Saturday, November 28, 2009

A Random Walk Down Wall Street: Chapter 7

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.

The author now turns his attention to discrediting fundamental analysis. The author discusses several academic studies (including some of his own work) that show how analysts add no value in predicting future earnings and how most mutual funds under perform the market.

Malkiel cites four reasons analysts can't get earnings growth predictions correct:

1) The influence of unpredictable events. Analysts can't forecast these, but analysts will believe strongly in their predictions anyway.

2) Creative accounting. Managements have a lot of leeway when it comes to producing their bottom-lines, making it difficult to predict the results in advance.

3) Incompetence. Malkiel cites several examples (including those which he has witnessed personally) where analysts simply do a poor job.

4) The promotion of the best analysts. Superior analysts don't stay at their jobs for too long.

While Malkiel recognizes that some fund managers do beat the averages consistently, he notes that these managers are so few that these incidences are not inconsistent with the laws of chance. He cites the example of a contest where 1000 people flip coins, where the "heads" move on to round 2 and the "tails" go home. After 5 flips, there will be approximately 30 people who flipped heads five times in a row, and their advice will be sought and their biographies will be written, despite the fact that they arrived at their rank by pure luck.

Despite the academic evidence that Malkiel cites throughout the chapter, he concludes by offering his personal opinion that the market is not completely efficient. He writes that "some gremlins are lurking about that harry the efficient-market theory and make it impossible for anyone to state that the theory is conclusively demonstrated." He vows to discuss these market anomalies in Chapter 10.

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