The shortest summary of A Random Walk Down Wall Street:
TLDR: “Market prices are so efficient that normal investors are better off buying and holding index funds than attempting to buy and sell individual stocks or actively managed funds.”
A somewhat longer summary:
A random walk is accepting that predicting any future stock price or valuation is impossible based on past information and actions. This means that short run changes in equity prices cannot be foreseen or predicted. This means that earning predictions, chart patterns, growth estimates, or the alignment of planets are useless for prediction in the stock market.
Two investing theories:
Firm foundation theory:
Each investment, stocks or real estate, has an anchor to something of value called intrinsic value. The value of the firm can be approximated roughly by careful analysis of present conditions and future prospects of growth. When prices fall below this carefully picked number a buying opportunity arises, when the value rise above that number, a selling opportunity arises. The theory stresses that the stock’s value should be based on earnings of the company both currently and in the future. This is the underpinning for fundamental analysis.
Castle in the air theory:
Castle in the air theory or sometimes called the greater fool theory, this concentrates on the psychological. John Keynes, the possibly the most influential economist and a professional investor, decided to devote his energy not to estimating a firm’s value but towards analyzing the crowd of investors and determining how they would behave in the future and during periods of optimism. He theorized that during good times investors tend to build castles in the sky in hopes they will get riches. The goal was not to pick their own ideal investment but to pick the most popular investment before everyone else. An investment is worth a certain price to a buyer because he expects to sell it to someone else at a higher price. This is the underpinning for technical analysis.
A new walking shoe – Modern Portfolio Theory:
Time passes and due to the difficult nature of estimating future growth prospects and current market conditions the firm foundation theory (or fundamental analysis) proves to be no better a predictor of a company’s success than random chance. Likewise, academics prove the castle in air theory (or technical analysis) to perform no better than a random walk.
The only way to get outsized gains is the market is to assume greater risk. Risk is defined as variance or standard deviation of returns. The patterns of historical returns from individual equities have not usually been symmetric, however, the returns from a well-diversified portfolio have typically been symmetric.
Modern Portfolio Theory assumes that all investors are risk averse. Harry Markowitz found that as long as the fortunes of companies in the economy are different, diversification will always reduce risk.
The Initial P/E predictor: Campbell and Shiller report that over 40% of the variability in long-horizon returns can be predicted on the basis of the initial market P/E.
Market valuations rest on both logical and psychological factors, but remain unpredictable. Stock prices display a remarkable degree of efficiency. Info contained in past prices or any publicly available fundamental info is rapidly assimilated into the market price. Prices adjust so fast and so well as to reflect all important info that a randomly selected and passively managed portfolio of stocks performs as well or often better than one picked by professionals. With respect to the evidence indicating that future returns are somewhat predictable there are a few points to make: 1. The question of long run dependability of these effects could be the result of “data snooping.” 2. Even if there is dependable predictable relationship it may not be exploitable by the average investor due to high transaction costs (bid/ask spread and other transaction costs).
Three Giant steps down wall street:
First step: Invest in index funds – the S&P500 has beat approximately two thirds of professionals in the 80s and 90s. Index funds regularly produced returns exceeding those of active managers by 2% – due to lower costs.
Second Step: Do it yourself stock picking – generally not advised but the 4 rules to help:
- Indexing the majority of your portfolio is recommended for both individuals and institutional investors
- Rule 1: confine stock purchase to companies that appear to sustain above average growth for 5 years or more.
- Rule 2: Never pay more for a stock than can be reasonably justified by the firm foundation theory
- Rule 3: Buy stocks with the kinds of stories that investors could build castles in the sky theories on
- Rule 4: Trade as little as possible – it hurts returns. If you have losses sell them before the end of the year.
The substitute player step: Hire a professional wall street walker
Instead of trying to pick stocks, hire another professional to do it. But be careful – advertisements are miss leading, there is no consistent long run relationship between returns in one period compared to the following period, use morning star mutual fund information, try to avoid high-cost fund managers.
There you have it. The shortest and most condensed “A Random Walk Down Wall Street” you could get. There’s a lot of really good information that I have left out here from things on leveraged investing to other possible risk adjusted methods of investing, but the main idea is present here. And I’d highly recommend picking it up if you haven’t done so. It has some really good advice and personal planning information in it.
Although, if you’re looking to get your random walk started on wall street the best possible place for long term investors is likely M1 Finance since it’s built for long term investors. Although, if you’re looking for merely good diversified funds to invest in, check those out here. And finally, if you’re looking for further ways to enhance returns check out our high risk and ultra-high risk newsletter.
Note: the m1 referral link gives the reader $10 extra dollars to invest with if they choose to fund a taxable with $100 dollars within 30 days of opening the account or fund an IRA with $500 within 30 days of opening an account. The author of this article will receive a $10 dollar compensation as a result of the reader opening an account. The compensation for both parties occurs 30 days after the deposit occurs and assumes the full amount is retained in the account until the end of 30 days from the deposit day.
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