In my quest to build wealth, I’ve decided the best way is to gain as much knowledge as I can in investing, and entrepreneurship. I’ve been reading as many personal finance and career focused blogs as possible. Additionally, I’ve been creating a list of investing, personal finance and small business related books. One of the first books I read was “A Random Walk Down Wall Street” by Burton G. Malkiel, who states that past performance of the stock market has no correlation to future performance.
The History of Market Crazes
The first section of the book is about the valuation of stocks throughout the history of the stock market. In my opinion the most important point of this section was about the madness of crowds. Malkiel details the various crazes that the market has experienced beginning with the tulip-bulb craze and ending with the internet bubble of the early 2000’s. It is important to remember as an investor that the market can go through depressing bear markets only to be followed by exuberant bull markets. Remaining grounded when the market hits new highs and preparing to take off again when the market returns to previous lows is a good way to take advantage of the market.
Beating the Market
The next two sections get into how the pros try to beat the stock market. Initially the two methods of evaluating future stock market performance were technical analysis and fundamental analysis. Technical analysis uses stock charts of past performance to look for special buy or sell indicators. Fundamental analysis seeks to learn the proper value of a stock and buy or sell stocks based on the difference between the calculated proper value and stock price.
New Investment Technology
Academics are continually attempting to discover new methods of predicting the stock market, known as new investment technology. The newest methods are modern portfolio theory (MPT), behavioral finance and efficient-market theory. MPT begins with the tenant that the more risky an investment, the higher the return. MPT ends with the idea that you can diversify your portfolio to maximize return for a given risk. Behavioral finance differs from MPT and efficient-market theory in that one believes that investors are rational while the other believes they are irrational. Behavioral finance claims individual investors are overconfident, make biased judgements, go with the flow and are more averse to losing than winning. The efficient-market theory suggests that the stock market is extremely efficient at rapidly and accurately reflecting new information.
A Guide to Investing in the Random Walk
The final section provides Malkiel’s guide for navigating the random walk that is the stock market. At first Malkiel goes through the different investment options such as stocks, bonds, money-market accounts and real estate and continues with the different investment vessels such as a 401k/403b, IRA and pension. He also warns that the quickest way to decrease your nest egg is to invest in funds with fees and loads.
Malkiel breaks asset allocation down into five principles:
- History shows that risk and return are related.
- The longer the investment in common stocks and bonds are held, the lower the risk.
- Dollar-cost averaging reduces the risk of stock and bond investment.
- Rebalancing can reduce risk and in some instances increase returns.
- Distinguishing between your attitude toward risk and your capacity for risk is important.
Finally, Malkiel discusses index funds, mutual funds, ETFs and individual stocks as well as the fees and loads associated with investing in each.
Overall, I found Malkiel’s book to be extremely informative and not as dry as you might imagine an investment book to be. I highly recommend reading this book if you are beginning your pursuit of investing knowledge. I will buy this book as soon as the down payment for my condo is completed and I begin focusing more on investing.
Malkiel made two points that I find very interesting and completely agreed upon in all circles of investing. He suggests keeping a small reserve in a money fund to dump into the stock market when sharp declines occur, as the upswings in the market are where the best returns exist. Also, he advises if at all possible to own a home because the interest payment and property taxes are deductible and realized gains are tax-exempt. What are your thoughts?