A Random Walk Down Wall Street

Text in black are quotes; text in green are my notes. I sometimes write in Spanish.

• In an efficient market, there are no possibilities for earning extraordinary gains without taking on extraordinary risks. #

• GREED RUN AMOK has been an essential feature of every spectacular boom in history. In their frenzy, market participants ignore firm foundations of value for the dubious but thrilling assumption that they can make a killing by building castles in the air. #

• Tuesday, October 29, 1929, was among the most catastrophic days in the history of the New York Stock Exchange. Only October 19 and 20, 1987, rivaled in intensity the panic on the exchange. More than 16.4 million shares were traded on that day in 1929. (A 16-million-share day in 1929 would be equivalent to a multibillion-share day today because of the greater number of listed shares.) #

• This system fundamentally changed in the early 2000s to what might be called the “originate and distribute” model of banking. Mortgage loans were still made by banks (as well as by big specialized mortgage companies). But the loans were held by the originating institution for only a few days, until they could be sold to an investment banker. The investment banker would then assemble packages of these mortgages and issue mortgage-backed securities—derivative bonds “securitized” by the underlying mortgages. These collateralized securities relied on the payments of interest and principal from the underlying mortgages to service the interest payment on the new mortgage-backed bonds. #

• This new system led to looser lending standards by bankers and mortgage companies. If the only risk a lender took was the risk that a mortgage loan would go bad in the few days before it could be sold to the investment banker, the lender did not need to consider the creditworthiness of the borrower. #

• Moreover, so-called NINJA loans were common—those were loans to people with no income, no job, and no assets. Increasingly, lenders did not even bother to ask for documentation about ability to pay. Those were called NO-DOC loans. #

• The lesson, however, is not that markets occasionally can be irrational and that we should therefore abandon the firm-foundation theory of the pricing of financial assets. Rather, the clear conclusion is that, in every case, the market did correct itself. The market eventually corrects any irrationality—albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic, and often they attract unwary investors. But, eventually, true value is recognized by the market, and this is the main lesson investors must heed. #

• And there is abundant empirical evidence that most day traders lose money. It is not hard, really, to make money in the market. As we shall see later, an investor who simply buys and holds a broad-based portfolio of stocks can make reasonably generous long-run returns. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges. #

• We can summarize the discussion thus far by restating the first two rules: Look for growth situations with low price-earnings multiples. If the growth takes place, there’s often a double bonus—both the earnings and the multiple rise, producing large gains. Beware of very high multiple stocks in which future growth is already discounted. If growth doesn’t materialize, losses are doubly heavy—both the earnings and the multiples drop. #

• Human nature likes order; people find it hard to accept the notion of randomness. No matter what the laws of chance might tell us, we search for patterns among random events wherever they might occur—not only in the stock market but even in interpreting sporting phenomena. #

• The psychologists conjecture that the persistent belief in the hot hand could be due to memory bias. If long sequences of hits or misses are more memorable than alternating sequences, observers are likely to overestimate the correlation between successive shots. When events sometimes do come in clusters and streaks, people refuse to believe that they are random, even though such clusters and streaks do occur frequently in random data such as are derived from the tossing of a coin. #

• Financial forecasting appears to be a science that makes astrology look respectable. #

• I do not mean to imply that Wall Street analysts are incompetent and simply parrot back what managements tell them. But I do imply that the average analyst is just that—a well-paid and usually highly intelligent person who has an extraordinarily difficult job and does it in a rather mediocre fashion. Analysts are often misguided, sometimes sloppy, and susceptible to the same pressures as other people. In short, they are very human beings. #

• Portfolio theory begins with the premise that all investors are like my wife—they are risk-averse. They want high returns and guaranteed outcomes. #

• Basically, beta is the numerical description of systematic risk. Despite the mathematical manipulations involved, the basic idea behind the beta measurement is one of putting some precise numbers on the subjective feelings money managers have had for years. The beta calculation is essentially a comparison between the movements of an individual stock (or portfolio) and the movements of the market as a whole. #

• Now, the important thing to realize is that systematic risk cannot be eliminated by diversification. It is precisely because all stocks move more or less in tandem (a large share of their variability is systematic) that even diversified stock portfolios are risky. Indeed, if you diversified perfectly by buying a share in a total stock market index (which by definition has a beta of 1), you would still have quite variable (risky) returns because the market as a whole fluctuates widely. #

