The Random Walk Guide to Investing

Table of Contents

By Burton G. Malkiel (W. W. Norton, 2003).

Overview

This is an abridged version of the author’s much longer book (see bottom). It talks about 10 rules for financial investing, most of which are common sense that a younger and more foolish me stubbornly ignored. Now I’ve paid my tuition, I thought I should take some notes from this little book.

Basic Point 1: fire your investment adviser

Woody Allen: A stockbroker is someone who invests other people’s money until it is all gone.
A good way to go broke quickly is to purchase stock issues (IPOs) immediately after they start trading.
It is incomprehensible to me that consumers will spend hours researching the merits of various $50 portable CD players yet will casually spend thousands of dollars to buy a stock that has been hyped in a TV interview, a brokerage report, or even worse on a rumor or stock tip from one’s golfing buddy or brother-in-law.
Most medical progress has come from one old invention and one simple technique. More lives have been saved and prolonged by penicillin and by washing hands than by any other pharmaceutical or medical technique.
Malcom Forbes: The way to get rich from investment advice is to sell it—not to take it.
Charles Ellis: It must be apparent to intelligent investors that if anyone possessed the ability [to forecast stock prices] consistently and accurately, he would become a billionaire so quickly that he would not find it necessary to sell his stock market guesses to the general public.

Basic Point 2: focus on 4 investment categories

Cash, stock, bond and real estate.
These lower-quality bonds are called high-yield bonds or, more pejoratively, junk bonds.
If a stock has earnings per share of $2 and it sells in the market at 40, it is said to have a price-earnings (P/E) ratio of 20.
Charles Kindleberger: There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.
Yet countless individuals who may have owned such diversified portfolios found it impossible to stay the course when their neighbors boasted of an Internet stock that doubled during the previous week.
The consistent losers in the market, from my personal experience, are those who are unable to resist being swept up in some kind of tulip-bulb craze and who bet their entire stake on a single stock or a single industry.
REIT: real estate investment trusts.
the most dangerous words in the English language that investors can hear are, “This time is different.”

Basic Point 3: understand the risk/return relationship

higher investment returns can only be achieved by accepting greater risk (in an efficient market).
The returns that you hope to receive from any investment are always influenced by the level of inflation.
inflation has even more devastating effects on a bond portfolio; when inflation is rampant, interest rates have to rise to entice buyers to hold bonds.
real estate tends to shine when inflation accelerates. And common stocks also protect investors over the long run from high inflation.

Rule 1: start saving now

Procrastination is the natural assassin of opportunity.
Trust in time rather than timing.
rule of 72 (for doubling investment): take the rate of return you will earn from an investment and divide it into the number 72

$y = \ln(2) / \ln(1+r) \approx .69 / r$ for small $r$
Benjamin Franklin: The money that money makes, makes money.
put time on your side
Luck in picking the right time to invest is all well and good, but time is far more important than timing.
You can only get poor quickly. To get rich, you will have to do it slowly, and you have to start now.

Rule 2: keep a steady course

The harsh truth is that the most important driver in the growth of your assets is how much you save, and saving requires discipline.
commit in advance to allocate a portion of any salary increases toward retirement saving.
Benjamin Franklin: Beware of small expenses, a small leak will sink a great ship.
The kids have the option of either ordering a soft drink or ordering water and receiving a dollar from me. The money stays in the family, the kids learn to forego present gratification, and water is healthier for them.
Wealth is more often the result of a lifestyle of hard work and the discipline of regular savings.
François de La Rochefoucauld: Before desiring something passionately, one should inquire into the happiness of the man who possesses it.
don’t touch the money that’s been set aside.
The only thing worse than being dead is to outlive the money you have put aside for retirement.

Rule 3: don’t be caught empty-handed

Murphy’s law: what can go wrong will go wrong. O’Toole’s commentary: Murphy was an optimist.
CDIC insures eligible deposits separately up to $100,000. To be on the ultra safe side (to account for interests), you may not want to put more than \$90,000 in any single bank.
Those with family obligations are downright negligent if they don’t purchase insurance.
Life insurance to protect one’s family from the death of the breadwinner(s) is also a necessity.
buy renewable term insurance; you can keep renewing your policy without the need for a physical examination, however, term insurance premiums escalate sharply when you reach the age of sixty or seventy or higher.
Don’t bet your life on a poorly capitalized insurance carrier. (Rating should dominate premium.)
Keep it simple. Avoid any complex financial products as well as the hungry agents who try to sell them to you.

