Saturday, December 17, 2016

A Random Walk Down Wall Street by Burton G. Malkiel (Book Review #77 of 2016)



A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Ninth Edition)

"The entire investment industry is built on the illusion of skill." - Daniel Kahneman

This book has been on too many colleagues' bookshelves to have not read it before. Alas, I knew well what it was about from other books. I was glad to find a 2007 edition in which Malkiel can reflect on events since his first 1973 edition was published. I followed it with Malkiel's book The Elements of Investing. While he chronicles the development of other fields since 1973, such as behavioral finance, Malkiel's overall take is that they have added little to his own thinking on investing and only highlighted the cognitive biases that make fools think otherwise.

No one can "beat the market" because no one can say with 100% certainty that "the price is wrong." Malkiel begins by looking at the various strategies of portfolio analysis. Firm Foundation theory by Benjamin's Graham and David Dodd is what they still basically teach in business school. This involved looking at the "fundamentals" and relies heavily on projecting future revenue streams to discount and get the present value. Others have built on this work over the years but Malkiel, Eugene Fama, and others' criticisms are the same. Analysts are wrong, and not single analyst can know with absolute certainty all the information about one company AND all available information about ALL OTHER companies, which would be necessary to determine "right" price. Even if an analyst's analysis adds value, it costs something in fees. Once one accounts for fees and risk premium, returns from actively-managed portfolios picked by "fundamental analysis" do not beat the market. 75% of actively managed funds are beaten by index funds every year. Actively managed funds often have fees 15 times that of indexed funds-- study after study finds they underform AND cost you more.

Peter Lynch had returns at Magellan that outperformed the market for decades, if there is an exception to the rule it may be him. Lynch also holds to a form of fundamental analysis, advising investors to research heavily into companies and be familiar with its products-- "invest in what you know." Warren Buffet invests similarly, citing Graham as his model. But the above critique still applies--if so many others have applied the same analysis, why haven't they all beaten the market? Human psychology loves to pretend randomness doesn't exist. The "hot hand" has been proven time and again not to exist, yet people still "see it." As Nobel laureate Daniel Kahneman puts it "There is general agreement among researchers that nearly all stock pickers, whether they know it or not – and few of them do – are playing a game of chance." If 1,000 portfolio managers had a 50/50 chance of beating the market annually, then odds are that after a decade there would be one who had done it every year-- by randomness (try it with a coin yourself). Lynch also put premium on young, growth stocks. But if a stock is growing, why is it growing and how long will it continue? Analysts look for "momentum" and even financial officers at companies will try gimmicks like stock splits to add "momentum" to their company's price but which hundreds of studies have found worthless. IPOs underperform the overall market by 4% annually.

Malkiel investigates every rule and theory out there--CAPM and everything else--and presents plenty of evidence that convinces him they're inadequate. The modern "quants" have done no better (and as Nassim Taleb points out, they all get fired every decade or so when the next big crash happens) and modern portfolio theory has little to offer. Beta will always be impossible to measure correctly. While Markowitz showed that diversification rules, and Nobel laureates have devised equations for proper diversification, you cannot diversify away systemic risk. There is no evidence to support "dow theory" and "breaking barriers" and "support levels" that you might see some CFAs write about also has little demonstrated scientific support. Malkiel comments on recent books claiming the market is indeed predictable, a sad irony to the collapse of 2007.

Malkiel examines the history of crazes, manias, and bubbles. Schiller and others have written on this and come up with their own theories, but even these are difficult to prove. Even when one shows that fundamentals are way off, no one knows when the bubble will burst. The market can stay irrational longer than you can stay solvent if you're betting the other direction (Keynes). The author examines Keynes' chapter on storck markets in his General Theory-- his "castle in the air" theory. To Keynes, fundamental analysis did not matter as much as the "beauty contest," ie: what do you suppose everyone ELSE will think about this stock? That's half of what financial shows on CNBC are-- ways for people to make others think their stock is prettier than it is.

The author gives a rundown of behavioral finance, Kahneman and Tversky, experiments demonstrating irrational behavior and cognitive biases, etc. The investor does want to be aware of herding, but one can never know how long or how far the herd will run. So, the price is not always "right" but we have no way of identifying a more right price than the market-- we can never say when it will reach that "right" price and how much everything else in the world will have changed as it reaches that price.

Malkiel parlays all of the above into his basic advice on saving and purchasing insurance. Avoid active funds, avoid fees. In 1973 there were no index funds, now you have the ability to track the Russell 3000 Index. He answers the "guaranteed mediocrity" criticism that I see in some of the negative comments on this book.

Oddly enough, Malkiel closes by giving some advice on picking stocks. I suppose it's a "if you must pick stocks, here's how you should do it" but I found it really weakened his other premises. There are some tax-advantaged strategies, such as selling your losses at the end of the year to take a tax write off, which makes sense over a rigid "buy and hold." There are other strategies, for which I recommend Jim Paul's What I Learned from Losing a Million Dollars that Malkiel does not cover here-- such as set a hard rule for how much loss you're willing to take before you sell. That puts a floor on your losses. Pick a strategy/style/group of companies that you invest in and stay with it. Don't let someone talk you out of it as it's unlikely anyone can prove your strategy is any better, and you'll lose more money when you deviate from your rules.

Malkiel explains options and futures and their usefulness in hedging, while not recommended for the average investor. But it seems Malkiel totally believed from his 2007 publishing that there would not be a worldwide financial meltdown related to the derivatives traded on real estate. Hmm, that didn't work out well did it? The 2007 collapse is the ultimate example of the myth of skill-- no one has perfect information, and plenty missed the fact that CDOs and the credit default swaps written on them were a ticking timebomb that would drive a lot of fundamentally sound companies (many on Jim Collins' Good to Great list) out of business in months. That error brings the book down to 4 stars. Still the best book out there arguing against modern portfolio theory and actively-managed funds.

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