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Tom Firey: Four decades of slowly making people rich

March 13, 2013|By THOMAS A. FIREY

Forty years ago this month, Americans received a powerful tool for increasing their wealth when Princeton economist Burton Malkiel’s book “A Random Walk Down Wall Street” first appeared in stores. Instead of offering esoteric strategies to “beat the market” or complex formulas to calculate stocks’ “true value,” Malkiel uses simple language to describe decades of academic research on how those strategies perform. The consensus? Not very well. But rather than disillusioning would-be investors, Malkiel explains that the research points the way to financial success. Now in its 10th edition, “Random Walk” continues to help people “get rich, slowly but surely.”

Most financial analysts can be lumped into two groups: technical analysts and fundamental analysts. The techies examine movements in stock prices, trying to discern patterns that indicate whether investors are about to bid up a stock or sell it off. These analysts pay little attention to the firms they buy and sell, instead studying investors’ behavior so as to take advantage of it. In contrast, the fundamentalists study particular industries and individual firms, trying to determine which ones are in soon-to-boom industries, or have promising products, or employ especially talented managers.

The problem is, over the long term, neither type of analyst proves especially adroit at picking stock market winners and losers. The analysts’ research — and the high fees some investors pay for it — typically provides no better returns than a large, randomly selected bundle of stocks. Or as Malkiel writes, “a blindfolded monkey throwing darts at the stock market listings could select a portfolio that would do just as well as one selected by experts” — and the monkey gets paid in bananas.

Malkiel ascribes to the “efficient market hypothesis”— the idea that stock prices naturally change in light of available information. Especially promising firms indentified by fundamental analysts, and “hot” stocks identified by technical analysts, will have higher stock prices, and that reduces the net profits from those investments. Malkiel stresses that he does not believe markets are perfect or clairvoyant, but “no one person or institution knows more than the market.”

But doesn’t that show the financial world is an irrational, dangerous place that people should avoid? Quite the opposite, Malkiel explains. Because the market is so efficient at incorporating available information, the factors that dramatically alter returns are usually genuine surprises — which can be good or bad. Hence, stock prices look like a “random walk,” shifting up and down as different surprises hit. But that walk typically “drifts” upward because employees and managers like having jobs, and investors like profits, and thus they work to make their firms succeed. Not all succeed, of course, and more than a few are operated by fools and cheats, but the random walk of the broader market moves upward over long periods of time, making lots of money for sensible investors. As Malkiel notes, “An investor with $10,000 at the start of 1969 who invested in a Standard & Poor’s 500-Stock Index Fund would have had a portfolio net worth of $463,000 by 2010” — nearly an eight-fold increase after inflation.

It turns out the blindfolded monkey is a pretty good stock picker, provided he throws enough darts to have a large, diverse portfolio that’s not overly vulnerable to a particular bad surprise. And though few Americans have a dart-throwing monkey, most have access to index funds — the monkey’s low-cost equivalent — through a 401(k) or their bank. Investors should use index funds, and then hold the investments for a long time, not sweating momentary (or even year-long) periods of bad surprises.

Beyond index funds, Malkiel’s book offers other sound advice — which indexes to buy, given a person’s risk tolerance and age; how much money to invest at a given time; how to use insurance to protect financial standing; how to use bonds and real estate to further diversify one’s portfolio; and what factors to consider when buying a home. He also offers advice on avoiding investment manias — periods when the market’s efficiency flags. If people had followed this advice in earlier editions of his book, they would have been much less exposed to the dot-com and housing busts.

Every adult (and soon-to-be-adult) should have a well-read copy of “Random Walk.”

Thomas A. Firey is a senior fellow for the Maryland Public Policy Institute and a Washington County native.

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