INTRODUCTION TO THE FIFTIETH ANNIVERSARY EDITION

IT HAS BEEN fifty years since the first edition of A Random Walk Down Wall Street was published. The investment advice of the original edition was very simple: Investors would be far better off buying and holding a broad-based index fund than attempting to buy and sell individual securities or actively managed mutual funds. I boldly stated that any information affecting the prospects for individual companies would be quickly reflected in the prices of their shares. In such a situation, a blindfolded chimpanzee throwing darts at a listing of stock prices could select a portfolio that would do as well as the portfolios selected by experts. Of course, the advice was not literally to throw darts. The more correct analogy was to throw a towel over the stock listings and buy and hold a portfolio consisting of all the stocks in a broad stock-market index. Such a portfolio was likely to outperform professionally managed equity funds, whose high yearly expense charges, substantial trading costs, and tax consequences detract from investment returns.

Now, fifty years later, I believe even more strongly in that original thesis, and there’s a seven-figure gain to prove it. An investor with $10,000 to invest at the start of 1977 (when the first index fund became available) would have a portfolio worth $2,143,500 at the start of 2022, assuming all dividends were reinvested. A second investor who instead purchased shares in the average actively managed mutual fund would have seen the investment grow to $1,477,033. The difference is astonishing. Through January 1, 2022, the index investor was ahead by $666,467, or a staggering two-thirds of a million dollars.

Today there is broad acceptance of the idea that index investing is an optimal investment strategy. Currently, more than half the money invested in equity mutual funds is in index funds. And trillions more are invested in indexed exchange-traded funds (ETFs; index funds that trade in public securities markets). But at the beginning, the idea that investors should buy index funds was ridiculed as foolish and imprudent.

To say that Random Walk did not generate a positive initial response would be a vast understatement. The first edition was reviewed by a stock-market professional in BusinessWeek magazine, where it was thoroughly trashed. The reviewer believed that the ideas presented were naive at best, imprudent at worst. Why investors should be satisfied with “guaranteed mediocrity” puzzled the reviewer. Other reviewers described the idea that our financial markets were reasonably efficient as “one of the most remarkable errors in the history of economic thought.”

Fortunately, I was not deterred. I figured that if no one hates what you have written, perhaps you have not published anything worth writing. You can always avoid criticism by saying nothing and doing nothing.

Three years after the initial publication of the book, Jack Bogle, the CEO of the Vanguard Group, introduced the first index fund that would be available for the public to invest in. The reception of “The First Index Fund” was no better than that for Random Walk. Vanguard initiated its new fund by hiring a number of Wall Street investment bankers to sell $250 million of the shares. The bankers could find buyers for only $11 million. While Vanguard was willing to sell more shares of the fund at zero commission, buyers were still scarce. I used to joke with Jack Bogle that he and I were the only shareholders. The fund was widely described as a failure. It was called “Bogle’s Folly,” “doomed to fail,” and even “un-American.” For many years thereafter, the index fund attracted little capital. As optimistic as Jack was about indexing, even he could not have imagined that index funds would eventually attract trillions of dollars in investments.

In these pages, readers will find considerable support for the idea that our markets reflect new information without delay and are highly efficient. Moreover, the convincing evidence accumulated over years should make even skeptics believers in the indexing propositions I have promoted. Most important, the book has always been meant as a comprehensive investment guide, and the very practical uses of these ideas will be clearly explained. But before we begin, I want to tell you, as simply as possible, what is meant by the term “efficient markets” and how that term is often misinterpreted in the press. And I want to make clear the commonsense arguments in favor of making index funds the core investments for anyone saving for a comfortable retirement or to achieve financial security.

The theory behind the view that indexing is the best way to invest the core of your portfolio goes by the fancy title “the efficient market hypothesis,” or EMH for short. Albert Einstein once said about hypotheses and theories, “If you can’t explain them to a six-year-old, then you don’t understand them yourself.” So here’s my simple explanation of the theory.

Two fundamental tenets make up the efficient market hypothesis. EMH first asserts that public information gets reflected in stock prices without delay. Information that should beneficially (or adversely) affect the future price of any financial instrument will be reflected in the asset’s price today. If a pharmaceutical company now selling at $20 per share receives approval for a new drug that will give the company a value of $40 per share tomorrow, the stock price will move to $40 right away, not slowly over time. Because any purchase of the stock at a price below $40 will yield an immediate profit, we can expect market participants to bid the price up to $40 without delay.

