People in general, think that the individual investor doesn't stand a chance against the professionals.
Pointing to high-frequency trading and the complexity of the financial instruments that Wall Street has become renowned for, many argue that this must be true.
And besides, why would the professional analysts have such high salaries otherwise?
In this book Burton Malkiel argues that this couldn't be further from the truth!
He shows that even a blindfolded monkey throwing darts at stock listings would outperform their professionals. Fees,
taxes, human psychology, and most of all that markets behave like a random walk, are stated to be reasons for this.
This is an extremely controversial topic, as you probably can tell already. And the stakes are high.
Banker's bonuses all over the world are threatened. Fasten your seat belt, for the following takeaways won't be any less provocative!
Takeaway number 1: Fundamental analysis doesn't outperform the market.
In beating the market, professionals tend to rely on one of two strategies: The fundamental approach or the technical approach.
The investors who use fundamental analysis as their vehicle for earning money in the market, believe in the so-called "firm
foundation theory" This theory argues that the price of an investment is anchored is something called
"intrinsic value", and that the price of an asset typically over or underestimates this value.
The task of the fundamentalist is therefore to buy assets that have an intrinsic value
higher than the current price of the asset, and sell if the opposite is true.
The intrinsic value can be determined by discounting all the future cash flows of an investment.
Discounting is the process of turning future earnings into today's value.
Remember that a dollar today is worth more than a dollar tomorrow!
To calculate the correct intrinsic value of a stock, a fundamentalist must assess the following 4:
1. Earnings growth rate. The most important part of the calculation revolves around the estimation of future growth rates of earnings.
2: The expected dividend payout. The higher the dividend payout, the greater the value of the stock, everything else equal. 3: The degree of risk.
Everyone prefers an investment with a lower risk of losing money over an investment with a higher risk of losing money,
even though the expected returns are the same.
Would you prefer to get a $100 in your hand now or to flip a coin for $200?
I thought so. A riskier investment must therefore be compensated with a higher potential reward. 4: Future market interest rates.
I stated earlier that a Swedish crown today, is worth more than a Swedish crown tomorrow.
But I didn't state how much more.
The so-called "risk-free rate of return", which is decided by the interest rate of the
three-month US Treasury bill for US investors is used as a baseline for this.
The higher the risk free rate of return, the higher the return should be expected from any other investment.
Perhaps you already see some of the problems ...
1: Faulty information. The information given by the company you are interested in acquiring could be misleading.
This has been common, especially during times of mass optimism, such as during the dot-com bubble. In these situations
CEO could mean "chief embezzlement officer", and you can't be sure where the CFO is a "corporate fraud officer" or not.
Also the EBITDA in the income statement might be an acronym for "earnings before I tricked the dump auditor". All kidding aside,
there are many cases where reported earnings, assets and the likes are misleading, which makes it very hard for the fundamentalist to predict the future.
Any computer scientist knows that garbage in means garbage outs. 2: Errors and wrong conclusions in the analysis.
Even if the information given to the fundamentalist is trustworthy, he's still faced with the daunting task:
He must make predictions about the future without the benefit of divine inspiration.
He must use the information available without conducting errors or drawing the wrong conclusions.
As Samuel Goldwyn famously used to say: "forecasts are difficult to make, particularly those about the future." 3: Influence of unexpected events.
The fundamentalist might use all the current information available to assess a
perfect analysis of the stock, only to find out later that the company's primary production plant was hit by an earthquake. Or that the CEO,
and the founder of the company, dies of a sudden heart attack.
Approximately 90% of the analysts on Wall Street are fundamentalists.
Takeaway number 2: Technical analysis doesn't outperform the market either.
Technicians, as the people believing in a technical analysis are called, trust in the "castle-in-the-air theory".
As opposed to the fundamentalist view, this theory argues that intrinsic value is of less importance.
Instead, what's most important is the behavior of the investment community.
Crowds do not act rational, and they are susceptible to building castles in the air in the hopes of acquiring wealth.
A successful investor's primary task is therefore to estimate which investments that are most prone to castle building. A sucker is born every
minutes and the technicians task is to buy
investments that later can be sold to these people. If someone else is willing to buy higher, the price you pay matters not!
Here's a simple analogy of how it works:
You and 100 other people have randomly been chosen to decide who the 3 prettiest girls in town are. The one whose selection is most
like that of the crowd, wins. If you're a smart player, you realize that personal opinion doesn't matter in this competition.
