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

THE ROLE OF RISK
Efficient-market theory explains why the random walk is
possible. It holds that the stock market is so good at adjusting
to new information that no one can predict its future course
in a superior manner. Because of the actions of the pros, the
prices of individual stocks quickly reflect all the news that is
available. Thus, the odds of selecting superior stocks or
anticipating the general direction of the market are even. Your
guess is as good as that of the ape, your stockbroker, or even

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mine.
Hmmm. “I smell a rat,” as Samuel Butler wrote long ago.
Money is being made in the market; some stocks do
outperform others. Common sense attests that some people
can and do beat the market. It’s not all chance. Many
academics agree; but the method of beating the market, they
say, is not to exercise superior clairvoyance but rather to
assume greater risk. Risk, and risk alone, determines the
degree to which returns will be above or below average.
DEFINING RISK: THE DISPERSION
OF RETURNS
Risk is a most slippery and elusive concept. It’s hard for
investors—let alone economists—to agree on a precise
definition. The 
American Heritage Dictionary
defines risk as
“the possibility of suffering harm or loss.” If I am able to buy
one-year Treasury bills to yield 5 percent and hold them until
they mature, I am virtually certain of earning a 5 percent
monetary return, before income taxes. The possibility of loss
is so small as to be considered nonexistent. If I hold common
stock in my local electric utility for one year, anticipating a 6

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percent dividend return, the possibility of loss is greater. The
dividend of the company may be cut and, more important,
the market price at the end of the year may be much lower,
causing me to suffer a net loss. Investment risk, then, is the
chance that expected security returns will not materialize and,
in particular, that the securities you hold will fall in price.
Once academics accepted the idea that risk for investors is
related to the chance of disappointment in achieving expected
security returns, a natural measure suggested itself—the
probable dispersion of future returns. Thus, financial risk has
generally been defined as the variance or standard deviation of
returns. Being long-winded, we use the accompanying exhibit
to illustrate what we mean. A security whose returns are not
likely to depart much, if at all, from its average (or expected)
return is said to carry little or no risk. A security whose
returns from year to year are likely to be quite volatile (and
for which sharp losses occur in some years) is said to be
risky.