It is, of course, possible that the full effect of the new information is not immediately obvious to market participants. Some participants may vastly underestimate the significance of the drug, but others may greatly overestimate it. Therefore, markets could underreact or overreact to news. The COVID-19 pandemic presents an excellent example of how investor sentiment and the difficulty of predicting the extent and severity of the resulting economic disruption can intensify market volatility. But it is far from clear that systematic underreaction or overreaction to news presents an opportunity for stock-market investors to earn extraordinary profits. It is this aspect of EMH that implies a second—and in my view, the most fundamental—tenet of the hypothesis. In an efficient market, there are no possibilities for earning extraordinary gains without taking on extraordinary risks.

This lack of opportunities for extraordinary profits is often explained by a joke popular with professors of finance. A professor who espouses EMH is walking along the street with a student. The student spots a $100 bill lying on the ground and stoops to pick it up. “Don’t bother to try to pick it up,” says the professor. “If it was really a $100 bill it wouldn’t be there.” Perhaps a less extreme telling of the story would have the professor telling the student to pick the bill up right away because it will not be lying around very long. In an efficient market, competition will ensure that opportunities for extraordinary risk-adjusted gain will not persist.

EMH does not imply that prices will always be “correct” or that all market participants are always rational. There is abundant evidence that many (perhaps even most) market participants are far from rational and suffer from systematic biases in their processing of information and their trading proclivities. But even if price setting was always determined by rational investors, prices (which depend on imperfect forecasts) can never be “correct.” They are “wrong” all the time. EMH implies that we can never be sure whether they are too high or too low. And any profits attributable to judgments that are more accurate than the market consensus will not represent opportunities for extraordinary returns without taking on far more risk than would be involved in the purchase of a broad-based index fund.

I am well aware that the stock markets can make egregious mistakes. In January 2021, a horde of crazed Internet investors drove the price of GameStop from $15 a share to almost $500 before it fell back to earth in February. The entire stock market soared to unprecedented valuation levels in early 2000. In the period that followed, the leaders in the upswing fell by 90 percent or more. But even this spectacular bubble (considered “damning evidence” against EMH) did not provide any easy route to excess profits.

There was no way anyone could have predicted how much the bubble would expand and when it was likely to pop. In 1996, stock prices and valuation relationships had already risen to extraordinary levels. Price-earnings multiples were in nosebleed territory. This influenced Federal Reserve chairman Alan Greenspan to make a famous speech suggesting that the stock market was at bubble levels and that investors were exhibiting “irrational exuberance.” The stock market rallied strongly for four years thereafter, and long-term investors who bought stocks after the speech earned generous rates of return.

We now know (after the fact) that market prices were at peak bubble levels in early 2000. But no one was able accurately to identify the timing of the bubble in advance. In fact, there is substantial evidence that both individual and institutional investors who try to time the market invariably do the wrong thing. They buy at market tops when optimism reigns, and they sell at market bottoms when pessimism is rampant. And while some investors made excess returns over certain periods by making judgments that were more accurate than the market consensus, such profits did not represent unexploited arbitrage possibilities for riskless extraordinary returns. Such transactions were extremely risky, and many others who bet against the market experienced financial ruin. Even some hedge funds that bet against GameStop, as it was rising to the stratosphere, suffered bankrupting losses.

The idea that markets are able to process new information with reasonable speed and without delay is associated with the view that stock prices move over time similarly to a random walk. The term “random walk” is a mathematical concept that implies the next number in a sequence of numbers is independent of the previous number in the series and is unforecastable. The term was apparently first used in an exchange of correspondence that appeared in the journal Nature in 1905. The subject of the correspondence was the optimal search procedure for finding a drunkard who had been left in the middle of a field. The answer was quite complex, but the place to start was simply the place where the drunkard had been left, because if he did move, he would presumably stagger in a random, unpredictable fashion.

Similarly, if stock-market prices fully incorporate the information and expectations of all market participants, then price changes must be random. Prices will, of course, change as new information is revealed to the market, but true news is random—it cannot be forecast from past events. Thus, in an informationally efficient market, price changes are unforecastable. Random price movements do not imply that the stock market is capricious. Randomness indicates a well-functioning and efficient market rather than an irrational one.

If prices reasonably reflect all known information, then even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as generous as that achieved by the experts.

