Book SummaryA Random Walk Down Wall Street, by Burton G. Malkiel

1-Page Summary1-Page Book Summary of A Random Walk Down Wall Street

A Random Walk Down Wall Street is designed as an accessible guide to financial markets for the individual investor. Written by Burton Malkiel, an economist (Ph.D., Princeton) with years of practical experience on Wall Street, the book covers everything from buying life insurance to pricing commodities to understanding credit default swaps. But, for the most part, Malkiel’s focus is on common stocks—shares in individual firms—and the stock market.

Although Malkiel offers a wealth of information that investors can use to make individual investments on their own, he repeatedly emphasizes the advantages of index investing. If you only take one thing away from A Random Walk Down Wall Street, it should be this: Investors are better off putting their money in a passively managed index fund—a total market index fund, to be precise—than trading stocks themselves or investing in an actively managed mutual fund. For example, an investor who put $10,000 into an S&P 500 Index Fund in 1969 would have had a $1,092,489 portfolio in April 2018 (assuming all dividends were reinvested). An investor who put the same amount of money into an actively managed fund would’ve only had $817,741.

The one-page summary is divided into two parts. The first part covers the first three parts of A Random Walk Down Wall Street, guiding you through the key financial concepts Malkiel discusses as well as “Malkiel’s Take” on those concepts. The second part covers Malkiel’s practical investment tips.

Part 1: Firm Foundations vs. Castles in the Air

There are two basic theories for stocks’ valuation, one based on stocks’ actual characteristics, another based solely on human psychology.

The Firm-Foundation Theory

The firm-foundation theory holds that assets have an “intrinsic value” based on their present conditions and future potential. The firm-foundation theorist will calculate the stock’s intrinsic value by summing (1) the value of its present dividends and (2) the estimated growth of its dividends in the future.

Once an intrinsic value is established, the investor will make buying and selling decisions based on the difference between the actual price of the stock and the intrinsic value (because, according to the theory, the price will eventually regress to the intrinsic value).

The Castle-in-the-Air Theory

The castle-in-the-air theory of asset valuation holds that an asset is only worth what someone else will pay for it. In other words, no asset has an “intrinsic value” that can be determined analytically or mathematically; rather, the value of an asset is purely psychological—it’s worth whatever the majority of investors think it’s worth.

A castle-in-the-air investor makes her money by investing in stocks she thinks other investors will value.

Malkiel’s Take

There are glaring flaws with both theories of stock valuation.

With the firm-foundation theory, the problem is its reliance on future estimates. No analyst can know for certain how much or how long a stock’s dividends will grow—or even if they’ll grow at all.

With the castle-in-the-air theory, the challenge is timing. The successful castle-in-the-air investor needs to buy an asset just before mass enthusiasm causes its price to rise (and sell before that enthusiasm wanes).

Technical Analysis vs. Fundamental Analysis

The two primary methods of security analysis that financial professionals use are technical analysis and fundamental analysis.

Technical Analysis

Technical analysis relies on stock charts—graphs of past price movements and trading volumes—to predict future price movements.

Technical analysts adhere to two primary principles: (1) that all economic data—revenues, dividends, and future performance—are reflected in a stock’s past prices; and (2) that stock prices tend to follow trends (if a price is rising, it will continue to rise, and vice versa).

Fundamental Analysis

Fundamental analysis attempts to predict a firm’s future earnings and dividends by in-depth study. Fundamental analysts pore over firms’ balance sheets, earnings reports, and tax rates; they even, on occasion, pay personal visits to companies to assess their management teams.

Fundamental analysts also study the industry in which a company is operating. They do so to understand what is making current companies successful in that space—so they can recognize an innovator when it comes along.

Malkiel’s Take

Although Wall Street professionals today continue to use these methods of security analysis, the empirical evidence indicates that neither is a particularly reliable way to make investment decisions.

Regarding technical analysis, the key finding among researchers is that a stock’s past performance is no indication of its future performance. (In fact, stocks’ price movements resemble a “random walk” that’s similar to the results of flipping a coin.) Any method of analysis that relies on stocks’ “momentum”—whether a stock is generally moving either up or down—is sure to prove faulty.

Regarding fundamental analysis, no matter how lucid and well-founded a fundamentalist’s value determination is, he or she simply cannot account for randomness—the appearance of a groundbreaking technology, a new legal regime, or a catastrophic event like a public-health or environmental emergency. Fundamentalists can also make random mistakes in their analysis that result in bad bets.