Rule 4: stiff the Tax Collector

TFSA, RRSP, RESP, HBP, etc.
One silly mistake I made with my TFSA is to invest it on individual stocks, not knowing any loss in this account is permanent. (My thinking went: I will pick the best stock that will increase so much, tax-free! It never crossed my mind what happens on the other direction, until the damage is well done.) A better strategy is to invest your TFSA a bit more conservatively (and leave the more volatile investments to a non-registered account).

Rule 5: match your asset mix to your investment personality

the major determinant (90%) of the overall rate of return earned by investors is not the particular bond or stock funds they buy, but rather the way they allocate their investment funds among the various asset classes.
set the proportion of bonds in your portfolio equal to your age.
J. P. Morgan: Sell (stock) down to the sleeping point.
High investment rewards can be achieved only at the cost of substantial risk-taking.
rebalance at least once a year (but not too frequently).

Rule 6: diversity reduces adversity

don’t buy individual stocks—buy mutual funds (or ETFs)
With dollar-cost averaging, there are circumstances where you could actually come out better in a market where prices are very volatile and don’t rise over time than you would if you were investing in an ebullient market environment.
Indeed, let $a_i$ be the amount invested at price $b_i$ at stage $i$. The total number of shares we obtain is $\sum_i \frac{a_i}{b_i}$. If instead we invest the total amount $\sum_i a_i$ at average price $\bar b = \frac{\sum_i b_i} {\sum_i 1}$ we would have $\frac{\sum_i a_i}{\sum_i b_i} \cdot \sum_i 1$ shares.
- when $b_i \equiv b$, i.e., no price fluctuation, there is no difference between the two strategies.
- when $a_i \equiv a$, i.e., investing fixed amount in each stage, applying the arithmetic-geometric-mean inequality we obtain $$ \sum_i \frac{a_i}{b_i} \geq \frac{\sum_i a_i}{\sum_i b_i} \cdot \sum_i 1.$$
- fixing the sum $\sum_i a_i$ we are comparing $$ \sum_i \frac{a_i}{\sum_{\iota} a_{\iota}} \cdot \frac{1}{b_i} ~~\mathrm{ v.s. }~~ \frac{\sum_i 1}{\sum_i b_i}.$$ To maximize the former, the higher (price) $b_i$ is, obviously the smaller (allocation) $a_i$ is. Is it possible to apply Hedging to achieve small regret against the baseline $a_i \equiv a$?
you might actually wish for lower stock prices (at least for a while) after you begin your investment program. Prospective purchasers should much prefer sinking prices.
have both the cash and the courage to continue to invest during bear markets as regularly as you do in better periods. No matter how pessimistic you are (and everybody else is), and no matter how bad the financial and world news is, you must not interrupt the automatic pilot nature of the plan or you will lose the important benefit of ensuring that you buy at least some of your shares after a sharp market decline.
The worst thing you could do is to sell out after the market declines.
usually a good time to buy after the market has fallen out of bed and no one can think of any reason why it should rise. Just as hope and greed can sometimes feed on themselves to produce speculative bubbles, so do pessimism and despair react to produce market panics.

Rule 7: pay yourself, not the piper

Jack Bogle: The surest route to top-quartile returns is bottom-quartile expenses.
Most mutual funds turn over their entire portfolio once a year through purchases and sales of securities adding as much as one additional percentage point in transaction costs to the management expense they charge.
Never buy a mutual fund with a load charge. Never buy a newly issued fund from a broker even if the broker tells you there is no commission. The fund pays the brokerage firm a large commission to sell the new shares, and you will be paying one dollar for about 94 cents of assets.
index funds have the lowest expense ratios. Moreover, index fund managers are fundamentally “buy and hold” investors.
Don’t let low commission rates seduce you into becoming one of the legion of unsuccessful former day traders.
With those kinds of expenses, it will be virtually impossible for you to beat the market. My advice here is: Avoid taking the wrap (e.g., annual advisory fees).

Rule 8: bow to the wisdom of the market

Academic studies only confirm what we all believe.
efficient-market theory (EMT): the stock market is an extraordinarily efficient institution for reflecting without delay any information that arises. (hmmm)
true “news” must itself be unpredictable and random. Otherwise, it wouldn’t be news at all.
the more efficient a stock market is, the more unpredictable it will be. really new information arises in an unpredictable fashion.
professional “advice” is often worth less than zero since it induces investors to pay fees that are too high, undertake investment strategies that involve costly transactions charges, and pay more in taxes than they need to.
The knowledge that I don’t need to know anything is an incredibly profound form of knowledge: “don’t know and I don’t care.”
Being smarter doesn’t always mean be smart.
Charles Ellis: the importance of being there and using patient persistence—so they are there when opportunity knocks.
an investor made an average annual return of more than 18%. But if he or she had missed the best 30 days in the market, the return would have been only 11.2%.
Charles Ellis: Market timing is a wicked idea: Don’t try it—ever.
Why many professional investors do not earn the market return, after all, they are the market?

