Hedge Funds & Wall Street
A Random Walk Down Wall Street
Malkiel spent thirty years arguing that the chart on your screen holds no information you can trade on, and he brought the tests to back it. This is the strongest opposition case on the shelf, and the one book here whose central claim has gotten more right since publication, not less.
The one idea
Malkiel's claim is narrow and it is testable: the past path of a price tells you nothing useful about its next move, and neither does any published fact about the company. Not because prices are meaningless, but for the opposite reason. If enough people are hunting for an advantage, whatever any of them finds is already in the price by the time you see it. A signal everyone can see is not a signal. It is a price.
He backs this with a demolition rather than a theory. He had students build stock charts by flipping a coin (start at $50, heads is up half a point, tails is down half a point) and the charts came out with head-and-shoulders tops, triple bottoms, and clean breakouts. A chartist friend saw one and wanted to buy immediately. Then he walks through the machine tests: filter rules from 1 percent to 50 percent run on data back to 1897, Dow theory, relative strength over a 25-year window, price-volume rules, the 200-day moving average, and a computer scan of 548 New York Stock Exchange stocks over five years hunting for 32 named chart patterns. After trading costs, not one beat simply buying and holding. In one of those tests, the strategy that came closest to above-average returns was buying right after a bear signal.
The second half of the argument is more expensive to ignore. He does the same audit on the professionals who dismiss charting. He and John Cragg collected earnings forecasts from 19 major Wall Street firms and found the five-year estimates were worse than assuming every company grows at the rate of national income, and the one-year estimates were worse still. A Harvard and MIT study of the 1,000 most-followed companies put the average annual forecast error at 31.3 percent. For the ten years to June 30, 1998, the average general equity fund returned 15.24 percent a year against 18.56 percent for the S&P 500. Over the 25 years since his first edition, more than two-thirds of fund managers lost to an unmanaged index. His conclusion is not that everyone is stupid. It is that fees, spreads, turnover, and taxes are a certain cost paid against an uncertain gain.
What it actually teaches
The actual instructions live in the last four chapters, they run in order, and buying stocks is the last thing you do.
COVER THE DOWNSIDE FIRST
Exercise 1 in his fitness manual. Buy renewable term insurance rather than whole life, because your early premiums on a cash-value policy go mainly to commissions and overhead, then invest the difference yourself inside a tax-sheltered plan. Hold a liquid reserve so a job loss never forces you to sell stock at the bottom (he treats three months of living expenses as satisfactory for many people). Any expense with a known date, like a tuition bill, gets funded by a bond that matures on that date, not by equities.
SHELTER EVERY DOLLAR YOU LEGALLY CAN
Exercise 3. Max the workplace plan and the IRA before anything else, and put the bonds inside the shelter first, since interest is taxed hardest. Annuities only after the retirement plans are full, because their costs run high. His evidence for why this matters more than stock picking: Joel Dickson and John Shoven at Stanford tracked 62 long-record mutual funds and found a dollar invested in 1962 grew to $21.89 by 1992 before tax, but only $9.87 after tax for a high-income holder. Tax was a bigger drag than manager skill.
SET THE STOCK AND BOND SPLIT BY AGE
Chapter Thirteen. His rule of thumb is that the bond percentage should sit roughly equal to your age. The worked portfolio for someone in their mid-fifties: 5 percent cash, 37.5 percent bonds (with 5 percent of the total portfolio in inflation-protected Treasuries), 12.5 percent real estate trusts, and 45 percent stocks split 34 percent United States, 7.5 percent developed international, 3.5 percent emerging markets. Even in the late sixties he keeps 25 percent in regular stocks and 15 percent in real estate so the income can outrun inflation.
BUY THE WHOLE MARKET, NOT THE S&P 500
Chapter Fourteen, and this is where he revises his own earlier advice. He now prefers a total market fund tracking the Wilshire 5000 over an S&P 500 fund, for two reasons. First, S&P indexing got so popular that being added to the index pushed a stock up by more than 5 percent on its own, which makes index members slightly expensive. Second, the S&P 500 is only about 75 percent of United States market value, and from 1926 to 1997 smaller stocks returned more than 12.5 percent a year against roughly 11 percent for large ones. He also says never hold only United States stocks: add international and real estate.
PAY ALMOST NOTHING AND TRADE ALMOST NEVER
The whole gap comes from costs, not from stock selection. Index funds in 1998 charged under 0.2 percent a year. Actively managed funds averaged 150 basis points, and turnover near 100 percent cost another 0.5 to 1 percent on top. The Plexus Group put professional trading costs as high as 0.8 percent of the amount traded, which at 50 percent turnover is another 80 basis points. Add capital gains tax on every realized trade. Malkiel's point is arithmetic, not opinion: active managers as a group hold the market, so as a group they must lose to it by exactly these costs.