There’s also the problem of bad actors. Firms can fudge their earnings reports, leading fundamental analysts astray. And fundamentalists’ reports can be unduly influenced by their own employer’s clients, resulting in conflicts of interest in their buy or sell recommendations.

Modern Portfolio Theory

Modern Portfolio Theory (MPT) builds on the “efficient market hypothesis” (EMH), which holds that _stock prices already reflect all...

A Random Walk Down Wall Street Summary Shortform Introduction

With over 1.5 million copies sold and 12 editions, Burton Malkiel’s A Random Walk Down Wall Street is one of the most popular investment books ever published. Malkiel holds a bachelor’s degree and MBA from Harvard and a Ph.D. in economics from Princeton, where he’s currently a professor of economics. In addition to A Random Walk, by far his best-known work, Malkiel has published influential technical papers in scholarly economics journals and was a longtime trustee of Vanguard mutual funds. Before moving into academia, he worked on Wall Street as a stock analyst and...

A Random Walk Down Wall Street Summary Part 1: Valuing Stocks | Chapter 1: Two Theories of Asset Valuation

Before a novice investor can begin to make the right decisions about how to invest her money, she must know how stocks are valued. Traditionally, there are two primary theories of asset valuation: the firm-foundation theory and castle-in-the-air theory. (There’s a third—called “the new investment technology”—that Malkiel describes later in the book.)

Both theories, as we’ll see, are flawed, and Malkiel is skeptical of them both as a reliable source of returns (though, in the short run, either may produce better-than-market-average returns).

The Firm-Foundation Theory

Adherents of the firm-foundation theory argue that assets have an “intrinsic value” based on their present conditions and future potential. For example, if the asset being valued is a common stock, the firm-foundation theorist will calculate the stock’s intrinsic value by summing (1) the value of its present dividends and (2) the estimated growth of its dividends in the future.

Once an intrinsic value is established, the investor will make buying and selling decisions based on the...

A Random Walk Down Wall Street Summary Chapter 2: Booms and Busts

Speculative bubbles, of course, are examples of the castle-in-the-air theory run amok. In a bubble, investors completely disregard firm foundations for fantastical notions of assets’ values, often with disastrous results. And while some investors are savvy enough—or lucky enough—to sell just before the crash comes, most are left holding the bag.

The Tulip-Bulb Bubble

Arguably the most famous—or infamous—speculative bubble in history, the tulip mania that struck 17th-century Holland perfectly illustrates the dangers of castle-in-the-air investing.

The craze centered on specific bulbs, called “bizarres” by the Dutch, that were infected with a nonfatal virus that caused the petals to develop vivid colors and patterns. The demand for these striking flowers caused tulip merchants to buy bulbs in bulk, which resulted in a rise in prices and attracted value investors as well as speculators. The craze became self-perpetuating: Prices continued to rise due to ever greater investment, which led to even higher prices and then even more investment. In 1634–1637, the years just before the crash, people began bartering valuables like jewelry and land to buy tulip bulbs.

Adding...

A Random Walk Down Wall Street Summary Chapter 3: The Insecurity of Institutions

Given the dangers presented by speculative bubbles, novice investors have turned to finance professionals—portfolio managers—to handle their investments. The thinking is that these professionals, backed by esteemed and successful financial institutions, won’t be swayed by the madness of the crowd.

The truth, however, is that financial institutions, and the human capital they employ, are just as susceptible to irrational optimism as we are. That optimism typically manifests itself in the “price-earnings multiple” applied to a firm’s common stock—that is, the number by which a stock’s earnings is multiplied to determine the price of the stock. Deriving this number is not an exact science: The personalities and cognitive biases of securities analysts can play a role, and all too often a hot new issue (initial public offering, or IPO) will cause institutional investors to adopt castle-in-the-air thinking.

A note about IPOs: It’s worth remembering that the people selling shares in an IPO are the company’s managers themselves. In other words, an IPO is timed to take advantage of favorable earnings, good buzz, or both, and minimize flaws in a company’s business model...

