A Random Walk Down Wallstreet

“A Random Walk Down Wall Street”

There is a sense of complexity today that has led many to believe the individual investor has little chance of competing with professional brokers and investment firms. However, Malkiel states this is a major misconception as he explains in his book “A Random Walk Down Wall Street”. What does a random walk mean? The random walk means in terms of the stock market that, “short term changes in stock prices cannot be predicted”. So how does a rational investor determine which stocks to purchase to maximize returns? Chapter 1 begins by defining and determining the difference in investing and speculating. Investing defined by Malkiel is the method of “purchasing assets to gain profit in the form of reasonably predictable income or appreciation over the long term”. Speculating in a sense is predicting, but without sufficient data to support any kind of conclusion. What is investing? Investing in its simplest form is the expectation to receive greater value in the future than you have today by saving income rather than spending. For example a savings account will earn a particular interest rate as will a corporate bond. Investment returns therefore depend on the allocation of funds and future events. Traditionally there have been two approaches used by the investment community to determine asset valuation: “the firm-foundation theory” and the “castle in the air theory”. The firm foundation theory argues that each investment instrument has something called intrinsic value, which can be determined analyzing securities present conditions and future growth. The basis of this theory is to buy securities when they are temporarily undervalued and sell them when they are temporarily overvalued in comparison to there intrinsic value One of the main variables used in this theory is dividend income. A stocks intrinsic value is said to be “equal to the present value of all its future dividends”. This is done using a method called discounting. Another variable to consider is the growth rate of the dividends. The greater the growth rate the more valuable the stock. However it is difficult to determine how long growth rates will last. Other factors are risk and interest rates, which will be discussed later. Warren Buffet, the great investor of our time, used this technique in making his fortune.

The second theory is known as the “castle in the air theory”. This method is more psychological in nature rather than value based. Investors using this theory would buy securities early when exciting news and growth is speculated, then sell them when the securities temporarily increased in value. I used the term speculated because often times these forecasts were not based on any kind of asset valuation or operating game plan. It was purely based on the “hype” surrounding the security. These were short-term investments and were based on the premise “that a buyer could pay any price for a stock as long as they expected future buyers to assign a higher value”. This theory is also known as the “greater fool” theory.

Now that the two theories have been explained, let’s look at some historical examples from Malkiel that really paint the picture in chapter 2. The first speculative craze noted was over tulips in the seventeenth century in Holland. The tulips were brought from Turkey and the Dutch valued the beauty and rarity of the new flowers. Thus the prices for the flowers inflated. As the prices rose merchants would by stockpiles to sell to the public. The more expensive they got the more the public believed they were making smart investments. People would sell off the personal belongings to get their hands on the bulbs. The mania surrounding the bulbs created a bubble that would soon burst. The prices got so high some people decided to cash in and sell them to make a handsome profit. Soon others joined in causing a snowball effect and the prices tumbled. Eventually there was no demand and they were worthless. Many went bankrupt. So what happened? The speculative craze increased prices well beyond any reasonable level, and at some point prices had to regain stability. I believe prices can remain high as long as demand supports it, but demand is not constant and will rise and fall until equilibrium is reached.

A more modern version of the bubble is known as Black Thursday. During little more than a year period from 1928 to 1929 the market experienced unprecedented growth, more than that of the prior five years combined. There was a speculative market and everyone was getting in. Stocks were being bought on margin, thus exemplifying the crazes. Furthermore, the investment pool strategy became popular around this time. This involved a group of traders banding together to manipulate a stock. The process entailed a pool manager who would buy large portions of stock over a period of time. The pool manager