Burton Malkiel | Efficient Market Hypothesis ?
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A Random Walk Down Wall Street, by Burton Malkiel.
Malkiel, a Princeton economist, argues that asset prices exhibit signs of a ‘random walk’, which later popularized the random walk hypothesis.
He believes that an investor cannot consistently outperform market averages.
Although, I must say I raised an eyebrow when I read this statement, nonetheless I offer an impartial review of the book for those looking to learn from some of the key topics presented.
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The random walk theory discussed by Malkiel is similar to the efficient market theory. Both suggest that the price reflects all known information about an asset, and both advocate that the only consistent approach to investing is a strategy of buy and hold.
In fact Malkiel went on to say:-
Conversely, on the opposing camp, we have the approach of technical and fundamental analysis, each looking for opportunities conflicting with the concept of random and efficient theories. But which is right? Or can they all be right?
Malkiel does however align all theories and strategies to a common purpose, that is, improving upon a return better than inflation. He said :-
“It is clear that if we are to cope with even a mild inflation, we must undertake investment strategies that maintain our real purchasing power; otherwise, we are doomed to an ever-decreasing standard of living”.
An example of how inflation can slowly erode purchasing power is provided with a Mcdonalds double burger, in 1962 the burger would have cost 28 cents, in 2018 the same burger cost almost five dollars. An increase of 1610%.
Malkiel segregates investing theories into two buckets; The firm foundation theory, and the Castle in the sky theory.
The firm foundation theory argues that stocks or even a piece of real estate have a firm anchor of value, also known as intrinsic value.
For example, fundamental analysts fall into this bucket, they might look for current and future earnings or dividend yields, and then work backwards to determine the intrinsic value of a stock.
Benjamin Graham and Warren Buffet typically follow this firm foundation approach.
Next, the castles in the sky theory looks at what Malkiel calls ‘psychic values’. He alluded that investors were more inclined at analyzing crowd behavior, known by technical analysts and traders as trend following, often without any consideration of the stocks value.
Malkiel said;
“In this kind of world, a sucker is born every minute—and he exists to buy your investments at a higher price than you paid for them, any price will do as long as others may be willing to pay more”.
In theory, the investor looks to buy high but sell higher, the opposite of the firm foundation investors looking to buy low and sell high.
Growth and momentum stocks are the likely selections in this bucket.
In my opinion however you do not need to choose between either, my strategy is a combination of both, which I will call the hybrid theory.
Malkiel expands upon his castles in the sky theory by discussing the madness of crowds.
He notes the irrational exuberance of crowds which have been the cause of many financial bubbles over the years. Including the Dutch tulip craze of the 1600’s, the stock market bubble of 1929, the biotech craze in the 80’s, and more recently the dot com bubble and 2008 real estate bubble.
The bubbles eventually burst, many dropping in price by between 50 and 90%. Using the previous theory, the sucker who bought hoping to sell at a higher price would have been left with a huge loss.
Malkiel gives reason for such irrational exuberance through his lessons of behavioral finance. He said; -
“In investing, we are often our worst enemy, as Pogo put it, “We have met the enemy and it is us,” an understanding of how vulnerable we are to our own psychology can help us avoid the stupid investor delusions that can screw up our financial security”.
Behavioural finance questions the idea of the rational investor, highlighting that there are at least four factors causing irrational investor behaviour:
Overconfidence, Biased judgements, Herd mentality, and loss aversion.
The herd mentality in particular is often the reason for asset bubbles like these, the lure of getting rich quick and getting swept up into speculative investment decisions usually leaves you trampled by the herd.
Malkiel suggests that to make the transition from an irrational to rational investor, we must avoid the herd mentality, over trading, IPO’s, hot tips, and sell losers not winners.
According to the random walk theory, despite becoming a rational investor we are still unlikely to beat the market, although, we are more likely to beat inflation and less likely to suffer huge financial losses.
So how does Malkiel suggest we invest?
He says:-
“The core of every portfolio should consist of low-cost, tax-efficient, broad-based index funds.”