A Random Walk Down Wall Street Summary Chapter 4: 21st-Century Booms and Busts

One might imagine that with 300 years’ worth of economic experience, during which societies suffered steep recessions and depressions due to speculative bubbles, humanity would have improved its mechanisms for recognizing and mitigating those bubbles. Not so. In fact, the crashes of the early 2000s—the internet bubble at the beginning of the century and the real-estate bubble 10 years later—illustrate that castle-in-the-air thinking is just as prevalent today as it was in 18th-century Holland.

The investing principle we should take away from any bubble, the internet and housing bubbles not least among them, is this: There is no “sure thing” or “get rich quick” in the market. Invest in industries that have profit-making and profit-sustaining potential, rather than industries that purport to transform society. Avoid getting caught up in the hype of a new sector or technology; stay calm and keep your portfolio as broadly diverse as possible.

The Dot-Com Bubble

In the financial world, the early 2000s were marked by the rise of Internet stocks. Even though many of these “dot-com” companies had zero earnings (and zero potential for realizing earnings), they...

Shortform Exercise: Examine Methods of Valuation, Fads, and Bubbles

Consider the basic theories of valuation—and valuations run amok—in light of your goals.

What are the two primary methods of stock valuation? Despite their shortcomings, which seems more useful to you and why?

A Random Walk Down Wall Street Summary Part 2: Classic Methods of Analysis | Chapter 5: The Canard of Technical Analysis

As established by their role in speculative bubbles, professional portfolio managers, for all their experience and expertise, are as susceptible to castle-in-the-air thinking as the rest of us. “But,” a portfolio manager might say, “in the long run and on average, we manage risk for our clients and provide returns that beat the market—that’s why so many Americans trust us with their life savings and why we deserve our fees and commissions.”

Unfortunately for portfolio managers, academics have compared managers’ returns with those provided by a market index fund—a mutual fund with holdings that replicate a market index—and found that portfolio managers simply aren’t worth the money. That is, no investor can do better in the long run than a market index fund.

Why can’t portfolio managers consistently outperform index funds? Fatally flawed methods of analysis.

What Is Technical Analysis?

Security analysts typically use one of two methods for predicting the movement of stock prices: fundamental analysis (discussed at length below) and technical analysis.

**Technical analysis relies on stock charts—graphs of past price movements and trading volumes—to...

A Random Walk Down Wall Street Summary Chapters 6-7: Fundamental Analysis: The Equally Flawed Alternative

The other major method of stock valuation employed by finance professionals is fundamental analysis; in fact, most security analysts see themselves as fundamentalists. Its method, which takes into account a number of factors in addition to past price movement, including revenues, growth rate, and management skill, would seem to be superior to technical analysis. But studies have shown that fundamental analysis is just as unreliable as technical analysis.

What Is Fundamental Analysis?

Whereas technical analysis focuses exclusively on the movements of a stock’s price, fundamental analysis attempts to predict a firm’s future earnings and dividends by in-depth study. Fundamental analysts pore over firms’ balance sheets, earnings reports, and tax rates; they even, on occasion, pay personal visits to companies to assess their management teams.

Fundamental analysts also study the industry in which a company is operating. They do so to understand what is making current companies successful in that space—so they can recognize an innovator when it comes along.

The Four Investment Principles of the Fundamental Analyst

Investors using the fundamental method...

Shortform Exercise: Reflect on Security Analysis and the Efficient Market Hypothesis

Consider how security analysis and the EMH affects you.

If you’re an investor, which theory of security analysis—technical or fundamental—best describes your own process of picking stocks? If you haven’t invested before, which seems more useful to you?

A Random Walk Down Wall Street Summary Part 3: New Investment Strategies | Chapter 8: Modern Portfolio Theory (MPT)

With the two canonical methods of security analysis roundly debunked by empirical studies, scholars set out to develop their own theories of stock valuation. These “new investment technologies” include approaches like “smart beta” and “risk parity” (discussed below) that, at least according to their innovators, improve on technical and fundamental analysis.

Arguably the most prominent of the new investment technologies is “Modern Portfolio Theory (MPT).” Basic enough to have been widely adopted on Wall Street, MPT proceeds from the recognition that most—if not all—investors want to maximize their returns while minimizing their risk.

(Note: Although Malkiel views some of the new investment technologies favorably, he still believes traditional index funds are the best bet for investors.)

What Is Modern Portfolio Theory (MPT)?

Developed by Nobel Prize–winning economist Harry Markowitz, MPT in its purest form uses complex mathematics to diversify a portfolio in such a way that it earns a particular return with the smallest amount of risk. More basically, it asserts that a **diversified portfolio—one that features holdings in a variety of industries and countries—is...

