Friday, August 22, 2008

Security Analysis: Chapter 52, Part I

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

In this the final chapter, the authors discuss whether forecasting prices (termed "market analysis") is a useful alternative or supplement to security analysis. Although the two are often used in concert by Wall Street firms, Graham and Dodd believe there is nothing to gain from market analysis.

Market analysis is divided into two groups. In the first group, market movements are predicted solely from past market data (termed "chart reading"). In the second group, a variety of economic factors are considered ranging from interest rates to political outlooks.

Chart reading cannot be a science, as its conclusions are not dependable. If they were dependable, everybody could make accurate predictions. This is impossible because these actions would result in a loss of the method's effectiveness. Effectiveness for a given chart reading methodology is thus necessarily dependent on keeping the knowledge secret.

As such, the authors argue, there is no method which has been continually successful for a long period of time, for if there were, it would be adopted by masses of traders, bringing its usefulness to an end.

The theory of chart reading also has logical fallacies. Just because the market behaved in a certain way in the past, it does not follow that this serves as an accurate predictor of the future. In security analysis, the same may hold true for past earnings, which are used to help predict future earnings. Though these predictions again are not perfect, the security analyst has the ability to protect himself with a margin of safety, while the market analyst does not.

Chart readers tend to encourage people to immediately cut losses short when they should occur while riding profits for as long as possible. Though this prevents large losses and allows for large gains, mathematically there is no benefit to such policy, as the aggregate of small losses exceeds the few large profits. With transaction fees serving as the "house advantage" to use a gambling analogy, traders are sure to lose over the long term.

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