“A Random Walk Down Wall Street” by Burton Malkiel: Part One

Finances are a leading stressor in many people’s lives. Just as we’ve talked about our limited mental resources and how one must balance them in order to be successful, balancing our physical resources is just as important. I clearly enjoy finance and psychology books. “A Random Walk Down Wall Street” is a blend of both of those subjects. I myself have fallen into the trap of believing that I myself or someone I hire could beat the market. This book helped me realize that statistically, that is very unlikely. Enjoy these notes and apply them practically.

  1. I view investing as a method of purchasing assets to gain profit in the form of reasonably predictable income (dividends, interest, or income) (link to “Rich Dad Poor Dad”) and/or appreciation over the long term. It is the definition of the returns that often distinguish an investment from speculation. A speculator buys stocks hoping for short-term gain over the next days or weeks. An investor buys stocks likely to produce dependable future stream of cash returns and capital gains when measured over years or decades.
  2. It’s exciting to review your investment returns and see how they are accumulating at a rate faster than your salary. And it’s also stimulating to learn about new ideas for products and services, and innovations in the form of financial investments. A successful investor is generally a well-rounded individual who puts a natural curiosity and an intellectual interest to work to earn more money.
  3. All investment returns, whether from common stocks or exceptional diamonds, are dependent to varying degrees, on future events. That’s what makes the fascination of investing: It’s a gamble whose success depends on the ability to predict the future.
  4. The firm-foundation theory argues that each investment instrument, be it a common stock, or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below intrinsic value, a buying opportunity exists because this fluctuation will eventually be corrected, or so the theory goes.
  5. It was his opinion that professional investors prefer to devote their energies not to estimating intrinsic value, but rather to analyzing how the crowd of investors are likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle building and then buying before the crowd.
  6. It is analogous to entering a newspaper beauty-judging contest in which one must select the six prettiest faces out of a hundred photos, with the prize going to the person who selections most closely conform to those of the group as a whole.
  7. An investment is worth a certain price to a buyer because she expects to sell it to someone else at a higher price.
  8. A sucker is born every minute– and he exists to buy your investments at a higher price than you paid for them. Any price will do as long as others are willing to pay more.
  9. Options provide one way to leverage one’s investment to increase the potential rewards as well as the risks. Such devices helped to ensure broad participation in the market. The same is true today.
  10. The key to investing is not how much an industry will affect society or even how much it will grow, but rather its ability to make and sustain profits.
  11. The stock market is not a voting mechanism but a weighing mechanism. Valuation metrics have not changed. Eventually, every stock can only be worth the present value of the cash flow it is able to earn for the benefit of investors.
  12. Stock investors can do no better than simply buying and holding an index fund that own a portfolio consisting of all the stock in the market.
  13. Many chartists believe that the market is only 10% logical and 90% psychological. They generally subscribe to the castles-in-the-air school and view the investment game as one of anticipating how the other players will behave.
  14. Fundamental analysts take the opposite tack, believing that the market is 90% logical and 10% psychological. Caring little about the particular pattern of past price movement, fundamentalists seek to determine a stock’s proper value.
  15. Three Explanations of Technical Analysis:
    1. It has been argued that the crowd instinct of mass psychology makes trends perpetuate themselves. When investors see the price of a speculative favorite going higher and higher, they want to jump on the bandwagon and join the rise.
    2. There may be unequal access to fundamental information about a company. When some favorable piece of news occurs, it is alleged that the insiders are the first to know, and they act, buying the stock and causing its price to rise.
    3. Investors often underreact initially to new information. There is some evidence that when earnings are released that beat Wall Street estimates, the stock price reacts positively but that the initial adjustment is incomplete.
  16. Fundamentalists use four basic determinants to help determine the proper value for any stock:
    1. Rule #1: Buy only companies that are expected to have above-average earnings growth for 5 or more years.
    2. Rule #2: Never pay more for a stock than its firm foundation of value.
  17. The expected growth rate. Most people don’t understand the implications of compound growth for financial decisions.
  18. The expected dividend payout. The amount of dividends you receive at each payout, as contrasted to their growth rate, is readily understandable as being an important factor in determining the stock’s price. The higher the dividend payout, other things being equal, the greater the value of the stock.
