Keeping up with the Dow-Joneses

A Random Walk down Wall Street
April 5, 1996

Every year my grandmother used to buy a colourful wall calendar full of pious stories of saints and advice to farmers as well as humorous anecdotes, recipes and practical advice, such as how to remove grease spots from your frock without damaging the material.

She did so not only to be kind to the Franciscan missionary monk who used to peddle it door to door, but also because she enjoyed reading bits of the calendar daily.

The modern equivalent of that wall calendar is the American investment advice book. I say this with a straight face and without intending to be offensive or patronising towards Burton Malkiel's most entertaining and useful book, A Random Walk Down Wall Street.

Just as I had great affection and esteem for the Franciscan monk, I have great respect for the author and his thorough work. The book is in its sixth edition, a proof of success few authors of bestsellers can claim. And I just love his piglets' faces that express happiness or grief at various option strategies.

It is remarkable that an academic can, in more than 500 pages, succeed in communicating consistently with his target audience, the great public at large, at a level that is understandable and enjoyable, simple, without sacrifice of the basic underlying theory. It is even more remarkable that he also succeeds in retaining the interest of practitioners like myself throughout the book, as it is well known that such people tend to have an attention span of 30 seconds.

In a way it is like writing books for children. Not only does it take great skill, but also great empathy. And Malkiel indeed shows great empathy with the public, the Smiths of one of his stories, by treating their needs and their sentiments with great respect when faced with the investment decision. He does this regardless of the fact that the magnitude of such decisions may be an infinitesimal fraction of those he faces himself as an investor or as a trustee.

Halfway through reading his text, I looked through various investment books from the late 1960s to date. Most of those books either sold theories long forgotten or were clumsy attempts at vulgarisation of the latest research, dressed in formulas, a bit like the way some lawyers once used Latin to try to cover up their ignorance of the law. It takes deep knowledge to express complex issues clearly and simply and, needless to say, none of those books ever made a second edition.

In praising this book, I am at risk of being left bereft of any friends, in the City, Wall Street, Zurich or Chicago. In fact, Malkiel savages without mercy, but with good humour, technical analysts or chartists, security analysts or fundamentalists as well as beta worshippers and active investment managers.

If placed in charge of the industry and true to his convictions, he would with one stroke put more than half of those employed in financial services out of their misery and out of a job. I can almost see the glee in the eye of the passive investment manager, the only friend I would have left, reading through the pages with ever-increasing appetite. He would be thankful someone was finally doing away with those dreadful active investment managers and their red braces, those awful salesmen and their pompous analyst colleagues and those technicians with a personality bypass or those mathematicians on an outing into the field of finance, with their scaring and obsessive stochastic calculus armoury and their irritating absent-mindedness.

I like my friends, whether they be active or passive investment managers, technicians or fundamentalists, so I must state upfront that I do not agree with Malkiel's wholesale disqualification of the profession, but I do agree that there is a lot of mediocre talent in the industry and that the "winner takes all" approach often applies to the winner of one game, rather than the winner of the tournament.

Malkiel spices up his teaching with stories and anecdotes, from the tulip bulb craze and the South Sea Bubble to the crash of October 1987. Having read historians' accounts of the first two events and having lived and worked through the last, I was pleasantly surprised to see that, while making past and recent financial history accessible to all, he did not deviate from the core truths and did not surrender to the temptation to romanticise.

Great are his quotations: "I failed to believe my own charts" - the technician (I have also heard a dozen or so chartists say the same in 25 years); "Patience is the necessary ingredient of genius" - Disraeli; "In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well" - J. Kenfield Morley.

Great are his maxims: "If you can remain calm when everyone around you is panicked, perhaps you don't understand the problem"; "Some things in life can never fully be appreciated or understood by a virgin. The same might be said of the stock market."

Good are his financial cook-book recipes: "Make the proportion of bonds in your portfolio almost equal to your age" or "the longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio".

Sound, down-to-earth advice comes in "A fitness manual for random walkers", in ten healthy exercises and final checkup, and a framework in four key principles is reconfirmed in "A life-cycle guide to investing".

In short, though, as Malkiel states more than once, he is "a weak or semi-strong random walker", that is, one of those proponents of the efficient market theory who do leave some small space - not much - to fundamental analysis and insider knowledge.

Most of the rest of the book descends from that belief, but the author does share with us several insights that are original and some predilections that are not generally shared, such as for the Wilshire 5000 Index as opposed to the S & P 500.

In introducing the concept of random walk he reminds us that "taken to its logical extreme, it means that a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts", and he justifies the practitioners' early reaction to the academics on the basis that "financial analysts in pin-striped suits do not like being compared with bare-assed apes".

To explain the castle-in-the-air theory Malkiel borrows from Keynes: "It is analogous to entering a newspaper beauty-judging contest in which you have to select the six prettiest faces out of 100 photographs, with the prize going to the person whose selections most nearly conform to those of the group as a whole. The smart player recognises that personal criteria of beauty are irrelevant in determining the contest winner."

He chastises the everlasting ability of investors to be easily conned by recalling some of the corporate talk of the 1960s: "market matrices, core technology fulcrums, modular building blocks, and the nuclear theory of growth". However, he shies away from analysing the con-talk of the 1990s, perhaps to avoid losing the few remaining friends left on the other side of the investment divide.

Remarkably he does a pretty good job at explaining postfactum the rationale for the crash of 1987. Courageously he judges that "the standard of ethics in Wall Street are very high". He misses two opportunities, however. Having stated that "option premiums fluctuate reasonably closely around the values suggested by the Black-Scholes model", he fails to look beyond that. What else did he expect if the majority of practitioners use slight variation of Black-Scholes to price their options? But what will happen when a critical mass of intermediaries and principals come to adopt more sophisticated models?

Furthermore, he recognises that "the S & P indexing strategy has become so popular that it has actually affected the pricing of the component stocks in the index", but fails to admit that this is the natural evolution he has indeed proposed.

So, what is next? The underlying common stock only as an auxiliary device for the mass of investments in index derivatives? He does not say. And in any case, why not? After all, today we carry cash only as an emergency auxiliary device for those times when that more fungible and more leveraged instrument, the credit card, is not accepted.

But, then, what will happen to the corporations' capital-raising efforts and to corporate governance when we shall all be invested in indexed funds? I would have liked to have learned Malkiel's views on this.

Only one minor detail caused raised eyebrows. For a book published on both sides of the Atlantic, the absence of a chapter dedicated to the United Kingdom or the European investor and the total focus on the United States investor reminds me again of my grandmother's wall calendar: it was sold in town, but the advice was only for farmers.

Rudi Bogni, former chief executive of Swiss Bank Corporation, London, is currently on a research sabbatical at Imperial College.

A Random Walk down Wall Street: Including a Life-Cycle Guide to Personal Investing

Author - Burton G. Malkiel
ISBN - 0 393 03888 2
Publisher - W.W. Norton
Price - £19.95
Pages - 522

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