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A Random Walk Down Wall Street
Including A Life-Cycle Guide To Personal Investing
By Burton G. Malkiel
A Random Walk Down Wall Street by Burton G. Malkiel is one of the classic books about investment. While Malkiel believes that stock markets are "efficient," (i.e., the markets quickly incorporate any available information about a stock which affect the stock's pricing, and, thus, more often than not, the stock is fairly priced based upon all the available information), Malkiel also points out that from time-to-time euphoria or utter despair takes hold of the markets.
The old joke about the efficient-market professor has him walking down the street with one of his students. The student sees a $10 bill lying on the sidewalk and bends down to pick it up. The professor says, "Don't bother. If that $10 bill were really there, somebody would have picked it up already."
Malkiel advises us to pick up that $10 bill quickly, because if we don't, somebody else will and the opportunity will vanish. A recurring theme of A Random Walk Down Wall Street is that any investment theory that becomes too popular will probably fail to work in the future.
For example, the Dogs of the Dow strategy involved buying ten of the thirty Dow Jones Industrial Average stocks with the highest dividend yields. The theory was that these stocks were out of favor and thus represented value.
However, Malkiel tells us that by the mid-1990's, this strategy has performed very badly. Malkiel says that by the mid-1990's, more than $20 billion dollars had poured into mutual funds whose goal was to buy the Dogs of the Dow. Thus, all the buying drove out the value to be offered, and Malkiel writes that "'The Dogs of the Dow' no longer hunt.
Similarly, today, while Malkiel is a big proponent of index funds, he leans more toward the Wilshire 5000 index composed of over 6,000 stocks. Malkiel points out that when a new stock is added to the S&P Index, its price tends to rise about 5%. Thus, all the index buying inflates the price paid for the stocks in the S&P 500.
Incidentally, Malkiel was one of the earliest proponents of index funds, recommending there creation in the earliest editions of A Random Walk Down Wall Street. Today, Malkiel is on the Board of Directors of Vanguard, the leading mutual fund company providing low-cost index funds.
A Random Walk Down Wall Street includes an excellent life-cycle guide to investing with advice about how to divide your portfolio between stocks, bonds, REITs, and other asset classes.
By using index funds, an investor can put together a widely-diversified portfolio. While index funds didn't exist when Malkiel published the first copy of A Random Walk Down Wall Street, today there is an abundance of index funds, including:Vanguard Total Stock Market
Vanguard REIT Index Fund
Vanguard European Index Fund
Vanguard Pacific Index Fund
Vanguard Emerging Markets Index Fund
While Malkiel mentions other non-Vanguard index funds, Vanguard tends to have the lowest expenses, averaging about 0.2 percent.
A Random Walk Down Wall Street also offers some excellent advice about avoiding buying securities in an overvalued market. Malkiel provides some excellent charts showing that, in 1998, the U.S. stock market was overvalued by historical standards.
One chart shows that the dividend yield of the S&P index was at historical lows in 1998. As Malkiel explains, neglecting changes in how stocks are valued (i.e., changing P/E ratios), we can calculate the expected return from a stock or from the general stock market via the formula:
Expected Return = Initial Dividend Yield of Stock + Expected Growth Rate in Earnings
Hence, the initial dividend yield of stocks is an important factor in determining the anticipated return. Buying stocks when the market's dividend yield is low usually means overpaying.
Another chart shows that, in 1998, the value of the U.S. Stock Market was very high relative to the national GDP. This also tended to show an overvalued stock market.
I found these charts indicating current value to be interesting. Similar charts could also be constructed for many other non-U.S. economies, thus giving a means of evaluating if foreign markets were under- or over-valued. Such information could help an investor decide where to index new money most heavily.
While A Random Walk Down Wall Street doesn't give much detailed advice about selecting individual stocks, there is a great deal of general market information which investors will find useful.