"Random Walk Down Wall Street" Book Report

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“A Random Walk Down Wall Street”
Book Report
By: James S. Parker
BFIN 546 - Investments
02/22/2007
A Random Walk Down Wall Street is the “Average Joe’s” introduction to
investing. The author does an excellent job of mixing humor, personal feelings, and
historical examples of how people succumb to the “Castles in the Air” mentality. The first
chapter is devoted to an introduction to the book and the explanation of a “random walk”.
The “Random Walk” as Malkiel explains is the unpredictability of future steps or
directions based on past actions. He further integrates this term into the unpredictability of
the world of investing specifically the stock market. In chapter one he introduces the two
techniques used by market professionals to determine what stocks to invest in and when to
purchase them. These techniques are fundamental analysis and technical analysis. The
first chapter goes on to introduce other concepts in investing such as the effect of inflation,
the theory of investing, the Firm-Foundation theory, and what I believe to be the author’s
favorite term, the Castle-in-the-Air Theory. I really enjoyed one quote from the author that
gives me some confidence in investing in the stock market. The author wrote: “A
successful investor is generally a well-rounded individual who puts a natural curiosity and
an intellectual interest to work to earn more money.” This quote says to me that with the
right motivation and using my own intellect I could be successful in investing also.
In the second chapter the author dives into a historical look of how crowds of
people have reacted to the prospect of making money no matter how unreasonable the
investment is. Examples of such events include: Tulip-Bulb Craze, the South Sea Bubble,
and the few years before the Great Depression, where examples of financial disasters
waiting to happen. The Tulip-Bulb Craze in Holland proved to be an example of people
wanting to get in on an investment no matter how risky or unique it appeared. This craze
created a new method for investors to get the most action for their money and is still
popular today in the stock market. The “Call Option” allows an investor to pay 15-20% of
the current market price of an investment to sell it later at a profit if the investment
increased. Personally, I was introduced into this when I worked as a bank teller for Bank
of America in 1996-1998. As an employee, every 6 months we were given 50 stock option
shares at the current market price minus a discount. I really didn’t know much about it at
the time and all I was told was that if the price of the stock increased we could exercise our
options and make a profit. In other words to me at the time, I would make free money. So
as I continued to work for about 2 years I accumulated more stock options and Bank of
America even issued a stock split and I ended up with more shares. Then they announced
that they were planning to merge with Nations Bank and the price of the stock increased. I
ended up leaving Bank of America in 1998 to move to Chattanooga and had to decide to
purchase the shares of my stock options at the option price or cash out and make some
money. Being inexperienced and in need of money for college I cashed out and made a
good chunk of money. At least, that is what I thought at the time. Had I found a way to
purchase the options I would be sitting on an even larger investment since the growth and
increase in value of Bank of America. It is hard to say what my options would be worth
today but I might be better off not knowing. This chapter reminds me of how uneducated I
was as a beginning investor. I probably would have invested in the Tulip-Craze when I
was 20 years old also. I am not even sure if I should even be considering myself an
investor at the time. I just wanted to make money. Now, I want to make money but I also
am more cautious of what I invest in. I consider myself an investor now but not when I
was 20 years old. The main thing I learned from this chapter was to not get caught up in
the craze. As the author wrote, “The consistent losers in the market, from my personal
experience, are those who are unable to resist being swept up in some kind of tulip-bulb
craze.” As the author notes, history has a habit of repeating itself.
The third chapter is about how stocks were valued in the 1960’s-1990. This
exceedingly long chapter deals with the current craze of growth stocks. The author
explains the extremely high price-earnings multiples that stocks were trading at with the
expectations that someone else will come by and purchase the stock at a higher price. The
author goes on to explain the practices of underwriters for newly issued securities and how
they mislead investors but followed the necessary SEC rules. This did not prevent
investors from being caught up in another craze to purchase the next hot electronics
company. Most companies did not have any assets or earnings. Companies even went so
far to change the name of their company to make it sound more electronic to generate an
increased value in their stock. As the author stated, “The SEC can warn a fool but it
cannot prevent him from parting with his money”. Another problem in this era was the
method that companies conducted mergers. Conglomerates were formed between
companies with no growth in order to create in my terms “fake growth”. This chapter
although very long and hard to read was very interesting. To me it showed just what
companies will do in order to manipulate the real truth all for increasing the bottom line
value. The most shocking example was the story of Barry Minkow. Being a young
entrepreneur and a Christian myself, I found his story to be very appealing. I would like to
learn more about him and even find out how he came to be a front for organized crime.