Of course, it is possible that the stock market could fail fully to reflect some news event. And price changes from day to day could depart from randomness in some instances. Therefore, it is probably useful to think of the stock market in terms of “relative” rather than absolute efficiency. Andrew Lo, an economist at MIT, suggests that few engineers would contemplate testing whether a given engine is perfectly efficient. But they would attempt to measure the efficiency of that engine relative to a frictionless ideal. Similarly, it is unrealistic to require our financial markets to be perfectly efficient in order to accept EMH. But I believe that markets do an excellent job in incorporating information into stock prices and that our stock markets are remarkably efficient. And the evidence is incontrovertible that low-cost index funds do not produce mediocre performance. Index funds provide investors with returns that are a full percentage point higher than those available from the average actively managed mutual fund.

The occasional craziness of market prices makes a belief in EMH (even in relative efficiency) hard for many people to accept. But even nonbelievers should embrace index funds as optimal portfolio investments. Index funds should continue to outperform actively managed funds even if markets are inefficient.

Consider the following syllogism. It is indisputable that all the stocks in any market must be held by someone. All the stocks in the U.S. market are held by either individuals or institutions. Thus, investors as a whole will earn a gross return equal to whatever return the stock market delivers. Index funds as a group, by holding all the stocks in the entire market, will also earn the market return. But then it must follow that all other investors, who actively manage their portfolios, will also earn the gross market return because the shares available to them will be a portion of the entire market portfolio.

Competition has now driven the expenses charged by index funds essentially to zero. On the other hand, investors in actively managed mutual funds will pay a fee of close to 1 percent per year (the average expense ratio charged to investors in active funds). Hence the index-fund investor will earn a net return that averages close to 1 percentage point per year higher than that of the active-fund investor. And this differential does not even consider that index funds (which don’t trade from one security to another) will incur lower transactions costs and lower taxes.

In my view, the most compelling evidence that our stock markets are extremely efficient is that they are extraordinarily hard to beat. If market prices were generally determined by irrational investors, and if it were easy to identify predictable patterns in security returns or exploitable errors in security prices, then professional managers should be able to beat the market. Later in the book, I will show you the full evidence of how badly active managers do. Here I will point out that each year, about two-thirds of professionally managed stock portfolios perform worse than a simple index fund does. And those portfolios composing the one-third that beats the market in one year are usually not the portfolios that outperform in the next year. Thus, when you look at the ten- and fifteen-year performance of actively managed mutual funds, it turns out that 90 percent of them do worse than the market. It’s not that outperformance is impossible. But finding the real star stock picker is like looking for a needle in a haystack. If you try to pick the star of the future, you will be much more likely to have a result inferior to that of a simple index fund. And just because some manager beat the market during the past year or past decade is no reliable sign that he or she will do so in the next. Direct measures of the actual returns earned by professionals, who are compensated with strong incentives to outperform, represent the most compelling evidence of market efficiency. As the well-known Wall Street maxim puts it: When you are sure you have the keys to beating the market, they change the locks.

If the basic message of the book—that markets are efficient and indexing is the best strategy for investors—is right, then why was it necessary for the book to go through thirteen editions during its fifty-year history? The answer is that there have been enormous changes in the financial instruments available to the public, and that accumulated evidence has strongly supported the investment strategies I have recommended. Index funds did not even exist when the book was first published. A book meant to provide a comprehensive investment guide for individual investors needs to be updated to cover the full range of investment products available. In addition, investors can benefit from a critical analysis of the wealth of new information provided by academic researchers and market professionals—made comprehensible in prose accessible to everyone with an interest in investing. There have been so many bewildering claims about the stock market that it’s important to have a book that sets the record straight.

Over the past fifty years, we have become accustomed to accepting a rapid pace of technological change in our physical environment. Today we are more likely to enjoy movies and video games at home through streaming services rather than going to movie theaters or buying a physical disc. We continue to meet and socialize virtually even as the COVID-19 pandemic eases. We increasingly get our daily news over the Internet. New medical advances have materially affected our quality of life. Electric and self-driving cars are no longer the province of science fiction. Our ability to learn has been advanced with artificial intelligence, and cloud technology has allowed businesses to accelerate innovation, increase business agility, and reduce costs.

Financial innovation over the same period has been equally rapid. In 1973, when the first edition of this book appeared, we did not have money-market funds, ATMs, index mutual funds, ETFs, tax-exempt funds, emerging-market funds, target-date funds, floating-rate notes, volatility derivatives, inflation-protection securities, equity REITs, asset-backed securities, Roth IRAs, 529 college savings plans, zero-coupon bonds, financial and commodity futures and options, and new trading techniques, just to mention a few of the changes in our financial environment.

