Summary of Malkiel’s The Random Walk Guide to Investing

From my on-going study on investing, from Malkiel’s  The Random Walk Guide on Investing.

[The initial installments of my summary of Malkiel’s book are below. The later portions are accessed through the links above.]

Introduction.  This is the first of three books I am reading on investing due to my discontent on returns from my investments in recent years.  The unmanaged DOW has consistently beaten my “managed” investments.

Part One – The Basics

Albert Einstein once remarked, “Everything should be made as simple as possible.” A good teaching philosophy. Investing is often thought of as too complex for regular people. Malkiel says, “But obtaining well above average investment returns is strikingly easy, and this book will tell you how to do it.”

Malkiel starts with three crucial precursors to his 10 Rules, which are summarized below.

Basic Point One – Fire Your Investment Adviser

In this chapter he argues that we can do better without investment advisers. These advisers are making money at our expense. They are generally compensated by earning commissions on products they sell us. They make investing seem very complicated so we have to turn to them for advice.  But their products do not return the promised results of beating the market. [As he shows later, 85% of the money managers are beat by the market].

“We will see later that the correct investment strategy is actually to throw a tower over the stock page and buy a lost-cost mutual fund that includes all the stocks and does not trade.”

“Following the advice of these financial “experts” can be hazardous to our wealth.”

2000 Forbes article, “…your average pro on Wall Street has failed to beat the indexes.”

”The way to get rich from investment advice is to sell it.”

“By keeping your savings and investment strategy as simple as possible, you will free up time to do the really important things you want to do with your life such as spending more time with friends and family.”

Basic Point Two – Focus on Four Investment Categories

“While ignorance may be bliss, as the English poet Thomas Gray once wrote, it is not profitable.”

In this section of his book, Malkiel overview the four types of investments to consider (he does not include insurance, which he says should only be used for protection, or collectables included gold):

  • Cash – this includes checking accounts and other short term securities that can be turned into cash on short notice and with no risk of loss on principle. This includes short term Treasury bills, short term CDs that can be made to cash without penalty, money market mutual funds. “Every investor needs a cash reserve to meet the various emergencies of life…” More in Rule 3 on how to build this cash reserve.
  • Bonds– A long-term IOU from government, industry. Owning bonds make you a creditor of the company. They yield a specific rate of interest. If interest rates rise, bond prices fall. Some bonds are sold at discount and yield their face value at maturity (called zero coupon bonds). Bonds are fixed income investments. High quality bonds are good for retirees. Types of bonds:
    • U.S. Treasury
    • Ginny Mae (Gov’t National Mortgage Association)
    • Sally Mae (Student Loan Marking Association)
    • Municipal (including state and local gov’t)
    • Corporate. Varying quality. Riskier than other bonds so they offer a greater return to attract buyers. Junk bonds are high yielding but the riskiest.
  • Common stocks– Owning stock makes you part owner of a company.
    • You can make greater yields if the company does well; but greater risk if not. There is no specific promise of return as in bonds.
    • However, over the long haul, stocks have done well. (average yield is 8-9%/year vs 5-6%/year for high quality bonds).
    • “Bull” (gaining) markets dominate the long history of the stock market. But “bear (loosing) markets can go on for years. So your money in stocks needs to be for long-term objectives (e.g. retirement).
    • He says the stock market is pretty efficient about pricing stocks over the long term.  But once in a while the stock market goes “loony”.  There can be a “herd mentality” where something starts doing well and then everyone wants a piece of the gain so that a particular stock or segment gets overvalued. Eventually, it will come back to reasonable values and those who bought at the end will lose much (e.g. internet, “dot.com” craze).
    • He recommends a simple, low-risk, diversified strategy that will make money and keep us from making mistakes of following the herd. But it will take discipline when others boast of their short-term gains.
  • Real estate– besides owning your own home, it can be profitable to invest in commercial real estate.
    • Values of real estate typically rise (and thus the value of this investment) and you also get share in the income of the property.
    • Like stock mutual funds, real estate investment trusts (REITs) allow you to share ownership in real estate with many others. There are differing REITs depending on the segment of property you are interested in.  While they have only been around for 20 years, they look like a place to have some of your investment portfolio.

Basic Point Three – Understand the Risk/Return Relationship

In investing, risk and return are related.  Risk is the possibility of suffering harm or loss. Some things have little risk, e.g. Treasury bonds. But their return is relatively limited. To induce investors in riskier investments, higher returns must be offered.

He has a table of investment type, historic average annual returns (for the period 1926-2002) and range of annual returns (volatility).

  • Cash (including Treasury Bonds) returns on average 3-4%/year with a range of +1% to 9% annually.
  • Long-term corporate bonds return on average 6%/year but can range from -5% to +15% annually.
  • Common stocks return on average 10%/year but can range from -27% to +52% annually.

While the stock market tends to rise most of the time, he reviews the history of bear (declining) markets. Such declining periods can go on for several years. But eventually, the market comes back and recovers these losses and begins to gain once again. So the market is a good place for long-term investments but can be a poor choice for short-term investments.

Part Two – The Rules

Having laid out some groundwork in his 3 “basic points”, Malkiel goes on to his 10 “rules” for financial success. Some of them are straightforward. But even here is provides his insight and help on getting it done.

Rule One – Start Saving Now, Not Later: Time is Money

“The amount of capital you start with is not nearly as important as getting started early.. Every year you put off investing make your ultimate retirement goals more difficult to achieve.”

The first rule then: Start Saving Now, Not Later: Time is Money.  The secret of getting rich is the miracle of compound interest, slowly but surely (something we likely don’t want to hear). Albert Einstein once described compound interest as the “greatest mathematical discovery of all time.”

Malkiel illustrate this miracle three ways.

1) “The rule of 72”. Divide the number 72 by the rate of return on an investment you can earn over the long-haul. The result will be the number of years to double your investment. For example, if you can earn an average of 7.2% per year, it will take you 10 years to double your money (72/7.2). So if you start investing at age 25 rather than 55, you will have 8 times as much when you are done (2x2x2).

2)  Malkiel’s book includes a link to a graph by Jeremy Siegel in his book: Investing for the Long Run.  The graphs shows the long-term performance (over 200 years) of a number of investment choices including gold, treasury bills, bonds, and stocks compared with the growth of the consumer price index over the period 1802 to 2002. To see an inflation adjusted version, go to this link to the page of his book on Google Books. It shows compounding pays you when it is on your side.

Long-term growth in investment types
Long-term growth in investment types

3) Finally, there is a case study, “the million dollar difference”.  Pay close attention. Which would you chose:

  • One brother saved $ 2,000/year for 20 years, starting at age 20, and then he saved no more (total saved = $40,000). He earned 10% tax free on what he saved.
  • The second brother did not start saving until he was 40. He saved $ 2,000/ year from age 40 to age 65. He also earned 10% tax free (total saved = $50,000).
  • How much did they end up with?
    • The first brother earned $1.25 million on his $40,000 invested.
    • The second brother earned: $200,000  on his $50,000 invested.
  • The difference: time. The moral: get started early.

The moral is clear, you can accumulate more money just by starting now.

To get rich, you will have to do it slowly, and you have to start now.