FIN5220-001: Security Analysis Port Mgmt.
Dr. S. Zong
18th November 2014
A Random Walk Down Wall Street
By Burton G. Malkiel
A Random Walk refers to the term that future steps or directions cannot be predicted by past history. In the investment world this means that how a stock performs in the immediate future cannot be predicted from its past performances. Academics point out that any randomly selected group of securities would perform just as well or better than carefully analyzed portfolio created by fund managers based on its performance history. Currently in its 10th edition A Random Walk Down Wall Street by Burton G. Malkiel is a time tested strategy for successful investing for people of all walks; from the novice entrepreneur to the seasoned investor. It gives a clear understanding of how the stock market works and makes a compelling argument for passive investing with a long term goal. Efficient Markets
In his preface Burton G. Malkiel states that the original message behind A Random Walk Down Wall Street is that “investors would be better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed funds”, and that the stock market is pretty efficient and most everyone is wasting their time trying to find inefficiencies to exploit. By market being efficient does not mean that the market is always correct, but that the market is quick to reflects new information and mostly correctly, secondly that the market will not allow above average returns without relative risk. In chapter 11 he some common arguments against EMH and subsequently debunks them all. Firm Foundations and Castles in the Air
Chapter 1 begins by defining two theories traditionally used by investment professionals to determine asset valuation, the “firm foundation theory” and the “castles in the air theory”. The firm foundation theory suggests that investments should be made by determining the intrinsic value of the investment instrument. This is done by analyzing the firm’s present condition and its future prospects. Basically once you are able to determine the intrinsic value of the stock, a buying opportunity arises whenever the prices fall below that. The theory is that the market will correct itself and the price will go back up to match its intrinsic value there by making a profit for the investor. The castles in the air theory, concentrates more on the psychological value of the asset. That a stock is worth buying, regardless of intrinsic value, if you believe it can be sold at a higher price. You just have to figure out a way to be ahead of the rest of the public. It’s like getting in and buying at the beginning of the bubble. This theory was promoted and successfully implemented by renowned economists John Maynard Keynes in the 1930s-40s. While many professionals try to master this approach, it can be a very dangerous game since it is not only almost impossible to predict how groups of people will behave but also how long the increase in value will last. I find that there is some validity to both theories. If I am a serious investor looking to invest in a particular business or industry, especially if I am familiar or already affiliated with that industry I would be able to get the necessary information and make an educated decision. Otherwise it is a lot of work and any number of variables could change the industry. Obviously John Maynard Keynes was able to make money using the castle in the air theory, so it can be done. The question is do you consider yourself as savvy an investor as him. I don’t.
Madness of Crowds
The castles in the air theory, thrives with the madness of crowds and is essentially responsible for creating bubbles in the market. Burton G. Malkiel gives several examples in this chapter of bubbles created and busted over the years beginning with The Dutch Tulip Bulb craze of the 1630s to the Housing Bubble burst of 2008-2009....
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