A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

1. Avoid Herd Behavior
Behavioral financial economists understand the feedback
mechanisms that lead investors to follow the crowd. When
Internet stocks were consistently rising, it was hard not to get
swept up in the euphoria—especially when all your friends
were boasting of their spectacular stock-market profits. A
large literature documents the pervasiveness of the influence
of friends on one’s investment decisions. Robert Shiller and
John Pound surveyed 131 individual investors and asked
what had drawn their attention to the stock they had most
recently purchased. A typical response was that a personal
contact, such as a friend or relative, had recommended the
purchase. Harrison Hong, Jeffrey Kubik, and Jeremy Stein
provided more systematic evidence as to the importance of
friends in influencing investors’ decisions. They found that
social households—those who interact with their neighbors,
or attend church—are substantially more likely to invest in

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the market than nonsocial households, controlling for wealth,
race, education, and risk tolerance.
Any investment that has become a topic of widespread
conversation is likely to be especially 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 early 2000 and
condominiums in California, Nevada, and Florida in the first
decade of the 2000s.
Invariably, the hottest stocks or funds in one period are
the worst performers in the next. And just as herding induces
investors to take greater and greater risks during periods of
euphoria, so the same behavior often leads many investors
simultaneously to throw in the towel when pessimism is
rampant. The media tend to encourage such self-destructive
behavior by hyping the severity of market declines and
blowing the events out of proportion to gain viewers and
listeners. Even without excessive media attention, large
market movements encourage buy and sell decisions that are
based on emotion rather than on logic.
Because of bad timing, the typical mutual-fund investor
earns a rate of return from the stock market far below the

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returns that would be earned by simply buying and holding a
market index fund. This is because investors tend to put their
money into mutual funds at or near market tops (when
everyone is enthusiastic) and to pull their money out at
market bottoms (when pessimism reigns). The exhibits below
make the point. In the first chart, we see that net new cash
flow into mutual funds peaked when the market reached a
high in early 2000. At the market trough in the fall of 2002,
investors pulled their money out. In late 2008 and early 2009,
just at the bottom of the market during the financial crisis,
more money went out of the market than ever before. This is
what is called “The Timing Penalty” in the first chart’s title.
The next exhibit documents “The Selection Penalty.” At
the peak of the market in early 2000, money flowed into
“growth”-oriented mutual funds, typically those associated
with high technology and the Internet, and flowed out of
“value” funds, those funds holding old-economy stocks that
sold at low prices relative to their book values and earnings.
Over the next three years, the “value” funds provided
generous positive returns to their investors, and “growth”
funds declined sharply. During the third quarter of 2002, after
an 80 percent decline from the peak of the NASDAQ Index,

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there were large redemptions out of growth funds. Chasing
today’s hot investment usually leads to tomorrow’s
investment freeze.