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

Part Three

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THE NEW INVESTMENT
TECHNOLOGY

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8

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A NEW WALKING SHOE:
MODERN PORTFOLIO
THEORY
…Practical men, who believe themselves to be quite exempt
from any intellectual influence, are usually the slaves of some
defunct economist. Madmen in authority, who hear voices in
the air, are distilling their frenzy from some academic
scribbler of a few years back.
—J. M. Keynes, 
The General Theory of Employment, Interest
and Money
T
HROUGHOUT THIS BOOK,
I have attempted
to explain the theories used by professionals—simplified as

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the firm-foundation and the castle-in-the-air theories—to
predict the valuation of stocks. As we have seen, many
academics have earned their reputations by attacking these
theories and maintaining that they cannot be relied on to yield
extraordinary profits.
As graduate schools continued to grind out bright young
financial economists, the attacking academics became so
numerous that it seemed obvious that a new strategy was
needed; ergo, the academic community busily went about
erecting its own theories of stock-market valuation. That’s
what this part of the book is all about: the rarefied world of
the “new investment technology” created within the towers
of the academy. One insight—modern portfolio theory
(MPT)—is so basic that it is now widely followed on the
Street. The others remain controversial enough to continue to
generate thesis material for students and hefty lecture fees for
their advisers.
This chapter is about modern portfolio theory, whose
insights will enable you to reduce risk while possibly earning
a higher return. In chapter 9, I turn to the academics who have
suggested that investors can increase their returns by
assuming a certain kind of risk. Then, in chapters 10 and 11, I

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cover the arguments of some academics and practitioners who
conclude that psychology, not rationality, rules the market,
and that there is no such thing as a random walk. They argue
that markets are not efficient, that market prices are
predictable, and that a number of investment strategies can be
followed to “beat the market.” Then I conclude by showing
how wrong they are. I do this, in part, by using the best
example of the efficient-market application—a common-stock
index fund—and I show that, despite all the critics, it remains
the undisputed champion in taking the most profitable stroll
through the market.