The better strategy is to try to anticipate what your competitors will answer.
Technical analysis is no different for this. Dutch tulip bulbs during the mid-1600s, conglomerate's in the late 1960s and
Internet stocks in the early 2000s, are great examples of castles in the air.
The technician will use charts of stock prices and trading volume to determine future prospects of castle building.
There are 3 primary reasons as to why technical analysis is stated to work according to Malkiel:
1. Price increases are self-perpetuating
Increases in price tend to cause additional increases.
People can't stand waiting on the sidelines when others are making money.
Therefore, demand increases with every price increase which causes prices to go even higher, creating a dangerous upward spiral.
2: Unequal access to information.
Insider's are the first to know about changes in a company.
Then comes the friends the families of these people, then the professionals and their institutional capital and finally, poor people like you and me.
Charts are supposed to give information about when either insiders or
professional are buying, so that you can make your move before the rest of the market does.
3: Investors underreact to new information.
The stock market will react to new information gradually, which results in longer periods of sustained momentum.
Malkiel, and other advocates of the random walk counter argues with:
1: Sharp reversals
Uptrends can happen drastically, which may cause the technician to miss the boat. When an uptrend is signaled,
it may already be too late.
2: Profit maximization. Let's say that company A's stock is at $20.
One day, it develops a new product that increases the value of the company to $30. Before releasing this information,
wouldn't it make sense for the insiders to buy the stock until $30 has been reached?
Every dollar they invest before $30 is an instant profit!
3: The techniques are self-defeating. Once people know about the techniques that are supposed to efficient,
the technicians will compete each other out.
Other traders will try to anticipate certain signals that they know that everyone else is buying or selling to.
Approximately 10% of the analysts of Wall Street are technicians.
Takeaway number 3: Human psychology makes it even more difficult to beat the market. As if the aforementioned reasons weren't enough,
there are 4 factors that professionals and individual investors alike face when they are trying to beat the market, which further reduces their chance of doing so.
Overconfidence.
This bias causes mortals like us to be over optimistic about assessments of the future, and to overestimate our own abilities.
Thereby, we conduct sloppier analysis and take higher risks than otherwise would have been the case.
Biased judgments. Humans tend to think that they have some control in situations, even though the situation is completely random.
Technicians are argued to be especially vulnerable to this as they think that they can predict future prices by looking at past ones.
Herd Mentality
This might be the most obvious one. Herd mentality is the primary reason for many of the stock market's greatest bubbles and following meltdowns.
When your friends all brag about their latest stock profits and the news of predicting economic "golden ages", it's hard if not impossible,
to stand idle on the sidelines.
One great example of this is group thinking. Individuals can influence each other into believing that an incorrect point of view is, in fact,
the right one. Let's do a quick test: Which one of these two lines is the longest?
Correct, it's A. In a laboratory experiment from the 1950s, participants were asked the same question.
But before they got to answer, six hired persons were going to answer incorrectly,
ie that B is the longest. The results were astonishing.
Even though A obviously is the longest, people tended to change their answer according to the crowd and therefore incorrectly picked B.
Later, it was proven that this isn't because of social pressure, but because we humans change our perception because of influence from others.
Loss Aversion. Lastly, loss aversion is another psychological factor that makes it difficult to us to stay rational in the market.
Losses are considered far more undesirable than equivalent gains are desirable.
Consider the classic game of a coin flip. Heads, you lose $100, and tails, you win $100.
Do you want to play? Most people don't.
Studies have shown that the positive payout had to be 250 dollars before people were ready to take this gamble.
You can only imagine the consequences that this results in for us in the stock market.
Takeaway number 4: The random walk and efficient market hypothesis.
Now, if neither fundamentalists nor technicians can predict the market, who can? According to the author, no one can!
Why? Because the development of the market is a random walk.
A random walk is one where future steps or direction cannot be predicted by history.
Based on this concept of the random walk, three versions of the so-called "Efficient Market Hypothesis" have been developed.
Weak EMH:
The market is efficient in the way that it is reflecting all currently available price
information. If there are obvious opportunities for returns, people will flock to exploit them until they disappear. The weak theory suggests that
technical analysis can't be used for beating the market, but that fundamental analysis might be able to.
Semi-strong EMH: The market is efficient in the way that it is reflecting all publicly available information.
This would mean that an investor cannot beat the market by either technical or fundamental analysis.
