A Random Walk Down Wall Street

There are many theories regarding the fluctuations and patterns of the stock market and the best ways to invest money. Malkiel is a proponent of the Efficient Market Hypothesis, or Theory, known as EMH or EMT, which asserts that the stock market reflects all relevant information immediately. This assertion means that there is no gap period between information becoming relevant and the corresponding change in the price of a stock. As an example, if a pharmaceutical company develops a new drug that will likely sell well and increase the earnings of the company, that corresponding increase in the price of their stock will happen as soon as that information is released, not days after the announcement or even when the drug is actually released. EMH is a debatable theory, as it concludes that no one can consistently beat the market, which forms the basis of Malkiel’s argument in Random Walk.

Malkiel presents two other theories of investing in Random Walk: The firm-foundation theory, which asserts that stocks have an accurate price that the market will either overvalue or undervalue; and the castle-in-the-air theory, which relies on the psychology of investors to determine which stocks are going to rise in value. Malkiel notes that the vast majority of professional investors identify with the firm-foundation theory. These securities analysts believe that they can consistently beat the market through analysis of the supposed real value of stocks. Technicians, or chartists, follow castle-in-the-air theory, also called the greater fool theory, which tries to predict the momentum of a given stock, purchasing during upward momentum to profit off the “greater fool” who will theoretically buy the stock at an even higher price.

Malkiel also discusses modern portfolio theory, or MPT, which attempts to minimize risk by constructing portfolios of multiple assets and asset types to provide a greater return. In Random Walk, Malkiel supports MPT in the sense that he advocates index funds, which essentially minimize risk through total diversification across the entire market. However, MPT is most used by professional mutual fund managers, who try to use different theories within MPT to beat the market, which, according to EMH, is not possible consistently. There are a multitude of remaining theories, including those behind beta, smart beta, and risk parity funds, which try to reduce and manipulate risk to yield greater returns.