A Random Walk Down Wall Street Summary Chapter 9: Leveraging Risk

As described in the previous chapter, the efficient market hypothesis means that better information or analysis doesn’t yield higher returns; rather, it’s an investment’s relative level of risk that holds the possibility of windfall gains.

But this principle raises any number of questions: What exactly do we mean by “risk”? How do we measure it? And how does it produce greater returns for investors?

Scholars of finance like Nobel laureate William Sharpe, John Lintner, and Fischer Black applied themselves to these questions in the 1980s and 1990s. Building on MPT, whose key finding was that diversification could reduce a great deal of risk but not all, they argued that greater long-term returns only accrue to a specific kind of risk—systematic risk, or “beta.”

(It’s important to note that Malkiel—along with scholars like Nobel laureate Eugene Fama and Kenneth French—has proven empirically that a higher beta does not in fact produce higher returns on average. In order to measure risk at all accurately, analysts need to incorporate further factors like national income, inflation, and interest rates, among others.)

Unsystematic Risk Versus Systematic...

A Random Walk Down Wall Street Summary Chapter 10: The New New Portfolio Theories

Building on the concepts embodied in advancements like MPT, CAPM, beta, and the like, scholars of finance have developed even more sophisticated models of portfolio construction. At present, two of the most influential are “smart beta” and “risk parity.”

As always, although both strategies show potential—especially for high-net-worth investors who can afford more risk—Malkiel avers that the core of every portfolio should be a broad-based market index fund, which offers a better return for the risk than most, if not every, other financial product.

Smart Beta: Between Passive and Active Management

Although definitions vary, a “smart beta” strategy can be defined as a rules-based, relatively passive model of portfolio construction that yields greater returns than the market without a commensurate increase in risk.

Essentially, smart beta strategies take a broad, market index portfolio—which, of course, has a beta of 1—and customize (or “flavor”) it in ways to increase returns without taking on unnecessary risk. For example, a “smart beta” investor might flavor her portfolio for “value” stocks over “growth” stocks, or small companies instead of large...

A Random Walk Down Wall Street Summary Chapter 11: Irrational Investors

Analytical concepts like the efficient market hypothesis, modern portfolio theory, beta, and the capital-asset pricing model all rely on a foundational assumption: that each decision an investor makes is intended to maximize gain and minimize loss—that is, that each investor is fully rational.

A group of financial analysts influenced by behavioral psychologists like Daniel Kahneman and Amos Tversky has challenged this assumption, however, and in so doing has founded a new area of economic research: behavioral finance. (Shortform note: Read our summary of Kahneman’s Thinking Fast and Slow.)

For the reader looking for investment advice from the behavioral finance literature without the background, the key points are four:

1) Don’t Follow the Crowd

Studies in behavioral finance have shown that word of mouth is a frequent driver of stock purchases. When some new investment is the talk of the town, it’s natural to want to take part. But resist the urge: Stocks or funds that are hot one quarter are almost invariably losers the next. It’s generally better to stick with “value” stocks—securities...

Shortform Exercise: Explore Financial Theory

Consider how financial theory can help you invest.

What is modern portfolio theory? (You might just name the central principle.) How might its findings affect your own investment decisions?

A Random Walk Down Wall Street Summary Part 4: A User’s Guide to Investing | Chapter 12: The Basics

In this part of A Random Walk Down Wall Street, Malkiel turns from the theoretical to the practical: What investments boast the best returns? How should I save for retirement? How can I anticipate future movements in the market? The balance of the book is devoted to actionable advice for investors, novice and experienced alike.

Before exploring specific investment vehicles and strategies, however, it’s vital to have some basic financial principles under your belt.

Principle #1: Start Saving Sooner Rather Than Later

In investing, there is truly no such thing as getting rich quick. The best way to realize returns is to begin investing as soon as possible and keep investing steadily, whether through the automatic reinvestment of dividends or regular contributions to a tax-advantaged retirement plan.

One simple way to increase your saving, if your employer offers a retirement plan, is to increase your voluntary contributions to the plan on a regular timetable, for example annually.

Principle #2: Back Yourself Up With Cash and Insurance

Rainy days happen, and even the most successful investor needs liquid assets that can be called upon in a pinch (or...