The only way to stay ahead of the curve according to its advocates is by using insider information.
Strong EMH: The market is efficient in that it is always mirroring the true value of an asset. In this case even
insider information wouldn't help you trading stocks and earning above market returns.
People often joke about supporters of the efficient market hypothesis by telling this story:
A professor and his students was walking down a road when the student suddenly spots a $100 bill.
He stops to pick it up, but is interrupted by his professor.
"Ah, don't bother picking it up boy. If it truly was 100 dollar bill, it wouldn't be laying there."
The author of this book is not a believer in this strongest form of the efficient market hypothesis.
But rather he would answer his pupils something along these lines:
"Hurry up and pick it up boy. If it's truly a hundred dollar bill, it won't be laying around for long."
Takeaway number 5: How you can beat Wall Street.
Because of the flaws of the two primary strategies of investing and because of human psychology,
Wall Street professionals have been unable to beat the market historically.
This can be proven by making a very simple point: An investor who puts $10,000 in the S&P 500
market index at the beginning of 1969 would have $736,000
in 2014, compared to an investor who puts his money in the average actively managed fund, who would end up with "only"
$501,000. When it comes to investing, you get what you don't pay for!
Herein also lies the solution on how to beat Wall Street: Invest for the long run, and in cheap index funds primarily.
There are other asset classes to consider as well, to increase
diversification and decrease your risk. Here's a lifecycle-guide on how to invest to beat "The Street".
Mid-20s
Late 30s
Mid-50s
Late 60s, and beyond
This might sound too simple to be true, and it actually is. You must also consider these 5 core principles for asset allocation:
1: Risk and reward are related.
Anyone would pick $100 guaranteed before a $200 coin flip. Risk in the stock market is defined as the volatility of the individual investment.
Volatility is measured by how much the return typically differs from its expected value.
A higher volatility means a higher risk that you might be forced to sell with a loss at a later stage and may imply that your
investment has a higher risk of defaulting. Here's a list of assets, their expected returns and their volatility.
2: Length of holding time decreases risk.
The longer you hold on to a position, the more likely that it will perform according to its expected value.
In other words, the longer you can hold on to an investment before you need that specific money, the less risk you take!
This is best illustrated by the following graph which shows how much yearly return different holding periods in stocks resulted in during 1950 to 2013.
Notice that when holding stocks for at least 15 years, there wasn't a single period of negative returns.
Trust in time in the market, rather than timing the market!
3: Use dollar cost averaging. Dollar cost averaging means investing the same fixed amount at regular intervals.
For instance, put 10% of your salary in an index fund every month.
By doing this you will benefit from the up- and downswings in the market.
Your average price per share will actually be lower than the average price at which you bought them.
Why? Because you'll buy more shares when the market is cheap and depressed and less of them when it's expensive and over-optimistic.
4: Decide your tolerance for risk. How much risk you can tolerate depends on your financial situation,
your age and your psychology. If losing your investment money,
means that you will have to
drastically change your lifestyle, as in the case of a retiree living from his or her investment income, you might want to downsize risk.
Similarly, if your sleep is affected by the volatility in your stock portfolio,
you might want to "sell down to the sleeping point" as JP Morgan once suggested to a friend.
5: Rebalancing can reduce risk and possibly increase returns.
Let's say that you're a 25 year old. You are then suggested to keep
70% of your assets in index funds, and
15% in bonds, according to the examples presented before. If stocks have been overperforming lately, you might end up with 80% index bonds and
5 percent bonds.
This might be riskier than you would prefer, as decided by the previous point.
By rebalancing every year or every other year to restore the same allocation as before, you can reduce this risk. Furthermore,
you might be able to sell stock when they are close to a bubble, if you are lucky.
Here's a super fast recap:
Takeaway number 1 is that fundamental analysis has a tough time beating the market and the 2nd takeaway is that
technical analysis doesn't seem to be a winning strategy either. Number 3
is that beating the market is made even more difficult due to human psychology.
4 is that future market development is essentially a random walk and therefore it cannot be predicted.
The final takeaway is a hopeful one for the individual investor, as it suggests that he can easily beat the average analyst on Wall Street,
by simply buying and holding the market index.
This was only a fraction of what the more than 420 pages of "A Random Walk Down
Wall Street" has to offer. By buying the book from the link in the description below,
you would support both your future self, and this channel.
Thanks for watching!