Saturday, November 14, 2009

A Random Walk Down Wall Street: Chapter 2

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.

This chapter contains a discussion of asset price bubbles throughout history, and the psychology behind them. Malkiel discusses the Tulip Bulb Craze, The South Sea Bubble, The Florida Real Estate Craze (the one in the 1920s...the book's writing preceded the one last year!) and the crash on Wall Street of 1929.

Of interesting note is the fact that it is obviously very difficult to sit on the sidelines and see one's friends and neighbours profit from a bubble. Therefore, even though many of the participating "investors" recognize that prices are irrational, they are willing to part with their money anyway, hoping for a "greater fool" to sell to later.

Another commonality of these bubbles is the fact that there are always groups of people who can rationalize the price no matter how high a level is achieved. Even after the bubble pops, such people will maintain that the high prices were rational, only this time their opinions are considered foolish, whereas during the bubble they were considered reasonable.

Even Isaac Newton fell victim to one of the bubbles described in the book. He is quoted as grumbling, "I can calculate the motions of heavenly bodies, but not the madness of people."

While unsustainable prices can persist for years, eventually they succumb to gravity. The larger the bubble, the more dramatic the reversal and the longer the resulting hangover. Few of the builders of the "castles in the air" (a reference from Chapter 1) can anticipate the reversals in time to realize their paper profits. Malkiel concludes by arguing that it is not difficult to make money in the market, but one of the easiest ways to become a loser is to be constantly swept up in the latest bubble.

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