What I take away from this example is that do not put the leader of a company on a
pedestal. They are human just like me and have the tendency to not be perfect and can be
deceptive. The quote I like best from this chapter sums everything up, “The stock market
at times conforms well to the castle-in-the-air theory. For this reason, the game of
investing can be extremely dangerous.”
Chapter four’s subject was very appealing to me because I have technical back
ground and I followed the Internet craze of the late 1990’s. I feel that I am somewhat
lucky to not have invested during this time period since I would have been an immature
investor and therefore missed being sucked into the Internet investment craze. Reading the
chapter and knowing the past examples of the technology companies in the 1960’s and the
tulip-bulb craze, I found it amazing that people still became a victim to the craze. It is
proof that the power of making fast money is many time overwhelming. The
implementation of the Internet in the 1990’s has changed how we live for the rest of our
lives. It made investing in stocks for the small investor possible, created a way for new
companies to compete against the older established companies; it created ways for people
to connect, and more. I believe the problem in the Internet craze was the fact that you had
non-technical (the non-geeks) business people and investors that did not understand the
technology boost about how great this is going to be. They were excited because people
can now buy shoes online for half the price and have them shipped directly to their home.
I don’t know about you but I need to try on the shoes and do the schmuck walk with them
on up and down the shoe isle a couple of times to see if they will be comfortable. There
are some things that as consumers we will need to see in person, touch, and try out before
purchasing. The real winners of the Internet craze were the brokers. The Internet created
ways for them to gain more customers to conduct more trades which led to more trading
fees. The term “Day Trader” was coined from people spending their whole day online
trading stock through one of the online brokerage companies. Terrance Odean’s study
found that most online traders actually lost money even during the bubble and
systematically did worse the more they traded. In fact, he found that the average survival
time of the day trader to be only six months. The author also states that the majority of the
money that brokers made was buried in the difference between the “bid” and “ask” prices
when conducting trades. Transactions were performed to benefit the broker. The main
point I took from this chapter was the second to last sentence, “Eventually, every stock can
only be worth the value of its cash flow it is able to earn for the benefit of investors.” My
current skepticism after reading this is, just when will the craze for Google stock subside?
Don’t get me wrong, I am a huge fan of Google, but not at $500 per share.
Chapter five is devoted to the firm-foundation theory of stock prices. The author
discusses what financial analysts look at to determine the price of a stock. Firmfoundation theorists usually take the standpoint as a long-term investor. These theorists
looked at dividends, and more often during the 1990’s, buybacks to determine the price of
a stock. During this time, companies favored the buy backs instead of increasing dividend
payouts. Another determinate used in analysis of stock price is the expected growth rate of
a company. The higher the growth rate, the higher the price that an investor is willing to
pay for a share of stock. The third determinate of the price of stock is that of risk. This
says with all other things being equal between different stocks if one is less risky, the
investor would be willing to pay a little more to purchase the stock. The last determinate
in stock price was the level of market interest rates. This says that the lower the interest
rates the higher an investor will be willing to pay for an investment. Even though the
author gives us these four guidelines in setting a purchase price for stock he also gives us
some caveats. These caveats boil down to not being able to predict the future. He
summarizes the possible pitfalls of the firm-foundation theory by stating, “The
mathematical precision of the firm-foundation value formulas is based on treacherous
ground: forecasting the future.” The author also goes into one more caveat asking, when
does an investor pay too much for higher growth? It is very risky to consistently pay
higher prices for more growth due to unforeseen incidents in the future. The basic
summary of this chapter is that these methods for determining the price of a stock are
based on theory but are used by professionals that are discussed later on in the book.