• Basically, there are four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion. #

• Steve Forbes, the longtime publisher of Forbes magazine, liked to quote the advice he received at his grandfather’s knee: “It’s far more profitable to sell advice than to take it.” #

• As the economic historian Charles Kindleberger has stated, “There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.” And as Robert Shiller, author of the best-selling Irrational Exuberance, has noted, the process feeds on itself in a “positive feedback loop.” #

• This illustrated the effect of “framing” as well as risk-seeking preferences in the domain of losses. When doctors are faced with decisions regarding treatment options for people with cancer, different choices tend to be made if the problem is stated in terms of survival probabilities rather than mortality probabilities. #

• Charles Ellis, a longtime observer of stock markets and author of the brilliant investing book Winning the Loser’s Game, observes that, in the game of amateur tennis, most points are won not by adroit plays on your part but rather by mistakes on the part of your opponent. So it is in investing. #

• Any investment that has become a topic of widespread conversation is likely to be hazardous to your wealth. It was true of gold in the early 1980s and Japanese real estate and stocks in the late 1980s. It was true of Internet-related stocks in the late 1990s and condominiums in California, Nevada, and Florida in the first decade of the 2000s, as well as bitcoin, GameStop, and AMC Entertainment in 2021. #

• Fidelity’s analysis covered 5.2 million customer accounts from 2011 to 2020. They found that female customers earned on average considerably more than their male counterparts. The source of women’s superior returns was the way they trade, or more accurately, their propensity not to trade. Male Fidelity customers traded twice as often as female customers. Vanguard saw similar patterns during the same decade. The evidence suggests that trading too much is hazardous to your wealth. #

• A “paper loss” is just as real as a realized loss. #

• My advice is that you should not buy IPOs at their initial offering price and that you should never buy an IPO just after it begins trading at prices that are generally higher than the IPO price. Historically, IPOs have been a bad deal. In measuring all IPOs five years after their initial issuance, researchers have found that IPOs underperform the total stock market by about 4 percentage points per year. The poor performance starts about six months after the issue is sold. Six months is generally set as the “lock-up” period, where insiders are prohibited from selling stock to the public. Once that constraint is lifted, the price of the stock often tanks. #

• Investors should also never forget the age-old maxim “If something is too good to be true, it is too good to be true.” #

• James Comey of FBI fame. Comey has said, “I’ve been ‘probed’ in this strange field trip through life. I’ve testified in court, I have briefed the president of the United States repeatedly, I’ve argued in front of the United States Supreme Court, and I’ve been probed at Bridgewater. And Bridgewater is by far the hardest.” And for all you can criticize Ray Dalio, Comey said, “he is one smart bastard.” #

• If you want a get-rich-quick investment strategy, this is not the book for you. I’ll leave that for the snake oil salesmen. You can only get poor quickly. To get rich, you will have to do it slowly, and you have to start now. #

• The two steps in this exercise—finding your risk level, and identifying your tax bracket and income needs—seem obvious. But it is incredible how many people go astray by mismatching the types of securities they buy with their risk tolerance and their income and tax needs. #

• There is no sure and easy road to riches. High returns can be achieved only through higher risk-taking (and perhaps through accepting lower liquidity). #

• The amount of risk you can tolerate is partly determined by your sleeping point. #

• According to Roger Ibbotson, who has spent a lifetime measuring returns from alternative portfolios, more than 90 percent of an investor’s total return is determined by the asset categories that are selected and their overall proportional representation. Less than 10 percent of investment success is determined by the specific stocks or mutual funds that an individual chooses. #

• 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. #

• If possible, keep a small reserve (in a money fund) to take advantage of market declines and buy a few extra shares if the market is down sharply. #

• Vanguard REIT Index Fund (VGSLX) or Fidelity Real Estate Index Fund (FSRNX) #

• TLH is the crown jewel of tax management. It involves selling an investment that is trading at a loss and replacing it with a highly correlated but not identical investment. Doing so allows you to maintain the risk and return characteristics of your portfolio while generating losses that can be used to reduce your current taxes. #

• Those timeless lessons involve broad diversification, annual rebalancing, using index funds, and staying the course. #