ONLY THEN, IF YOU MUST PICK STOCKS
He gives four rules and says up front he does not recommend the exercise. One, buy only companies that look able to sustain above-average earnings growth for five years or more. Two, never pay more than a firm foundation of value justifies: buy multiples in line with or not much above the market's, which he calls an adjusted low price-to-earnings strategy (low P/E relative to growth, the way Peter Lynch ranked 50 percent growth at a P/E of 25 above 20 percent growth at a P/E of 20). Three, favor a story the crowd can build castles in the air on. Four, trade as little as possible, but sell your losers before year-end so the loss offsets tax.
What it looks like Monday morning
You stop paying for the parts of your process that cost money and return nothing. Pull the expense ratio on every fund you own and put it next to a broad index fund's. Pull your realized trading volume for the year and multiply it by your all-in cost per round trip. Malkiel's argument is that these two numbers, not your stock selection, explain most of the distance between your account and the index. Then check where your bonds sit: if they are in a taxable account while your stocks sit in the retirement account, you have the tax treatment backwards.
For the charting half, the actionable test is the one Malkiel keeps applying and most traders never do: run your rule on data from a period other than the one you found it in. His whole case against systems is not that they fail in-sample, it is that people almost never check out-of-sample, and that any regularity strong enough to be worth trading gets arbitraged away once it is published. He names Dogs of the Dow as the live example: it beat the index by 2 to 3 points a year in James O'Shaughnessy's tests back to the 1920s, attracted more than $20 billion of fund money by the mid-1990s, then underperformed for the rest of the decade. Its own inventor said the strategy became too popular.
| Fund category | All funds each year (net) | Survivors only (net) | S&P 500 | All funds (gross of fees) |
|---|---|---|---|---|
| Capital appreciation | 16.32% | 18.08% | 17.52% | 17.49% |
| Growth | 15.81% | 17.89% | 17.52% | 16.81% |
| Small-company growth | 13.46% | 14.03% | 17.52% | 14.53% |
| Growth and income | 15.97% | 16.41% | 17.52% | 16.89% |
| Equity income | 15.66% | 16.90% | 17.52% | 16.53% |
| All general equity funds | 15.69% | 17.09% | 17.52% | 16.70% |
Read the last row across: survivors look like they nearly matched the index, but the full universe including funds that were quietly merged away trailed it by almost 2 points, and even before charging a single fee the universe still lost.
Technical strategies are usually amusing, often comforting, but of no real value.Burton G. Malkiel, A Random Walk Down Wall Street
Where it fails
- The trading costs his argument leans on have collapsed. A large share of his case is not that the pattern is fake, it is that the pattern is real but too small to trade. He rejects the January effect, short-horizon momentum, and part of the small-stock premium on exactly that basis, citing retail commissions of almost a dollar a share and the Plexus Group's 0.8 percent institutional trading cost. Commissions at United States brokers are now zero and spreads are pennies, which weakens the plank rather than the conclusion. Momentum specifically did not stay unexploitable: it became one of the most replicated findings in finance and is sold in cheap funds today. Malkiel goes further than his own evidence allows when he climbs, in his words, out on a limb to argue that no technical scheme whatever could work for any length of time, having just conceded that no economist can prove that.
- He tests the retail chart book, not systematic trend following. Every study he cites is a single mechanical rule applied to individual stocks: filter rules, Dow theory, relative strength, price-volume, and a computer scan of 548 stocks for 32 named patterns. That is a fair and fatal test of what a brokerage chart service sells to a retail account. It is not a test of a diversified, risk-controlled trend program running across dozens of uncorrelated futures markets with position sizing and hard stops, which is what the systematic trading industry actually runs and which has a long documented record. Managed futures does not appear in the book. If you came to see the strongest version of the other side dismantled, this is not it.
- His defense of the 1987 crash cannot be falsified. The Chapter Ten appendix explains a one-third drop in a single month with arithmetic: rate of return equals dividend yield plus growth. Long Treasury yields moved from 9 percent to 10.5 percent, the equity risk premium moved from 2 percent to 2.5 percent, and his index falls from $100 to $71.43. The math is right. It is also right for any decline of any size, because the risk premium is unobservable and can be set after the fact to whatever the price requires. Malkiel half-admits this when he writes that fundamental value is never a definite number but a fuzzy band. A band wide enough to swallow a 33 percent crash is a band wide enough to make the theory untestable, and Robert Shiller's excess-volatility challenge gets an answer of this kind rather than evidence.
