A random walk down wallstreet Essay Example
A random walk down wallstreet Essay Example

A random walk down wallstreet Essay Example

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  • Pages: 11 (2905 words)
  • Published: November 10, 2018
  • Type: Analysis
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In his book "A Random Walk Down Wall Street," Malkiel challenges the idea that individual investors cannot compete with professional brokers and investment firms due to the complexity of the market. He argues that the stock market operates on a concept called a "random walk," where short-term changes in stock prices are unpredictable. This unpredictability makes it difficult for rational investors to determine which stocks will provide the highest returns.

In Chapter 1, Malkiel distinguishes between investing and speculating. Investing involves buying assets with the goal of earning consistent income or long-term appreciation, while speculating lacks sufficient data to support any conclusions. At its core, investing involves saving income instead of spending it, with hopes of gaining more value in the future. Investment returns depend on how funds are allocated and future events.

The investment community traditionally uses


two approaches to assess asset valuation: the firm-foundation theory and the castle-in-the-air theory. The firm foundation theory suggests that every investment instrument has intrinsic value, which can be determined by analyzing current conditions and future growth trends of securities. According to this theory, one should buy undervalued securities and sell them when they become temporarily overvalued compared to their intrinsic value.The text discusses the significance of dividend income in determining a stock's true value and how it is calculated through discounting. The growth rate of dividends also plays a role in valuing stocks, although predicting the duration of these rates is challenging. Other factors like risk and interest rates will be examined later. Warren Buffet utilized this technique to amass his wealth and establish himself as an outstanding investor.

In contrast, the "castle in the air theory" relies more on

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psychological factors than intrinsic value. Investors who follow this theory make early investments based on speculation about exciting news and growth prospects, then sell when securities experience temporary increases in value. These predictions are often not grounded in asset valuation or operating plans but are influenced by hype surrounding the security. This approach involves short-term investments under the belief that buyers can pay any price for stocks as long as future buyers expect higher values. It is also referred to as the "greater fool" theory.

Malkiel's chapter 2 provides historical examples illustrating both theories, namely the tulip craze in seventeenth-century Holland and the stock market growth leading up to Black Thursday in 1929. In Holland, tulips from Turkey gained immense value due to their beauty and rarity.Merchants engaged in buying and selling at increasing prices, resulting in the public viewing them as smart investments. People even sold their personal belongings to acquire tulip bulbs. However, this bubble eventually burst when prices reached extreme heights. Some individuals decided to sell and make a profit, causing prices to decline. Ultimately, there was no longer any demand for the tulips, rendering them worthless and leading to numerous bankruptcies.

Similarly, during the period from 1928 to 1929 known as Black Thursday, there was an intense speculative frenzy in the stock market with widespread participation. The market experienced unprecedented growth surpassing that of the previous five years combined. Stocks were purchased on margin reflecting the investment craze. Traders also collaborated to manipulate stock prices by creating investment pools.

Both examples illustrate how speculation can unreasonably inflate prices but ultimately result in instability and financial consequences when demand fluctuates or collapses entirely. The pools

consisted of a pool manager and a stock specialist who had access to buy and sell rates above and below the market price. Within the pool, members would trade stocks among themselves at slightly higher prices, artificially boosting the stock price. This created a false perception of high activity and rising prices, often reinforced by media coverage of exciting news. Consequently, the public was enticed to invest in these seemingly attractive stocks.
The public primarily bought stocks while pool managers sold, resulting in significant profits for the pools. This manipulation of stock prices partially contributed to the 1929 crash. Despite the overall business slowing down for months, stock prices continued to rise steadily. However, this imbalance became unsustainable as it was not realistic for prices to keep increasing amidst a deteriorating business climate. Eventually, this disparity caught up with them: prices plummeted and triggered margin calls that forced customers to sell their stocks. As prices continued to drop, more members of the public sold their shares, ultimately leading to a market crash.

In Chapter 3 of Malkiel's analysis, it is emphasized that sharp increases in stock prices rarely lead to gradual stabilization; instead, they result in steep declines. The book explores stock valuation from the 1960s to the 1990s and highlights a common belief among individuals like me who trust financial professionals with managing our money. We assume these professionals are not influenced by speculative crazes that affect the general public. However, historical evidence disproves this belief.

During the 1960s, there was an increase in IPOs known as the "tronics boom." Companies with "tronics" in their name were considered favorable investments regardless of their actual affiliation with the

electronics industry.During the 20th century, there were significant trends and events in the stock market that had notable impacts. For example, some Initial Public Offerings (IPOs) went through rapid growth followed by quick declines. Market manipulation occurred when investment bankers artificially drove up stock prices by releasing small amounts of IPO shares into the market before selling the remaining shares at inflated prices. Insider trading was also prevalent during this time, with officers, relatives, and friends of firms receiving significant portions of IPO shares while limiting participation for the general public.

