Do you think individual retail investors cannot compete against Wall Street professionals?

Many believe so when considering the financial market’s complexity and high-frequency trading technology. However, “A Random Walk Down Wall Street” by Dr. Burton Malkiel challenges this.

We’ll explore Malkiel’s fascinating ideas by focusing on six key insights. With more than 1.5 million copies sold, this classic book review is definitely not one to miss.

Dr. Burton Malkiel is well-known as an economist with an MBA from Harvard University. The book was published in 1973 and since then it has impacted several industry professionals who have served on the Vanguard investment management company’s board of directors.

Malkiel claims that a blindfolded chimpanzee throwing darts at stocks can do equally as good as professional investors!

Key insight 1 – Fundamental and technical analysis limitations

Many rely on the fundamental approach that an investment’s price should reflect its intrinsic value. Fundamental analysis often attempts to identify assets with intrinsic values higher than their current price. Malkiel, on the other hand, believes that inaccurate information, analysis errors, and unexpected events may lower the accuracy of fundamental analysis. With these limitations, it’s easy to see that fundamental analysis isn’t perfect.

Another strategy investors often use is technical analysis which focuses on the behavior of historical prices. Technicians believe the markets are mostly moved by others identifying patterns and trends. But Malkiel argues that technical analysis alone will likely fail to beat the market consistently.

While technical analysis can provide objectivity and consistency when following a plan, it also has disadvantages. Some cons include false signals and hindsight bias, often resulting from inaccurate historical price data and user bias when backtesting. Further disadvantages include sharp reversals due to significant news releases, which can cause slippage that’s difficult to account for accurately when backtesting strategies.

The book explains how in addition to fundamental and technical analysis, human psychology plays a major part in a market’s unpredictability.

Overconfidence, biased judgements, herd mentality, and loss aversion are all examples of common psychological behavior. Overestimating our ability and thinking we can control every situation is particularly common for newer investors. These psychological reasons make it even more challenging to outperform the market continuously.

Key insight 2 – The random walk theory

The “random walk” concept in statistics refers to the unpredictable movement of variables that are devoid of any established relationship with historical data or other factors. Malkiel suggests that stock prices behave randomly over the short term without any apparent correlation to past values or other variables.

Despite this, the random walk theory doesn’t rule out the chance of patterns and relationships forming in stock price movements. The idea mainly applies to short-term timeframes on the daily, weekly, and monthly meaning it’s harder to predict short-term market movements.

The random walk theory shares similarities with the Efficient Market Hypothesis, which has three versions: weak, semi-strong, and strong.

The weak form suggests that the market reflects all the current price information, making technical analysis ineffective.

The semi-strong form claims that the market reflects all publicly available data, meaning that technical and fundamental analysis is practically useless.

And lastly, the strong form implies that the market always mirrors the actual value of an assets, making even insider knowledge worthless. Although Malkiel acknowledges the limitations of beating the market consistently, he doesn’t fully support the strong version in the book.

So how can retail investors beat Wall Street given the disadvantages of popular investment analysis techniques and human psychology?

Malkiel’s answer is simple and effective: investing for the long run in low-cost index funds. Diversifying across the broader index funds can help investors with lower risk tolerance. Also, he mentions that investing for the long term helps utilize dollar cost averaging efficiently as we can likely get a better average entry price over more extended periods.

Malkiel focuses on making investment returns that beat the inflation rate and places importance on methods that maintain purchasing power.

To help understand how important it is to beat inflation, let’s look at the rising cost of a McDonald’s burger from 1962 to 2018. The burger price went from $0.21 in 1960 to $1.81 in 2018, an incredible increase of over 750%. This example helps show the impact of inflation and the importance of beating it in order to grow wealth.

Key insight 3 – The importance of asset allocation

Malkiel places great importance on asset allocation in a portfolio. He recommends spreading investments across various assets, such as stocks and bonds. The idea is to spread risk across sectors and in different markets, including Europe and Asia.

While globalization has increased over the years, it does not mean stock markets move in correlation. An example of a low correlation between 2001 and 2010 is when the S&P 500 returned 1.48% annually compared to 15.9% from the Emerging Markets Index.

Diversifying more often helps reduce the chance of a portfolio having greater volatility. Malkiel recommends investing in low-cost index funds like the S&P 500 as it automatically achieves much diversification.

Index funds often provide broad market exposure, low expenses, and minimal portfolio turnover. Additionally, index funds can reduce costs and avoid much of the risk of attempting to outperform the market through active stock picking.

Bonus insight – Dollar cost averaging tips

Dollar-cost averaging means investing a consistent dollar amount into an asset over a period of time. Let’s start with some of the major negatives before moving on to the benefits.

Although dollar cost averaging can reduce risk, it’s less likely to result in market-beating returns. Also, as markets tend to rise over time, investing a larger amount sooner will likely outperform a smaller amount spread out over time. The lump sum investment should make a larger long-term return because of a market’s rising tendency.

Advantages of dollar-cost averaging include the reduction of letting our emotions get in the way of rational decisions and avoiding bad timing of investments. Dollar-cost averaging can provide a reasonable insurance policy against poor future stock market returns and minimizes the regret if you put all your money in during a market peak just before a crash. Overall, Malkiel suggests it’s safer to dollar cost average, especially for beginner investors.

Bonus insight 2 – Rebalancing

Malkiel recommends rebalancing at regular periods to make sure your portfolio stays aligned with how you originally wanted it. Rebalancing involves periodically adjusting your portfolio’s asset allocation to maintain your desired risk and return objectives. It simply requires selling assets that have performed well and buying more underperforming ones.

For example, your asset allocation target is 20 to 80 for bonds to stocks. At the end of the year, say stocks now make up 90% of your portfolio. You’ll sell some stocks to bring its allocation back down to 80% and buy more bonds to bring its allocation back up to 20%. You should be able to profit from selling the stocks while buying bonds at a lower price.

Bonus insight 3 – Time in the market matters

Malkiel places greater importance on spending time in the market instead of trying to time the market. The longer you’re invested, the greater the chance of benefiting from compounding returns and dealing with market fluctuations. He claims that having a long-term approach should increase your chances of achieving better investment results.

A Random Walk Down Wall Street challenges the idea that individual investors cannot beat Wall Street professionals. Dr Malkiel argues against relying only on fundamental or technical analysis and mentions human psychology’s limitations in investment decision-making.

His approach is conservative, and he claims that the markets are more random compared to what many successful investors believe. Buying individual stocks is perfectly fine if you work hard to research and understand why you bought the stock. If you enjoyed reading this make sure you check out more content from the blog.