Well, they do earn the market return before expenses. It is their expenses that drag their return down below that available from the market as a whole.
What a number of mutual fund complexes do is to start, say, ten small new funds, called incubator funds. Suppose two or three of them do better than the market; the mutual fund complex then kills off the seven or eight that did poorly (these are merged into successful funds, thus killing off the poor records) and heavily advertises the two or three that did well.
Peter Lynch by retiring at the peak of his performance, he guaranteed himself membership in the portfolio managers’ Hall of Fame.
rather than futilely attempting to find that needle in the haystack, buy the haystack.

Rule 9: model portfolios of index funds

Just because your fund was especially good yesterday, there is no reason to think it will continue to be good tomorrow.
Every payment into the plan will incur a transaction charge if ETFs are used. With a no-load mutual fund, no transactions charges are involved. Moreover, with a mutual fund, any dividends paid by the index fund will be automatically invested. With an ETF, additional transactions charges can be involved when you reinvest your dividends.
newly included companies (into S&P 500) tended to appreciate in price (at least temporarily) by more than 5%—simply because they are now a part of the S&P Index. Portfolio managers who run index funds are required to incur transactions costs to purchase the stocks of the new companies (in proportion to their relative size and, therefore, their weight in the index) so that their portfolio’s performance will continue to conform to that of the index.
in the aggregate, smaller stocks have tended to outperform larger ones.
even in one’s late sixties, 25% of the portfolio should be committed to regular stocks and 15% to real estate equities to give some income growth to cope with inflation.
hold most if not all of your securities in tax-advantaged retirement plans. Certainly all of your bonds should be held in such accounts.

Rule 10: avoid stupid investor tricks

overconfident, get trampled by the herd, harbor illusions of control, and refuse to recognize their investment mistakes.
If you sit down at the table and can’t figure out who the sucker is, get up and leave, because it’s you.
people all too often confuse luck with skill.
impossible for all investors to be above average.
in the game of amateur tennis, most points are won not by adroit plays on your part but rather by mistakes on the part of your opponent.
The psychologists conjecture that the persistent belief in the hot hand could be due to memory bias.
large market movements encourage buy and sell decisions that are based on emotion rather than logic.
avoid the temptation to follow the herd.
(illusion of control) the decision to let state lottery buyers pick their own numbers (instead of handing them a random number), even though luck alone determines lottery winners.
Investors tend to believe that events are more predictable after the fact than before. “Hindsight bias” leads us to believe that events that no one foresaw were, in fact, easily predictable in advance.
The biggest investment mistakes you can make are attempting to time the market or to select your mutual fund on the basis of good recent performance.
people are far more distressed at the prospect of losses than they are overjoyed by the possibility of gains. Thus, paradoxically, investors might take greater risks to avoid losses than they would to achieve equivalent gains. Moreover, investors are likely to avoid selling stocks that went down in order to avoid the realization of a loss and the necessity of admitting that they made a mistake. On the other hand, investors are generally winning to discard their winners because that enables them to enjoy the success of being correct.
A “paper loss” is just as real as a realized loss. The decision not to sell is exactly the same as the decision to buy the stock at the current price.
Never buy anything from someone who is out of breath.
The correct holding period for the stock market is forever.
The higher the costs you pay, the poorer your financial results will be. Buy only no-load low-cost mutual funds.
never buy an IPO just after it begins trading at prices that are generally higher than the IPO prices. The poor performance starts about six months after the issue is sold. Six months is generally set as the “lockup” period, where insiders are prohibited from selling stock to the public.
Only if the brokerage firm is unable to sell the shares to the big institutions and the best individual clients will you be offered the chance to buy at the initial offering price.

Conclusion

If an investment idea seems too good to be true, it is too good to be true.
Much of the financial advice offered to consumers is unnecessarily fancy and complex.
Investing is a marathon—not a spring. The prize goes to those with fortitude and endurance.
profit-hungary professional investment managers, who can charge much more for active management, will ensure that the dream of extraordinary returns is kept alive to snare less well informed investors.
in these markets where trading is less efficient and more costly, indexing is particularly advantageous. When transactions costs tend to be quite large, a passive buy and hold approach involves substantial cost savings.
Keep firmly in mind the words that appear in every mutual fund prospectus: Past results are no guarantee of future performance. Investment results tend to revert to the mean.

To Read

Galloway, Scott (2024). The Algebra of Wealth. Portfolio.
Malkiel, Burton G. (1973). A Random Walk Down Wall Street. W. W. Norton.
Graham, Benjamin (1973). The Intelligent Investor. HarperCollins.