One main issue was people investing in stocks that promised to be the next big thing even without generating any sales yet. This led to speculation and unjustifiably high prices. In addition, economist Malkiel introduced a concept called synergism where companies believed that acquiring and merging with other businesses would generate greater profits compared to operating independently - an idea summarized as believing "2 plus 2 equals 5".

Furthermore, conglomerates began acquiring businesses outside of their expertise during this period but eventually realized their flaws and sold off these acquired companies to avoid further losses. On the other hand, blue chip stocks gained popularity among investors in the 1970s as safe long-term investments. However, due to speculation and rising prices, these companies became overpriced which impacted their perceived infallibility.The economic conditions caused a gradual decrease in prices, impacting various sectors. In the 1980s, biotechnology stocks and new issues saw a surge in prices despite many companies having no earnings and being valued based on future products. Institutions and the public heavily invested in these stocks, even though there was no rational explanation for their high prices.


into the 1990s, the Japanese real estate market experienced a major collapse as stock prices exceeded asset values by five times. This collapse was attributed to factors such as population density, land use regulations, and tax laws. Multiple elements contributed to this collapse including declining profitability, difficulties in exporting due to a strong yen, slower growth in rental income compared to land values, and rising interest rates.

During this time period with low interest rates, individuals could easily borrow money. However, when the Bank of Japan increased interest rates to control property prices, it resulted in a market crash. This crash caused inflated prices to return to their actual values but had significant global financial consequences.

Chapter 4 discusses the well-known internet bubble that is familiar today. The rapid advancement of technology brought about major changes but excessive speculation led to financial disaster for numerous investors.The historical evidence shows that tragedy often ensues when people pursue unfounded hopes and dreams. During this period, numerous internet companies emerged, each claiming to be the next big corporate powerhouse. Investment firms eagerly embraced these companies and heavily promoted them, further fueling the speculative atmosphere. Determining the stock prices of these companies became a subject of investigation, leading analysts to develop new methods to justify their continuously increasing prices.

Traditional valuation techniques such as "price-to-earnings," "price-to-book value," and "price-to-sales" were abandoned. Instead, measures were based on factors like page views or monthly usage rates. However, it turned out that a significant number of internet users were not actually making purchases, resulting in hundreds of dot-com companies declaring bankruptcy.

The media played a role in exacerbating this frenzy by turning the Internet into its

own media channel. The easy accessibility of information through a simple click of a mouse led to the rise in popularity of online brokers. These brokers offered instant research, charts, and graphs to cater to investors' convenience.

However, instead of prioritizing investors' interests by directing customer orders to the market with the best price, these orders were sent to markets that compensated the online broker more for handling them.Online brokerage firms, despite claiming cost-effectiveness, did not consistently prioritize investors. Consequently, there was a notable surge in day traders within the online trading system during this period as many individuals quit their jobs in pursuit of quick wealth. Unfortunately, only a few achieved success. The early 2000s speculative market witnessed the emergence of various fraudulent cases, with Enron being the most prominent example. Companies eagerly complied with analysts' demands for high short-term earnings forecasts to boost stock prices. However, Enron went even further by manipulating its financial records to inflate earnings and conceal losses – deceiving its investors in the process. To make matters worse, top executives encouraged employees to heavily invest in the company while they themselves sold off shares, fully aware of Enron's impending downfall. Chapter 4 concludes by reminding readers that those who cannot resist participating in speculative crazes like tulip-bulb mania inevitably end up losing money in the market. Pursuing get-rich-quick schemes simply does not lead to successful outcomes.Chapter 5 of the book delves into discussing the fallacy of solely relying on psychological support for market valuations.Firm foundation theorists argue that this approach is unreliable because markets ultimately abide by financial lawsAccording to Malkiel, the firm foundation theory emphasizes the importance of a

company's cash dividends and values shares based on the present or discounted value of future dividends. There are four factors that influence share value. The first factor is the expected growth rate of dividends, which can be challenging to estimate but is crucial for understanding a corporation's life cycle. After the growth phase, stability and decline may follow unless new developments occur. These factors impact estimating the growth rate, with a shorter term like five years being more accurate than twenty years.
Rational investors, according to firm-foundation theorists' beliefs, are willing to pay a higher price for shares with larger growth rates of dividends and earnings, especially when an extraordinary growth rate is expected to last longer.
The second factor affecting share value is the expected dividend payout. Generally, a higher dividend payout can increase stock value; however, if it exceeds earnings significantly, it might indicate a lack of investment in future growth opportunities.
The text further discusses four additional factors that impact a stock's intrinsic value: risk, price, market interest rates, and expectations. According to the firm foundation theory, as risk decreases,
investors should be willing to pay a higher price for the stock. Conversely,
high-interest rates make other investments more attractive while low-interest rates make stocks more appealing.Accurately predicting future outcomes and estimating undetermined data is challenging and can undermine valuation accuracy. Nevertheless, these factors, along with expectations and market psychology, contribute to determining a stock's price. Chapter 6 explores technical and fundamental analysis methods highlighting the difficulty in determining optimal times for buying or selling stocks.

