“A Random Walk Down Wall Street” by Burton Malkiel: Part Two

Please check out Part One of “A Random Walk Down Wall Street” for more insights into the financial world. I found that this book was a great primer for understanding many of the complicated investment tools out there. For each tool Mr. Malkiel outlines why the tool is popular, what it’s underlying mechanisms are, and why these approaches are not more effective than a simple broad-based buy-and-hold approach to investing. I’ve been investing for many years with reasonable success but I’ve never taken an honest look at the time and effort I’ve put into that success and if those costs justify the benefits.

  1. Behaviorists believe that many (perhaps even most) stock market investors are far from fully rational. Behaviorists believe that market prices are highly imprecise. Moreover, people deviate in systemic ways from rationality, and the irrational trades of investors tend to be correlated. Basically, there are four factors that create irrational market behavior:
    1. Over-confidence
    2. Biased judgment
    3. Herd mentality
    4. Loss aversion
  2. More than most other groups, investors tend to exaggerate their own skill and deny the role of chance. They overestimate their own knowledge, underestimate the risks involved, and exaggerate their ability to control events.
  3. You remember your successful investments. And, in hindsight, it is easy to convince yourself that you know “Google was going to quintuple right after the IPO.” People are prone to attribute any good outcome to their own abilities. They tend to rationalize bad outcomes as resulting from unusual external events. “It’s far more profitable to sell advice than to take it.”
  4. Representative Heuristic: One cardinal rule of probability (Baye’s Law) tells us that a particular group should combine “representativeness” with base rates (the percentage of the population falling into various groups). This means that if we see somebody who looks like a criminal, our assessment of the probability that he is a criminal also requires knowledge about base rates– that is, the percentage of people who are criminals. (See more about Baye’s Theorem in “The Organized Mind”)
  5. Kahneman and Tversky’s most important contribution is called prospect theory (See Kahneman’s “Thinking Fast and Slow”), which describes individual behavior in the face of risky situations where there are prospects of gains and losses. They concluded that losses were 2 1/2 times as undesirable as equivalent gains were desirable. (See “Predictably Irrational”)
  6. Investors find it very difficult to admit, even to themselves, that they have made a bad stock market decision. Feelings of regret may be amplified if such an admission had to be made to friends or a spouse. On the other hand, investors are usually quite proud to tell the world about their successful investments that produced large gains.
  7. In investing, we are often our own worst enemy. An understanding of how vulnerable we are to our own psychology can help us avoid the stupid investor delusions that can screw up our financial security. There is an old adage about the game of poker: If you sit down at the table and can’t figure out who the sucker is, get up and leave because it’s you.
  8. Most investors bat themselves by engaging in mistaken stock market strategies rather than accepting the positive buy-and-hold indexing approach recommended in this book. The way most investors behave, the stock market becomes a loser’s game.
  9. Any investment that has become a topic of widespread conversation is likely to be especially hazardous to your wealth.
  10. Remember the advice of legendary investor Warren Buffett: Lethargy bordering on sloth remains the best investment style. The correct holding period for the stock market is forever.
  11. Researchers have found that IPOs underperform the stock market by about 4% per year. The poor performance starts about six months after the issue is sold. Six months is generally the “lockup” period where insiders are prohibited from selling stock to the public. Once that constraint is lifted, the price of the stock often tanks.
  12. No one can consistently predict either the direction of the stock market or the relative attractiveness of individual stocks, and thus no one can consistently obtain better overall returns than the market. And while there are undoubtedly profitable trading opportunities that occasionally appear, these are quickly wiped out once they are known.
  13. Psychologists in the field of behavioral finance find that short-run momentum is also consistent with psychological feedback mechanisms. Individuals see a stock price rising and are drawn into the market in a kind of “bandwagon effect.” As behavioral finance became more prominent, momentum, as opposed to randomness, seemed entirely reasonable to many investigators.
  14. Techniques that work on paper do not necessarily work when investing real money and incurring the transaction costs that are involved in the real world of investing.
  15. The most important driver in the growth of your assets is how much you save, and saving requires discipline.
  16. If you have kids or grandchildren who plan to go to college and you can afford to contribute to a 529 plan, the decision to establish such a plan is a no-brainer.
  17. Determining clear goals is a part of the investment process that too many people skip with disastrous results. You must decide at the outset what degree of risk you are willing to assume and what kinds of investments are most suitable to your tax bracket.
  18. High investment rewards can be achieved only at the cost of substantial risk-taking.
  19. A good house on good land keeps its value no matter what happens to money. As long as the world’s population continues to grow, the demand for real estate will be among the most dependable inflation hedges available.
  20. In principle, for the buyer who holds his stocks forever, a share of common stock is worth the “present” or “discounted” value of its stream of future dividends. Discounting reflects the fact that a dollar received tomorrow is worth less than the dollar in hand today. A stock buyer purchases an ownership interest in a business and hopes to receive a growing stream of dividends.
  21. Changes in valuation are fundamentally unpredictable. Thus, all we can do is estimate what returns the market is likely to give us if valuation relationships do not change.
  22. Don’t invest with a rearview mirror. Don’t simply project the returns from the past into the new millennium. The most likely estimates we can make for the stock market when dividend yields are in the vicinity of 2.5% is that the total rate of return over the long run will be in the upper single digits. (See “The Signal and the Noise“)
  23. There are two times in a man’s life when he should not speculate: When he can’t afford it, and when he can.
  24. The risk of investing in common stocks and bonds depends on the length of time the investments are held. The longer the holding period, the lower the likely variation in the asset’s return.
  25. Dollar-cost averaging can be a useful, though controversial, technique to reduce the risk of stock and bond investment.
  26. Re-balancing can reduce risk, and in some circumstances, increase investment returns.
  27. You must distinguish between your attitude towards and your capacity for risk. The risks you can afford to take depend on your total financial situation, including the types and sources of your income exclusive of investment income.
  28. For investors whose holding periods can be 25 years or more, and especially those who reinvest dividends and add to their holdings, common stocks are very likely to provide higher returns than are available from “safer” investments.
  29. The most important reason for investors to become conservative with age is that they have fewer years of paid labor ahead of them. Thus, they cannot count on salary income to sustain them if the stock market has a period of negative returns.
  30. If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period? Many investors get this wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall.
  31. Never take the same risks in your portfolio that attach to your major source of income.
  32. Three things to keep in mind before investing:
    1. Specific needs required dedicated specific assets.
    2. Recognize your tolerance for risk.
    3. Persistent saving in regular amounts, no matter how small, pays off.
  33. Even if stock markets were less than perfectly efficient, active management as a whole could not achieve gross returns exceeding the market. Therefore, active managers must, on average, underperform the indexes by the amount of those expenses and transaction cost disadvantages.
  34. Broad diversification rules out extraordinary losses relative to the whole market; it also, by definition rules out extraordinary gains. Thus, many Wall Street critics refer to index-fund investing as “guaranteed mediocrity.”
  35. The best U.S. index to emulate is one of the broader indexes such as the Russell 3000, the Whilshire 5000, or the MSCI, not the S&P 500.
  36. I suggest that a substantial part of every portfolio be invested in emerging markets.
  37. Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least 5 years.
  38. Never pay more for a stock than can be reasonably justified by a firm foundation of value.
  39. It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air.
  40. Trade as little as possible.
  41. With few exceptions, I sell before the end of each year any stocks on which I have a loss.
  42. There is a fundamental paradox about the usefulness of investment advice concerning specific securities. If the advice reaches enough people and they act on it, knowledge of the advice destroys its usefulness.

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

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