- He argues both sides and calls it the middle of the road. Chapters Six and Seven prove fundamental analysis does not produce excess returns. Chapter Fourteen then hands you four rules for doing fundamental analysis, including Rule 3, which asks you to guess which story will catch the fancy of the crowd, the precise castle-in-the-air timing he says nobody can do. He closes that section by calling the late 1990s potentially the ideal time to pick individual stocks using his rules, which is a market-timing call from the author of a section titled The Verdict on Market Timing. Chapters One through Three catalog four centuries of manias in loving detail, including the Internet craze he was watching as he wrote. His reconciliation is that the market may not always be rational in the short run but always is over the long haul, a claim you cannot check on any timescale you will live through.
- The 1999 shopping list is dead and the tax chapter is wrong. Roughly half of this edition is a general personal-finance manual pinned to 1998 United States tax law and 1998 products: whole life versus term, Keogh plans, Roth rules, money-market deposit accounts, bank certificates, zero-coupon bonds, wrap accounts at 3 percent a year. The specific portfolio in Chapter Fourteen names funds like Dreyfus Bond Market Index (Basic), Schwab 1000 Investor, and the Vanguard Tax-Managed Growth and Income Portfolio with its 2 percent redemption fee inside a year. He calls an expense ratio of 0.2 percent remarkably cheap, and broad index funds now run at a fraction of that, while exchange-traded funds solve the capital gains problem more cleanly than the deferral mechanics he describes. Every number in this write-up comes from the 7th edition (1999). Malkiel revises between editions: he dropped the practice of naming superior managers that earlier editions carried, and downgraded his own Malkiel Step (buying closed-end funds at a discount) once the discounts narrowed. Later editions add chapters on exchange-traded funds, behavioral finance, and factor investing that are not here.
- It assumes a long horizon and a steady paycheck, and mentions it only in passing. The method needs two things the book cannot supply. Dollar-cost averaging, his answer to entry timing, requires in his own words both the cash and the courage to keep investing during bear markets as regularly as in better periods, and he admits it is not the right approach for a lump sum such as an inheritance. The life-cycle guide assumes decades of employment income ahead of you. And the claim that stocks get safer the longer you hold them, which he borrows from Jeremy Siegel and which does a lot of work in his allocation advice, is the part a bad draw can break. The Japanese market he uses elsewhere as his own bubble case study spent more than three decades below its 1989 peak, longer than most people's working lives.
- Every case study he picks is a loser. His technicians are Joseph Granville (told 3,000 subscribers to sell everything on January 6, 1981, then spent the decade telling them to short a market that ran from 800 to 1,200), Robert Prechter (called Dow 3,686, then after October 1987 predicted the Dow would fall below 400 and missed the recovery), Elaine Garzarelli (nailed the 1987 crash to within a week, then underperformed every year until she left her fund in 1994), and the Beardstown Ladies (claimed 23.9 percent a year until Price Waterhouse recalculated it at 9.1 percent). The consistent winners inside his own tables, Templeton, Magellan under Peter Lynch, Buffett, get labeled chance and waved off in a sentence. His coin-flipping parable is a real argument for why some winners must exist by luck alone, but he never runs the statistical test on the actual survivors. That is selection working in his favor, the mirror image of the survivorship bias he correctly nails in the fund data.
Who it is for
Buy it if
Buy it if you trade off charts and have never had the case against them put properly, with the actual studies rather than a sneer. Buy it if you pay someone a percentage to manage money, because Chapter Ten is the most complete accounting anywhere of what that percentage costs you and how survivorship bias hides it. Buy it if you want the honest version of the opposing argument, since Chapter Ten spends thirty pages taking the anomalies seriously before rejecting them.
Skip it if
Skip it if you already index and already know why, because you will pay for 250 pages of 1998 personal finance to reread an argument you accept. Skip it if you want a working system, since the book's explicit position is that no system exists and its own four stock-picking rules are an afterthought Malkiel does not recommend. Skip it if you trade futures or run systematic strategies across markets, because he never engages with that and his tests do not reach it.
As an Amazon Associate I earn from qualifying purchases. It costs you nothing extra, and it does not change what gets recommended or what the verdict says.
Reviewed here is the seventh edition (1999). The link goes to the current edition. The core evidence against charting is unchanged, but the fund recommendations and every dated figure above belong to the 1999 text.
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