Shortform Exercise: Review the Basics

Explore Malkiel’s 10 essential investment principles.

Why is investing in real estate so important? If you don’t already own your home, how might you go about investing in real estate?

A Random Walk Down Wall Street Summary Chapter 13: Projecting Returns

Market projections in the short run—a month, or even a year, from the present—are generally a fool’s errand, but, by knowing which variables to examine, it is possible to make relatively accurate projections of returns in the long run.

In the following, Malkiel outlines the determinants of returns, and how they’re affected by market conditions, before offering his own predictions for asset returns in the coming years. As of late 2018, Malkiel foresaw quite modest long-run annual returns on bonds (about 1%–2%) and slightly higher returns on stocks (around 7%).

The Determinants of Returns for Stocks

Very long-run (at least 50 years) stock returns can be calculated using a simple formula:

Long-run equity return = Initial dividend yield + growth rate.

A stock’s “dividend yield” is the ratio of its dividend to its price; its growth rate is its percent growth in earnings and dividends. In plain language, you can estimate your long-run return on a share of common stock by adding its dividend yield at the time of purchase to the growth rate of earnings and dividends.

(Shortform note: The drawback of this method is that you have to estimate the...

Shortform Exercise: Practice Projecting Returns

Calculate future returns on assets.

A share of Widget Corp. sells for $20, pays a $1 dividend annually, and has an estimated growth rate of 5%. What is the estimated annual return on Widget Corp.?

A Random Walk Down Wall Street Summary Chapter 14: Age-Calibrated Strategies

Age may just be a number, but it’s vitally important when deciding how to allocate your investments. For example, a fully employed 30-year-old, with many years of labor income ahead of her, can weather more losses (and thus tolerate more risk) than a retired 70-year-old who relies on his investment income to get by.

In terms of age-dependent investing, Malkiel’s advice boils down to this: The longer you’re able to hold on to your investments, the more common stock you should have in your portfolio. If you have many years of working ahead of you, your allocation should be mostly stocks; if your working years are winding down, you should have a heavier share of bonds.

Five Allocation Principles

In order to choose your assets as wisely as possible based on your age, adhere to these five key principles.

1) Risk and Reward Are Two Sides of the Same Coin

Historical returns have shown conclusively that assets with higher volatility hold the potential for higher returns.

For example, between 1926 and 2017, small-company common stocks, which had the highest volatility of the standard investment instruments,** also boasted the highest average annual return....

Shortform Exercise: Invest According to Your Age

Review how age and investing are related.

Why is it important, in general, to hold onto investments for the long run?

A Random Walk Down Wall Street Summary Chapter 15: Picking Stocks

Once you’ve determined the ideal asset allocation for your age, economic situation, and risk tolerance, the next step is to decide which precise securities to purchase. But, with approximately 2,800 companies listed on the New York Stock Exchange, where does one start?

Malkiel proposes three strategies for picking stocks: The “autopilot” strategy, the “interested-and-engaged” strategy, and the “trust-the-experts” strategy.

The Autopilot Strategy

Ideal for the prospective investor who wants to take advantage of stock-market returns but isn’t interested in specifics, the autopilot strategy consists of purchasing broad index mutual funds or exchange-traded funds (ETFs) rather than individual stocks or industries.

(Some of the tax differences between traditional mutual funds and ETFs are described below, but the general rule of thumb is: If you have a large lump sum that you want to invest in index funds, ETFs are generally the most advantageous choice. If you’re going to be purchasing index fund shares in smaller amounts over a longer period of time, traditional mutual funds are your best bet.)

The autopilot strategy is Malkiel’s...

Shortform Exercise: Weigh Alternative Investment Approaches

Explore what the autopilot strategy, the interested-and-engaged strategy, and the trust-the-experts strategy mean for you.

Are you a set-it-and-forget-it type, or do you like to tinker? Which do you think is the best investment strategy for you and why?

A Random Walk Down Wall Street Summary Epilogue: The Index Fund Backlash

As of 2018, 40% of the amount invested in ETFs and mutual funds was in index funds. In response to the rapidly growing popularity of indexing, firms that rely on the fees and commissions attached to actively managed portfolios have criticized the practice. They believe that with greater indexing will come two issues: (1) prices will no longer reflect new information, because there will be no active investors to take advantage of, say, a positive clinical result for a new pharmaceutical; and (2) index-fund providers like Vanguard,...