We previously provided some detailed analysis of such advice in our review of the book Common Sense Investing, of which, author John Bogle provided clear evidence supporting Malkiel’s view.
Without repeating information previously covered, we add to the advice, in particular Malkiel provided some allocation principles.
He provided a table which shows a history of performance, and a clear correlation between the risk and return relationship for a given asset.
Here we can see the distribution of returns covering the period between 1926 and 2018.
In terms of distribution and return, we can see a positive bias amongst all the assets.
The point Malkiel makes here is that despite not being able to predict short term asset prices, which is the foundation of his random walk theory, he does acknowledge that over the long term there is some predictability in terms of achieving higher returns from bearing higher risk.
We can see here US treasury bills resulted in minimal risk and minimal return when adjusted for inflation.
In contrast, we can see small cap stocks have seen considerable risk, but they have been compensated by higher returns.
When building your own investment portfolio, it would be wise to consider your equity allocation against these metrics.
Having established a relationship between risk and reward, Malkiel provides advice on reducing risk, specifically, the Modern Portfolio Theory.
The key concept is diversification and the theory was developed by Harry Markowitz in 1950, backed by thorough mathematical justification. He suggests risky, volatile stocks become less risky when combined as a whole.
To simplify the concept, we provide an island which occupies only two businesses.
A resort owner, and an umbrella manufacturer.
We establish a 6-month rainy season and a 6-month sunny season, and each business had the following returns in each season.
We can see both businesses had the same return when looking at the full 12-month period, but individually they had very different results depending on the environment they were in.
A portfolio weighted with too many stocks that react in the same way to certain economic situations, or cyclical environments, can lead to larger drawdowns and erratic performance.
The message therefore is not simply ‘diversification’ over different assets, but diversification over assets which have a ‘negative covariance’.
Too often we hear investors say they have a diversified portfolio, but this often only relates to the ‘number’ of stocks being held. True diversification is holding a portfolio of ‘uncorrelated’ stocks which can reduce risk and volatility when constructed correctly.
Whilst on the subject of risk, diversification, and portfolio size, Malkiel provides further analysis relating to the number of stocks in a portfolio and the associated risk.
Here we can see the number of stocks, and here the assumed risk.
Looking at a typical well diversified US stock portfolio first, we can see that holding one stock assumes 100% risk, holding 5 stocks reduces risk by approximately 15%, and holding 20 stocks reduces risk by almost 50%.
The optimum portfolio size according to the study, suggested a portfolio of at least 50 stocks which provides risk reduction of 60%. Additional stocks thereafter provide minor risk reduction benefits.
The study also gave a comparison using a portfolio of international stocks, and we can see a 50-stock portfolio of diversified stocks across the globe, reduces risk by up to 70%.
Unsurprisingly, the more stocks you add to a portfolio the more your results will resemble the returns of the market, and the less random the walk becomes.
Equally, the longer you hold such a portfolio, the less random the returns become.
We can see in this chart the returns of the S&P 500 index for the period between 1950 to 2017.
Notice how a holding period of just one year can see a range of between a negative 37% return, to a positive 52.6% return.
And in almost a linear fashion, through to a holding period of 25 years, we can see the range is between a 5.9% and 17.5% return. Again, adding weight to Malkiels view that results are random in the short term and less so in the long term.
The final chart offered from our review compounds Malkiels overall opinion; Invest in a fully diversified portfolio or index, make periodic investments benefiting from dollar cost averaging, and take advantage of the immense power of compounding.
Incredibly, a $1 saving in the year 1800 would have compounded to over 27 million by 2021. No wonder Albert Einstein called compounding the greatest mathematical discovery of all time.
In summary, Burton Malkiel believes an investor would be better off buying and holding an index, whilst benefiting from diversification and eliminating the destructive psychological traits that often succumb an investor trying to beat the market.
The book offers excellent in-depth knowledge about investing, and with over 400 pages, its possibly the broadest of its kind. Too much to cover in this short review and a highly recommended purchase.
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