A Random Walk Down Wall Street

Two of the books I have read recently, Everything Is Obvious and The Signal and the Noise, made references to Burton Malkiel’s book “A Random Walk Down Wall Street”. They pointed out that the stock market is entirely unpredictable and therefore investment bankers are just guessing. I was curious to read more, so I picked up the book itself.

An index tracks stock market movements. For example the FTSE 100 tracks 100 companies on the London Stock Exchange, while the Standard & Poors (S&P) 500 or Russell 3000 track a far more broad range of stock prices. These therefore provide a good indication of whether the stock market moves up or down.

Now take a mutual fund – these are professionally managed funds that the general public put their money in for someone to manage on their behalf. The benchmark here is not whether they can grow their investment, but whether they can grow their investment at a better rate than the index (because the stock market generally moves up anyway). If they were just guessing, you would expect 50% of mutual funds to beat the index, and the other 50% to fail, in both cases just due to chance.

However, the research, as discussed at length in A Random Walk Down Wall Street, shows that only 40% of mutual funds can beat the index! This is not just guessing – this is worse than guessing. Professional investment managers not only do not add any value to the funds they are managing, they actually subtract value.

You could make the case that there are just a lot of bad fund managers. However, the research refutes this too. As Malkiel describes, if you take the top performing funds over a five year period they almost invariably fail to beat the index over the next five year period.

This should not actually be that surprising. The Wall Street Journal has long shown that throwing darts at the stock listings produces a better return than the experts; a noticeably better return once you adjust for risk. To see it in practice (I include this as an anecdote to make the facts more believable) just watch the BBC documentary Million Dollar Traders in which eight complete notices only lose 2.5% in a period where their multi-millionaire master-of-trading coach loses 5%.

Of course it is hard to believe. Why are all these people employed if they add no value? That is a fact I find hard to reconcile. Surely if we are talking about efficient markets, at least one bank would have realised they could fire all these traders and replace them with monkeys? Counter arguments to this suggest that the average trader actually earns a pittance, and that because it is in the interest of traders (justifying their own job) and brokers (getting rich of the transaction fees from all this needless trainers) to maintain the illusion that they actually do something, the industry keeps selling these products to the general public who simply don’t realise.

The evidence, at least if Malkiel is to be believed, is clear. You should invest all your money in an index tracker with the lowest fee you can find. That produces the most consistent returns compared with a mutual fund that charges you higher fees to produce a lower return. Nate Silver says the same thing.

In the final part of the book, Malkiel goes on offer some investment advice for those who do not want to use an index fund. He also hints that he picks individual stocks too. This is odd as it goes against a lot of what the evidence he has presented says, but is consistent with what the psychology says – that we have a really hard time accepting what the scientific evidence says when it contradicts our own pet theories, achievements and so called “common sense”.

A Random Walk Down Wall Street

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This entry was posted on Sunday, May 4th, 2014 at 10:08 am and is filed under Books. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.