crisis has been International stocks.
While the basic mathematical case for International diversification is strong, Dr. Malkiel also makes a case using demography.
Long-run growth depends upon a growing labor force. The working-age population in the western world is not really growing. And there are some western countries, like Japan, where the population is actually declining. Emerging markets are the only places in the world where populations are growing and not aging.
Behavioral Finance (40:05)
Behavioral finance wasn’t even taught in my college economics major, but these now more popularized ideas help explain how our behaviors make us our own worst enemy. As someone that has read at least a dozen behavioral finance books, I found that Dr. Malkiel hit on some of the most important areas investors ought to know.
In our conversation, we spoke about this new chapter in the book along with examples of the tendency of people to overestimate their abilities as well as their tendency to see patterns where they don’t truly exist.
Resources
- A Random Walk Down Wall Street by Dr. Burton Malkiel
- EP.74: The Failure of Active Management
- Dr. Malkiel’s summation of the South Sea Bubble
- EP.76: Is The 60/40 Portfolio Dead?
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
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