A Random Walk Down Wall Street

The EMH leaves little room to beat the market, but academics agree that an investor can outperform the market by assuming greater risk. Different investments carry different risks, as some stocks fluctuate in price and dividends, while investment options like Treasury bonds issued by the government carry little to no risk. The method of calculating dispersion or variance of returns and losses can provide some idea of the risk involved in each stock, plotting out the different possible outcomes, both positive and negative, and returning a likely average result. Standard deviation is used to measure risk because it shows an accurate spread of possible positive and negative returns over a given period, representing the likelihood of losses or risk. Looking at investments in bonds and stocks over time, the standard deviation is much broader for stocks, indicating greater risk, but the overall positive returns are higher over time, indicating greater reward to match that risk.

Summarizing Harry Markowitz’s research, Malkiel explains how diversification in modern portfolio theory, MPT, can reduce risk in almost any situation. If an investor invests in two businesses that have a negative covariance, meaning one business does well whenever the other does poorly, the success of one investment can cover the loss of the other investment.