Today we can trade stocks with zero commissions and do so over our smartphones. And index investing can be practiced with funds and ETFs charging close to zero annual expenses. Much of the new material that has been included in subsequent editions of this book has served to explain financial innovations and to show which of them can benefit the individual investor. So much new material has been added that readers who may have read an earlier edition in college or business school will find this anniversary edition rewarding reading.

The book remains fundamentally a readable investment guide for individual investors. It stresses the importance of regular savings and investing in index funds as the only reliable way to build wealth. The lessons of diversification and rebalancing are shown to be effective techniques to limit risk. The book demonstrates how high expense ratios can drain investment returns and how conflicted so-called wealth managers often put their own interests ahead of those of their clients. And it emphasizes the importance of tax management and shows the various plans that allow individual investors to compound their returns over time while avoiding taxes.

Above all, the book is intended to be empowering. Not only will it teach you how the stock market works, but also it will overcome any feelings you may have of powerlessness to make the best investment decisions. Market professionals will often argue that investing properly is too complicated for ordinary people to achieve on their own. Nothing could be further from the truth. The best investment strategies are remarkably simple. My purpose is to show you how easy it is to make informed and effective investment decisions so as to reach your goals and build financial stability. Resist the notion that you can’t do it yourself. Your financial life is yours to shape. Once you feel empowered to navigate your savings and investment choices yourself, you will experience added satisfaction and pride as well as improved emotional well-being.

It is not complicated. Being an above-average investor is extremely simple. It is not often in life that the easy thing to do is the smart thing to do. Paradoxically, the more complicated the world becomes, the more a simple investment program becomes the surest road to investment success. What is hard is having the discipline to save small amounts on a regular basis and to keep it up regardless of the inevitable crisis of the moment when news reports suggest that the sky is falling and economic disaster is sure to follow. In fact, the most profitable investments you will ever make are precisely at the times when pessimism is the most rampant.

An illustration using the actual net returns of the Vanguard stock-market index fund makes the point convincingly. Suppose an investor starts early and chooses a diversified equity index fund as the single vehicle for investment. (I actually recommend that young people starting out do just that and choose an indexed equity mutual fund to accumulate wealth.) For an investor who started the process forty-five years ago, when actual index funds first became available, the results are stunning. Suppose the investor started with a $500 investment and then put $100 into the fund each month thereafter. The investor would have made investments of $53,200 over his or her lifetime. By January 1, 2022, the portfolio would be worth almost $1.5 million if all dividends were reinvested in the fund.

During many occasions over the 45-year period, it looked like the end of the world as we knew it. In 1987, the stock market lost 20 percent of its value in a single day. When the dot.com bubble burst in 2000, some of the best-known growth companies lost most of their value. Apple fell by more than 80 percent, and Amazon lost more than 90 percent of its value. During the financial crisis of 2007–2008, obituaries were written about the capitalist system itself. And as the COVID-19 pandemic worsened in 2020, many press reports assured us that the world had fundamentally and irreparably changed.

But enough of all of this. The important point is that an investor saving $100 a month and putting it into an equity mutual fund became a millionaire.

To be sure, the calculations above that are based on the Vanguard index fund are simply a fictional illustration. But I can assure you that countless investors have followed the advice and are reaping the benefits today. The letters I have received from grateful readers convince me that comparable real results have been achieved by following the simple investment strategies advocated here.

I am pleased that Random Walk has enjoyed a long shelf-life. The book has helped influence the investment industry on the benefits of passive investing. It has helped usher in the acceptance of exchange-traded funds (index funds that trade continuously on organized security markets). The book has been used in colleges and business schools around the globe and has helped popularize some timeless portfolio advice such as cost minimization, regular savings, diversification, rebalancing, and tax management. But more important than any of these is the satisfaction that the advice in this book has helped innumerable ordinary individuals achieve their financial goals.

For me, the greatest satisfaction I have had over the fifty years since this book was first published comes from the countless letters I have received from readers who have followed my advice and, starting with nothing, have built sizeable wealth. When I receive a letter telling me that the writer had never earned more than a modest salary during a lifetime of work, but by saving small amounts each month and investing in index funds, the person now enjoys a comfortable, worry-free retirement, I feel the greatest satisfaction.

One always hopes that one’s professional activities have actually contributed to society’s welfare. If the criterion for a useful advice book is “Did it make a difference?” then Random Walk has clearly passed the test.