Random Walk Essay, Research Paper

A Random Walk Down Wall Street

Keypoints

Chapters 1 & 2

A. Random walk is a movement in which future steps or directions cannot be predicted. Applying random walk theory to stock market simply means short run gains/loses in stock prices cannot be predicted. Hence, advisory services, earnings predictions, and forecast analysis are obsolete, not to mention, costly. Eliminate the middlemen!

B. Malkiel promotes The Get Rich Slowly but Surely method that advises investors to stay even, meaning, investments must secure a rate of return equal to inflation. Ideally, most investors would want holdings that have rate of return higher than inflation. Rate of Return > Inflation.

C. Firm-Foundation Theory states that assets rely on their present conditions and future prospects in order to establish an intrinsic value. The prospective dividends are then factored into the stock s market price; hence, it s intrinsic value rises/falls.

D. Castle-in-the-Air Theory is one that focuses on the dreams and wants of masses. For example, the Tulip Bulb Craze was a classic example of a self-fulfilling prophecy. The prices of the bulbs skyrocketed because the buyers made them by way of DEMAND. There were not enough bulbs to go around and those individuals lucky enough to have them doubled their equity in tulip bulb holdings. However, the bubble burst when the price of bulbs got to high holders wanted to sell but to their dismay, there were no buyers bulb prices then plummeted. Res tantum valet quantum vendi postest A thing is worth only what somelse will pay for it. Similar lessons are depicted in The South Sea Bubble and The Florida Real Estate Craze.

Chapters 3 & 4

A. Determining the value of a stock is not easy. Companies can manipulate the value of shares outstanding with misleading announcements. For instance, General Electric s 1955 venture into diamond production resulted in a $400 million dollar gain. Air castles were being built and investors wanted in on the deal. They did not know the technology was bogus.

B. During the 1960 s there was a new-issue craze and at the bottom of it was the tronics suffix. Companies that had nothing to do with the electronics industry were adding tronics to their roster and going public. Similar themes can be found in the biotechnology/internet offerings of the 80 s and 90 s. Simply add a com, tech, net, to your name or make an announcement regarding a potential anything and they will buy! Many of these companies have yet to turn a profit.

C. Just like anything else, the stock market has trends and these trends often influence the prices of securities.

D. There are four fundamental determinants pertaining to stock prices. They are expected growth rate, expected dividend payment, market interest rates, and the degree of risk held by the stock.

Chapters 5 & 6

A. Technical analysis involves creating and analyzing stock charts. People that do this for a living are called chartists. According to Malkiel, chartists are worthless miserable people. They are worthless because their profession is pointless, and miserable because deep down inside, although they won t admit it, they understand that they are nothing more than erroneous expensive middlemen. Charts/chartists do nothing but try to predict the future using the past.

B. Fundamental analysis uses the four determinants to stock prices to predict future earnings. Malkiel believes that to some degree fundamental analysts are useless but not as useless as chartists.

C. Fundamental and technical analysis are often used together to dissect a stock s past and predict it s future.

D. Malkiel demonstrates the Random Walk theory by using a coin to determine the future of a stock. If the toss was a head the stock went up + point and if the toss was tail the stock then went down + point. This experiment displays a pattern (similar to any stock) and the chartist is put to shame again. Similar experiments have been done by throwing darts at stock indices and produced above average returns

E. There are many technical systems used to analyze the market s random walk. They are as following; The Dow Theory, The Relative-Strength System, Price Volume System, and my favorite, The Hemline Indicator.

F. Technical methods cannot be used to make useful investment strategies. This is the fundamental conclusion of the random-walk theory.

Chapters 7 & 8

A. A company is almost like a living-breathing organism. A company s earnings can seldom be accurately predicted because there are too many random factors that can alter the outcome. Third party product reviews can influence the price of a security. For instance, Consumer Reports gave STP oil negative publicity claiming that it was a worthless oil thickener , subsequently, the price of the stock fell dramatically.

B. In general analysts would be better off in sales and or management rather than producing overly complicated reports/charts. Again, eliminate the middlemen!

C. Malkiel feels that market timing should be every investor s friend and foe. In other words, pay attention to when and what you buy.

D. The academic community along with Wall Street s chartists believes that professionally managed portfolios will always outperform randomly selected portfolios of stocks with equal risk characteristics.

E. Risk determines the level of return.

F. Modern Portfolio Theory (MPT) helps reduce risk of high loss.

G. Modern Portfolio Theory advocates holdings in both foreign and domestic stocks along with bonds.

Chapters 9 & 10

A. Diversification cannot eliminate all risk, however, it will allow the investor avoid high losses.

B. Systematic risk cannot be controlled using diversification because all stocks move together. For example, a bad day on the NASDAQ usually means that all tech stocks suffered loses.

C. Unsystematic risk is the remaining variability a stock s returns have. Unsystematic risk can be controlled using diversification.

D. Investors that purchase high-risk stocks expect larger returns.

E. Capital-Asset Pricing Model analyzes the total risk and systematic risk for diversified portfolios.

F. Returns are sensitive to market swings, exchange rates, market interest rates, and other economic factors.

G. Stocks can fall into short and long run patterns but eventually they do change.

H. Stocks are affected by month, year, day of the week, as well as season.

I. High dividends usually mean high returns.

**NOTE** Chapters 11 through 14 were not included in this outline because I felt that they didn t have much to do with the purpose of this outline. They focus on how-to- invest as opposed to teaching the reader what investing actually is and the dynamics behind it.