Book of the Week: A Random Walk Down Wall Street
16 May 2016
This week I read A Random Walk Down Wall Street by Burton G. Malkiel. This book first came out in 1973 and gets revised often to reflect current information. The latest is the 11th edition (2016), the book I read was the 10th edition (2011). This book is still relevant 40 years later. I can summarize the book in one statement. Index funds are better than trying to invest in individual securities or actively managed funds. This is one of my favorite investing books. Malkiel explains things so plainly that it should be accessible to all audiences. Part 4 of the book gives practical advice for investors.
Most important of all, however is the fact that investing is fun.
Firm-Foundation Theory The firm-foundation theory states that investment instrument has an intrinsic value. The value investors Benjamin Graham and Warren Buffett would fall under this theory. Their objective is to buy value at a good price. Four valuation rules for technical and fundamental analysis. Rule 1: A rational investor should be willing to pay a higher price for a share of larger the growth rate of dividends and earnings. Corollary to Rule 1: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last. Rule 2: A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company’s earnings that is paid out in cash dividends. Rule 3: A rational (and risk-adverse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock. Rule 4: A rational investor should be willing to pay a higher price for a share, other things being equal, the lower the interest rates. Caveat 1: Expectations about the future cannot be proven in the present. Caveat 2: Precise figures cannot be calculated from undetermined data. Caveat 3: What’s growth for the goose is not always growth for the gander. Castle-in-the-air Theory In castle-in-the-air theory, you are trying to invest like paying poker. What matters is what other people are doing. This is how bubbles form since they are not linked to intrinsic value of the asset. You can make money if you can predict what other people will do. You can’t sell an asset at the intrinsic value if no one is willing to buy it at the value. The market determines the price. There is an entire field of behavioral finance. These are some tips that will help you guard against your weaknesses.
- Avoid herd behavior
- Avoid overtrading
- If you do trade, sell losers, not winners
3Com and Palm People who believe the efficient market hypothesis like to say the market is efficient and things get priced accurately and quickly. That is bullshit. Sometimes the market is not logical by concrete measures. 3Com owned Palm and sold 5% of Palm on an IPO, leaving 3Com with 95% of Palm shares. Those Palm shares got bid up, such that the 95% of Palm shares were worth $25 billion more than the market capitalization of 3Com. This implies that all the other assets of 3Com were worth negative $25 billion. The market is not always logical and does not price things accurately. Mortgage-backed securities weren’t properly priced either.
A firm’s income statement is likened to a bikini—what it reveals is interesting but what it conceals is vital.
As long as companies are accurate in their SEC documents, investors can’t plead ignorance when shit hits the fan. You can write that your company will crash and burn, but people will still buy it, because they don’t read the prospectus. I should make it a point to read the prospectus of any stock I buy. There is a lot of juicy information in them. Theory and Reality
University professors are sometimes asked by their students, “If you’re so smart, why aren’t you rich?”
People think of all types of different theories on how to trade stock. The problem is that none of them work. People are good at imaging patterns. If you’re trying to time the market, you need to make correct decisions 70% of the time to beat a buy and hold strategy.
As this portfolio manager sheeplishly told me, “I have never met a back test I didn’t like.” But let’s never forget that academic back tests are not the same thing as managing real money.
A back test takes historical data and runs some trading strategy against it. If it looks good, people will try to use it going forward with real money. The problem is that past performance is not an indicator of the future. It is easy to make a strategy look good on paper. You can automate this strategy generation with machine learning. Modern Portfolio Theory The book goes over data to explain why standard deviation is used to measure portfolio risk. I never believed this, but the data is somewhat compelling. One of the things I wanted to do is check whether correlations between stocks hold up over time since correlations between stocks form the basis of decreasing risk. The book shows correlations changing over time. Sometimes the entire market will become correlated in a recession when everything goes down. Your theories to decrease risk go out the window. It takes about 50 securities to diversity away risk. Capital Asset Pricing Model The capital-asset pricing model (CAPM) says that in order to get more reward, you need higher risks. There is some risk that can be diversified away, the systematic risk and there is some risk that cannot be diversified away, the unsystematic risk. Beta is a measure of systematic risk, which is the slope of the linear regression fit to the return of the stock versus return of the market. Practical Advice The last part of the book gives practical advice for investors. One of the most important things is how to allocate your portfolio. Here are give principles.
- Risk and reward are related
- Your actual risk in stock and bond investing depends on the length of time you hold your investment.
- Dollar-cost averaging can reduce the risks of investing in stocks and bonds.
- Rebalancing can reduce investment risk and possible increase returns
- Distinguishing between your attitude toward and your capacity for risk.
When you are young, you can afford to have a larger percentage of your portfolio be stocks, because you have a longer time of holding before you need to take money out. As you get older, your bond allocation should increase. You should be investing in index funds that are a mix of bonds, TIPS, REITs, U.S. and international stocks. Hold bonds in tax-exempt accounts. When you retire, you should spend less than 4% of your nest egg annually during retirement to make it last.
Index the core of the portfolio, and try the stock-picking game for the money you can afford to put at somewhat greater risk.
Sometimes index funds are boring. People want to gamble a little bit. Here are some guidelines for people who what to pick stocks.
- Confine stock purchases to companies that appear able to sustain above-average growth for at least five years.
- Never pay more for a stock than can be reasonably justified by a firm foundation value.
- It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air.
- Trade as little as possible.
I can deduct up to $3,000 in capital losses a year from my income. That is the amount I am willing to lose when trading stocks. When I hit that loss, I am done for the year. I keep the winners and sell the losers in order to not have any capital gains. As far as the IRS is concerned, I lose money trading stocks every year. Purchase A Random Walk Down Wall Street on Amazon.com or check it out from your library