Sunday, November 8, 2009

A Random Walk Down Wall Street: Chapter 1

Though not exactly a book related to value investing, this oft-cited work of Princeton economist Burton Malkiel discusses many important features of stock market investing. An understanding of its prime contentions is useful for beginners and experts alike.

Malkiel starts the book off by arguing that individual investors can indeed outperform the so-called "experts" on Wall Street by following the principles of the book. The term "random walk" in the title refers to the fact that future steps or directions in the stock market cannot be predicted. Malkiel argues that earnings predictions and chart patterns are useless.

One of the largest threats to investor portfolios is inflation, and while it has been tame in recent decades, Malkiel warns that it may not continue to be so. As the economy continues to become more service-based, Malkiel believes that productivity improvements will be harder to come by, which will drive up prices.

In the rest of the chapter, Malkiel describes and discusses the two approaches used on Wall Street to value assets:

1) The Firm Foundation

Each investment has an intrinsic value. When the price of the investment falls below that value, a buying opportunity exist. Malkiel argues that the logic of this theory is respectable, but that in practice it is very difficult to correctly value a security, because the future is so uncertain.

2) The Castle-In-The-Air

With this method, investors attempt to determine which securities will be popular in the future, and thereby buy before the crowd does. Malkiel also calls this the "Greater Fool" theory, since it suggests that it's allright to pay three times what something is worth as long as later on you can find someone else to pay five times what its worth.

1 comment:

Richard Beddard said...

Remarkably, in my edition at least, Malkiel says Benjamin Graham advocated efficient markets towards the end of his life. Actually Graham did reject the kind of complex analysis he'd taught in Security Analysis late in his life, but only because he thought simple and fairly mechanical value based rules could do the job. I blogged about this here: