Jonathan Clements reviews and recommends 5 books on personal investing:
Curiously, he omits what I regard as THE fundamental treatise on personal investing of our era: Burton Malkiel's Random Walk Down Wall Street.
In RANDOM WALK DOWN WALL STREET, Burton Malkiel sets out the basics of modern corporate financial theory in a way accessible to the law reader. As a teacher of corporate finance to law students, I have recommended this book to my students for over 10 years. Numerous alumni have told me that was the best advise they got in law school (a sad commentary on American legal education, but that's another story).
Two basic theories are expounded here. First, modern portfolio theory (MPT), which elucidates the relationship between risk and diversification. Because investors are risk averse, they must be paid for bearing risk, which is done through a higher expected rate of return. As such, we speak of a risk premium: the difference in the rate of return paid on a risky investment and the rate of return on a risk-free investment. In the real world, we measure the risk premium associated with a particular investment by subtracting the short-term Treasury bill interest rate from the risky investment's rate of return. The risk premium, however, will only reflect certain risks. MPT differentiates between two types of risk: unsystematic and systematic. Unsystematic risk might be regarded as firm-specific risk: The risk that the CEO will have a heart attack; the risk that the firm's workers will go out on strike; the risk that the plant will burn down. These are all firm-specific risks. Systematic risk might be regarded as market risk: risks that affect all firms to one degree or another: changes in market interest rates; election results; recessions; and so forth. MPT acknowledges that risk and return are related: investors will demand a higher rate of return from riskier investments. In other words, a corporation issuing junk bonds must pay a higher rate of return than a company issuing investment grade bonds. Yet, portfolio theory claims that issuers of securities need not compensate investors for unsystematic risk. In other words, investors will not demand a risk premium to reflect firm-specific risks. Why? There is a mathematical proof, which relates to variance and standard deviation, but Malkiel explains it in a way that is quite intuitive. Investors can eliminate unsystematic risk by diversifying their portfolio. Diversification eliminates unsystematic risk, because things tend to come out in the wash. One firm's plant burns down, but another hit oil. Thus, even though the actual rate of return earned on a particular investment is likely to diverge from the expected return, the actual return on a well-diversified portfolio is less likely to diverge from the expected return. Bottom line? If you hold a nondiversified portfolio (say all Internet stocks), you are bearing risks for which the market will not compensate you. You may do well for a while, but it will eventually catch up to you (as it has recently for tech stocks).
The second pillar of Malkiel's analysis is the efficient capital markets theory (ECMH). The fundamental thesis of the ECMH is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or underpriced: the current price will be an accurate reflection of the market's consensus as to the commodity's value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal. There are three forms of ECMH, each of which has relevance for investors: **Weak form: All information concerning historical prices is fully reflected in the current price. Price changes in securities are serially independent or random. What do I mean by "random"? Suppose the company makes a major oil find. Do I mean that we can't predict whether the stock will go up or down? No: obviously stock prices generally go up on good news and down on bad news. What randomness means is that investors can not profit by using past prices to predict future prices. If the Weak Form of the hypothesis is true, technical analysis (a/k/a charting)-the attempt to predict future prices by looking at the past history of stock prices-can not be a profitable trading strategy over time. And, indeed, empirical studies have demonstrated that securities prices do move randomly and, moreover, have shown that charting is not a long-term profitable trading strategy. ** Semi-Strong Form: Current prices incorporate not only all historical information but also all current public information. As such, investors can not expect to profit from studying available information because the market will have already incorporated the information accurately into the price. As Malkiel demonstrates, this version of the ECMH also has been well established by empirical studies. Implication: if you spend time and effort studying stocks and companies, you are wasting your time. If you pay somebody to do it for you, you are wasting your money. ** Strong Form holds that prices incorporate all information, publicly available or not. This version must be (and is) false, or insider trading would not be profitable.
In the last section of RANDOM WALK, Malkiel distills all this theory into an eminently practical life-cycle guide to investing. As one may infer, it has two basic principles. First, diversification. Second, no one systematically earns positive abnormal returns from trading in securities; in other words, over time nobody outperforms the market. Mutual funds may outperform the market in 1 year, but they may falter in another. Once adjustment is made for risks, every reputable empirical study finds that mutual funds generally don't outperform the market over time. Malkiel's recommendation: put your money into no-load passively managed index mutual funds. You will see lots of anonymous reviews of RANDOM WALK claiming Malkiel is wrong. Odds are, most of those folks are have either been misled by the long bull market or, even more likely, are brokers or other market professionals who make a living selling active portfolio management. In sum, buy it, read it, believe it, and practice it.
