Sunday, December 20, 2009

A Random Walk Down Wall Street: Chapter 14

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.

Once the investor has figured out what portion of his portfolio will be dedicated to equities (as per the last chapter), he is ready to consider the different ways in which he can go about investing in the equity asset class. In this final chapter of the book, Malkiel discusses the four main ways in which investors can participate in the equity market.

In the first edition of the book (back in 1973), Malkiel called for an index mutual fund that individual investors could buy into, as that product did not exist at the time. Now, however, investing in index funds has become the easiest way for investors to enjoy the market's return. Using this mechanism to invest, individuals will outperform most money managers after fees.

For those who must go it alone and invest in individual securities themselves, Malkiel has four rules of advice to help them beat the market:

1) Only buy companies that can grow earnings at an above-average pace for 5+ years
2) Don't pay more than the market's P/E ratio for a stock
3) Buy stocks with good stories on which other investors may jump
4) Minimize trading (subject to taxes, e.g. it is fine to sell losers at the end of the year to lower capital gains taxes)

Even following these rules, the investor is not guaranteed to outperform the index. But investing is fun, and for those who just have to play the game, these rules are designed to tilt the odds in the individual investor's favour.

The third manner by which the investor may enter the equity market is through a money manager. Malkiel does not believe investors can do well attempting this, as identifying the superior managers (of which there are few) appears only possible after the fact. Furthermore, in the studies Malkiel has conducted, good past performance does not persist into the future. Therefore, just because a manager's record is good does not seem to suggest that he will continue to be good. Malkiel does note that there are a few managers that are the exception to this, including Warren Buffett.

Finally, closed-end mutual funds that trade at large discounts to their net asset values are also considered good investments. Here, investors are offered the opportunity to buy shares in companies at a discount to the market. Sometimes, discounts can stretch as high as 40%, but the discounts do change over time. When the discount is above 25%, Malkiel suggests investing.

Malkiel ends the book with a discussion about how a great portion of one's returns from the stock market are due to luck, and that individuals wrongly attribute their returns, or lack thereof, to skill or a lack of skill.

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