The technical approach relies on analyzing charts and trends to make decisions. Technical analysts (chartists) observe how a stock's price has changed

over time and anticipate continued growth if trends persist. This decision-making process is driven by market sentiment rather than considering industry or financial data about the company. One downside of this approach is that downward trends often develop rapidly with chartists typically identifying them late.

The text discusses both fundamental analysis and technical analysis approaches for analyzing stocks. While fundamental analysis involves scrutinizing a company's financial data, it can be a tedious process. Chapter 5 provides a summary of the challenges associated with this approach.

In chapter 7, the text compares technical analysis to a random walk and revisits it. Technicians utilize various strategies, including the filter system, Dow theory, relative-strength system, and price volume systems, to determine when to buy or sell stocks based on market trends.However, the gains achieved through these strategies are often counterbalanced by transaction costs. These techniques aim to identify patterns in the stock market's random events. Malkiel argues that utilizing technical analysis when selecting stocks could yield similar results as flipping a coin. He demonstrates this by using the analogy of observing numbers on a roulette table and attempting to predict the next number without success due to not retesting identified patterns. This concept forms the foundation of the random walk theory, which consists of three assumptions. One of these assumptions is known as weak form efficiency and states that past prices cannot forecast future prices (as technicians believe). Other forms of this theory will be discussed in Chapter 8.

As an alternate strategy proposed by Malkiel, investors can consider employing a buy-hold strategy instead. This approach eliminates transaction costs and defers capital gains and losses until stocks are sold. The theory

will be further explored in Chapter 8 along with an examination of fundamental analysis. Many professionals on Wall Street concentrate on fundamental analysis by analyzing historical earnings, growth rates, and dividends to predict future performance; this serves as the basis for intrinsic value estimation. However, according to Malkiel, studies have shown that analysts are not better at predicting performance compared to technicians.He provides five reasons for this struggleThe text emphasizes the impossibility of predicting random events such as economic conditions or legislative changes. It highlights that firms have the ability to manipulate reported earnings, as exemplified in the Enron scandal. The reliability of analysts is also questioned due to potential mathematical errors and their tendency to prioritize sales positions and commissions over thorough company research. Chapter 8 explores various theories including the random walk theory and semi-strong/strong efficiency, challenging fundamentalist theory by asserting that all information affects stock prices. In Chapter 9, modern portfolio theory introduces risk management with the goal of minimizing risk while seeking higher returns. This theory evaluates a stock's riskiness based on its deviation from average returns. Although it is generally observed that taking on more risk leads to higher rates of return, individual stocks vary in terms of risk. Diversification is introduced as a concept in portfolio theory, suggesting that spreading investments across different stocks can decrease overall risk. Positive correlation occurs when stocks move in the same direction as the market, while diversification can be achieved by investing in stocks with negative correlation, allowing for offsetting losses if one stock decreases in value within a portfolio.The text highlights the challenges in determining correlation among companies and suggests investing in

different industries or foreign markets to diversify investments. Chapter 10 of a book introduces the Capital Asset Pricing Model (CAPM) and explores the relationship between risk and reward. The previous chapter examined the advantages of diversification, while now delving further into both risk and reward. According to the text, most investors would not take on additional risk without higher rewards as increased returns are typically associated with increased risk. This leads to the question of how to increase risk in a diversified portfolio. To address this inquiry, the text examines two types of risks associated with portfolios. The first type is systemic risk which is linked to market fluctuations. The concept of Beta is introduced as an indicator of risk by measuring portfolio or individual stock volatility relative to the market. It emphasizes that systemic risk cannot be diversified away (Note: remain unchanged). Furthermore, the text discusses unsystematic risk which impacts individual stocks or specific stock groups but does not affect the overall market situation. Diversification plays a crucial role in reducing this type of risk since when one stock increases in value, another may decrease, thereby minimizing overall risk.The Capital Asset Pricing Model (CAPM) states that no premium is given for risks that can be diversified away, and beta is used to measure this risk. However, some scholars question the accuracy of beta as an indicator of risk due to studies finding a flat relationship between beta and return. Despite this, beta is still considered a useful investment tool along with other factors like general market swings, interest rates, inflation, national income fluctuations, and other economic factors.

Chapter 11 explores efficient market theory and

concludes that attempts to discredit the random walk theory are not valid. Investors who try to exploit patterns will find them disappear while predicting growth rate valuation methods can be challenging. According to the random walk theory, there are no market patterns and accurate pricing in stock prices reflects all available information. Therefore, it considers the market to be efficient.

Although short-term pricing errors may occur, they will ultimately correct themselves over the long term. The theory suggests that buying stocks for the long term is advisable since short-term prices cannot be predicted.

In conclusion, Malkiel recommends consistently profiting by investing in a diversified market index fund and holding onto it. Historical data supports this recommendation by showing that as the market rises, investors' returns also increase.

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