  19. The degree of risk. Risk plays an important role in the stock market, no matter what your over-eager broker tells you. There is always a risk– and that’s what makes it so fascinating. Risk also affects the valuation of a stock.
    1. Rule #3: A rational (and risk averse) investor should be willing to pay a higher price for a share, the less risky a stock is.
  20. The level of market interest rates. The stock market does not exist as a world unto itself. Investors should consider how much profit they can obtain elsewhere.
    1. Rule #4: A rational investor should be willing to pay a higher price for a share, the lower the interest rates.
  21. The four valuation rules imply that a security’s firm-foundation value (and its price-earnings multiple) will be higher the larger the company’s growth rate and the longer its duration; the larger the dividend payout for the firm, the less risky the company’s stock, and the lower the general level of interest rates.
  22. The longer one projects growth, the greater is the stream of future dividends.
  23. Look for stocks whose stories of anticipated growth are the kind on which investors can build castles in the air.
  24. The problem is that once such a regularity is known to market participants, people will act in a way that prevents it from happening in the future. If people know that a stock will go up tomorrow, you can be sure it will go up today.
  25. The point is that we should not take for granted the reliability and accuracy of any judge, no matter how expert.
  26. Dividend increases, in fact, are usually an accurate indicator of increases in future earnings. There is also some tendency for a strong price performance to follow the dividend announcement.
  27. The common stock index fund, despite all the critics, remains the undisputed champion in taking the most profitable stroll through the market.
  28. Once academics accepted the idea that risk for investors is related to the chance of disappointment in achieving expected security returns, a natural measurement suggested itself– the probably dispersion of future returns. Thus, financial risk has generally been defined as the variance or standard deviation of returns.
  29. The higher the standard deviation (the more spread out are the returns), the more probably it is (the greater the risk) that at least in some periods you will take a real bath in the market. That’s why a measure of variability such as standard deviation is so often used and justified as an indication of risk.
  30. Portfolio theory begins with the premise that all investors are risk-averse. They want high returns and guaranteed outcome. The theory tells investors how to combine stocks in their portfolio to give them the least risk possible, consistent with the return they seek. It also gives a rigorous mathematical justification for the time-honored investment maxim that diversification is a sensible strategy for individuals who like to reduce their risks.
  31. As long as there is some lack of parallelism in the fortunes of the individual companies in the economy, diversification can reduce risk. In the present case, where there is a perfect negative relationship between the company’s fortunes (one always does well when the other does poorly) diversification can totally eliminate risk.
  32. In general, diversification will not help much if there is a high covariance (high correlation) between the returns of the two companies.
  33. Diversification has not continued to give the same degree of benefit as we previously the case. Globalization led to an increase in the correlation between the U.S. and foreign markets as well as between stocks and commodities.
  34. The basic logic behind the capital-asset pricing model is that there is no premium for bearing risks that can be diversified away. According to this theory, savvy investors can outperform the overall market by adjusting their portfolios with a risk measure known as beta.
  35. We go on to say that part of total risk or variability may be called the security’s systemic risk and that this arises from the basic variability of stock prices in general and the tendency for all stocks to go along with the general market, at least to some extent. The remaining variability in a stock’s returns is called the unsystemic risk and results from factors peculiar to that particular company. Systemic risk, also called market risk, captures the reaction of individual stocks to general market swings. Some stocks and portfolios tend to be very sensitive to market movements. Others are more stable. This relative volatility or sensitivity to market moves can be estimated on the basis of the past record, and is popularly known as Beta.
  36. The calculation begins by assigning a beta of 1 to a broad market index. If a stock has a beta of 2, then on average it swings twice as far as the market. If the market goes up 10%, the stock tends to rise 20%. If a stock has a beta of 0.5, a 10% market increase or decrease means a 5% increase or decrease in this stock’s value. Professionals call high-beta investments aggressive and label low-beta stocks as defensive.
  37. We saw that as the number of securities in the portfolio approached 60, the total risk of the portfolio was reduced to its systemic level.

Check here in a couple of days for the conclusion of this book in Part Two of “A Random Walk Down Wall Street”

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (Eleventh Edition)

 

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