A Random Walk Down Wall Street

Malkiel reiterates that single investors can outperform professionals, and he says this book will teach the reader practical advice on a variety of financial choices, though the focus is on common stock investments. A random walk means that history cannot be used to predict future activity; applied to stocks, it means that predicting the fluctuations of the market is useless. Malkiel frames this theory as a matter of academics against professionals, in which academics continually develop new theories while professionals assert their predictive prowess. Malkiel presents his qualifications, noting that he began as an investor on Wall Street, moving into reputable positions in large investment firms and academia, all of which inform his ability to explain the process of investing and the dynamics of the stock market. A minimum goal for investing, Malkiel says, is to earn at least enough to offset inflation, which is the continual decrease in the buying power of money. Malkiel predicts that inflation will continue to increase, and he notes that investing requires careful management of where and how to invest funds to avoid losses.

Malkiel describes two investment theories: the firm-foundation theory and the castle-in-the-air theory. The firm-foundation theory proposes an intrinsic value to stocks, advocating buying stocks that are temporarily below their intrinsic value and selling stocks that are temporarily above their intrinsic value. Malkiel is skeptical of firm-foundation theory, though he notes that well-known investors, like Warren Buffet, have found success in following firm-foundation theory. Castle-in-the-air theory, developed by John Maynard Keynes in the 1930s, relies on the psychology of the market, trying to predict how other investors will value a given stock. Keynes’s theory is to buy stocks that other people are likely to view as sound investments, as the other investors will increase demand and drive up the value of the stock. At that point, the initial investor, Keynes, would sell to the new investors, taking in a profit created by the predicted increase in demand. While the firm-foundation theory relies on the actual value of an investment, castle-in-the-air relies on the perceived value of an investment, and both can result in either success or failure.

Castle-in-the-air theory can be profitable, but it is rarely sustainable, with Malkiel warning against “overguessing” crowd responses to market changes. From 1593 to 1637, Holland underwent a tulip boom, in which people invested heavily in various tulips that were brought from Turkey. The price of tulips continued to increase over this period, during which time people bought and sold tulip bulbs much like stocks today. A new financial instrument, the “call option,” allowed buyers to purchase tulips at a preset price, which allowed them to buy and sell immediately when the market price increased. In 1637, the price of bulbs increased dramatically, then fell more dramatically as people decided to sell at incredibly high prices. After the collapse, the government tried to settle contracts to buy tulip bulbs, but it failed, as people refused to carry out contractual purchases for much higher prices than the bulbs were then worth.

The South Sea Company, formed in 1711, promised to engage in trade with South America and included taking on the debt of the English government. A similar company, the Mississippi Company, arranged to print paper money in place of using metal as currency. Public speculation led to large investments in the South Sea Company, which quickly drove up the price of their stock. Many other companies, called bubble companies, attempted to imitate the South Sea Company, which promised outlandish projects, drew in investors, then failed, taking whatever money was invested with them. Both the South Sea and Mississippi Companies ultimately failed, resulting in England passing the Bubble Act in 1720 to prevent private companies from issuing stock. In the 1920s in the United States, a similar process of speculative overpricing occurred, culminating in the stock market crash of 1929 that led to the Great Depression, an extended economic downturn that lasted through the 1930s. Part of the issue in the 1920s was investment pools, in which a group of investors would use inside knowledge and wash sales, in which they sold shares to each other at controlled prices, to create the false impression of public interest, which would then develop into real public interest as people saw the wash sales accumulate. Malkiel emphasizes that many modern economists try to make rational sense of events like the tulip boom, and, while they make good points, Malkiel largely believes these instances to be irrational and unpredictable.

The “tronics boom” of the early 1960s involved companies using names that reminded buyers of electronics to artificially inflate the price of their stocks. Much like the Dutch tulips and the South Sea Company, these companies’ stocks rose in value beyond what their material assets and production warranted, leading to another crash in 1962. During this time, the SEC, or Securities and Exchange Commission, which Malkiel notes could not prevent large-scale speculation, was only able to shut down some brokerage firms responsible for the “new-issue” boom. New-issue refers to companies “going public” or issuing additional stock, in which new stock is issued for exchange. The same kind of new-issue boom and crash happened in 1983, as well.

In the late 1960s, conglomeration, or the combining of two companies into one, became a way to artificially exhibit growth. By merging with a company with a lower earnings multiple, a company with a higher earnings multiple can increase their earnings per share, which then appears as growth to potential investors. Malkiel provides a hypothetical example, as well as two real-world examples: Automatic Sprinkler Corporation and Litton Industries, each of which engaged in multiple mergers over the 1960s that made it look as though their businesses were growing. However, by the end of the 1960s, their stock value fell back down, and the SEC and accounting professions began investigating the legitimacy of conglomerations.

In the 1970s, investment managers favored the Nifty Fifty, or the top growth “blue-chip,” meaning reputable companies, such as McDonald’s, Disney, and IBM. Speculation on these companies raised their earnings multiples into the 80-90 range, which led to a crash in 1980 as investors realized that no amount of speculated growth could justify such high prices. Illustrating fraud, Malkiel includes the story of Barry Minkow, who started ZZZZ Best carpet cleaning company in the 1980s, achieving astounding growth in a short period of time. Minkow was laundering money for organized crime while embezzling from his investors, which resulted in a 25-year prison sentence. After leaving prison, Minkow assisted the government in investigating fraud and became a pastor, though he was later convicted of securities fraud and embezzlement, again. As a non-American example, Malkiel details how real estate speculation in Japan led to a boom in stock prices during the late 1980s, which subsequently crashed, and the Japanese stock market, as of 2022, has not recovered to its 1989 levels.

In the early 2000s, the dotcom boom resulted from speculation regarding Internet business. Many such businesses offered little to no profitability, but investors dedicated over $1 trillion by 2002 to these businesses, which largely disappeared after the crash. Some analysts, like Mary Meeker, Henry Blodgett, and Jack Grubman became both rich and famous by speculating publicly on Internet companies. They created new metrics to measure the profitability of websites, including the number of visitors on a site or the amount of content used between different websites, none of which measured actual revenue. After the crash, all three notable analysts received death threats and were ridiculed in the media. Trading stocks became easier, allowing regular people, encouraged by news and magazines, to start investing. Fraud was prevalent, as companies like Enron overstated earnings and profitability.

In 2007-2008, a bubble burst in the housing market, as a combination of unethical lending and investing practices reached its peak. Banks would sell their mortgages to investment companies, which would combine mortgages into investment packages, split them into tranches, and trade them like securities. Many of these tranches were purchased with borrowed money, and companies began selling insurance to cover the cost if the investment went under. As a result, many people were allowed to take out mortgages they could not afford, and housing prices increased, leading to foreclosures and defaults on loans. When the bubble burst, even the largest organizations involved in the trading of mortgages faced bankruptcy, and the government had to step in to prevent total collapse.

Cryptocurrencies like Bitcoin, which are generated and maintained through a network of computers, may present a new bubble, though Malkiel does not offer a speculation on a potential crash. Meme stocks, named from their origin in Internet movements, can create short-term booms and crashes. He uses the example of GameStop, a company that sells video games and hardware, which was artificially inflated by users of the website Reddit with the specific purpose of abusing hedge funds that tried to make a quick profit from GameStop’s low-value stock. Malkiel concludes the chapter reiterating his point that the market is volatile, and the key to sound investing is to avoid getting drawn into bubbles and booms that can take in investments without paying anything out in the end.