In chapter six we get into how the professionals use the discussed theories to
choose what stocks to purchase, when to purchase them, and at what price. I was very
interested in this chapter because we finally get a view of applying all that the author has
told us thus far. In this chapter he talks again of technical and fundamental analysis, only
now we learn how it is used by today’s investors. Technical analysis is the making and
interpretation of stock charts. I have to admit that I have been one of these people before I
read this book. They study past performance of a stock and determine when the best time
to buy is and then when they own it, when the best time to sell is to maximize their return
on investment. Admittedly, it seemed pretty standard to me since I have been doing this
for a couple of years. One of my favorite parts of the book is when the author is
comparing the way a chartist chooses a stock for potential investment and as the author
describes the chartist, “he flirts with it to see if it is a worthy mate.” His sexual innuendoes
really made me laugh. The author does a good job explaining the pros and cons of
technical analysis. The second type of analysis is from the fundamental approach. Here
the main difference is “the technician is interested only in the record of the stock’s price,
whereas the fundamentalist’s primary concern is with what a stock is really worth. By
reading more about the fundamentalist approach it seems that there is much more work
involved in this analysis and still has its failures. Reading to this point of the book I
realized what was coming next. The author concludes the chapter with a hybrid approach
to fundamental and technical analysis by giving us three rules to use for market analysis.
Simply stated these rules are: 1. Buy only that expect to have above average earnings
growth for five or more years. 2. Don’t purchase very high multiple stocks in which future
growth is already discounted. 3. Ask yourself if a stock is one that is likely to catch the
fancy of the crowd which investors can build castles in the air that really have a firm
foundation. Who knows, maybe I am wrong about Google and I missed my chance.
Chapter seven consisted of a technical analysis and the Random-Walk Theory. The
author picks on the chartist a bit more and keeps emphasizing that the buy-and-hold
strategy outperforms the chartist strategy when transaction costs are involved. The author
also introduces “the wallpaper principle” which states that the sequence of a stock’s price
changes before any given day is important in predicting the price change for that day.
“The basic premise is that there are repeatable patterns in space and time.” By testing
stock price data over a large time range, the results state that stock prices cannot be used to
predict future price movements. The author then describes the random walk theory to be a
sequence of numbers produced by a random process and describes an example of flipping a
coin to run a test study of random stock prices. I found this example to very amusing when
he said he had shown it to a friend who was a chartist who thought to buy immediately,
even though there was no real company involved. The author goes on to describe more
elaborate technical systems of which one I found to be very amusing. The super bowl
indicator stated that a victory by an NFL team predicts a bull market in stocks, whereas a
victory by an AFL team is bad news for stock-market investors. I would place more
important emphasis on the commercials than the actual game. The commercials are ways
for companies to become exposed by the largest audience on a given day. Look at what it
has done for Budweiser. At the end of the chapter, the author states that using technical
analysis for market timing is very dangerous. The author ends the chapter discussing a few
last benefits of the buy-and-hold strategy. I think I am starting to see a pattern to his
advice.
Chapter eight discusses how good fundamental analysis is. The author makes it
very clear that growth is the key element needed to estimate a stock’s firm foundation of
value. By using the growth factor, it is still not easy to make predictions in any industry.
The author explains five factors that help explain why analysts have difficulty predicting
the future. These are: The influence of random events, the production of dubious reported
earnings, incompetence of analysts themselves, the loss of good analysts to other positions,
and the conflicts of interest facing securities. The author also states that “investors have
done no better with the average mutual fund than they could have done by purchasing and
holding an unmanaged broad stock index.” Some of these statements really surprised me
and I wondered how all these financial people have jobs. The author gives me a good
feeling about being successful in investing in stock on my own.
Chapter nine discusses the role of risk in your investments. Risk determines the
degree to which returns will be above or below average. Financial risk is the variance or
standard deviation of returns. By diversifying your stock portfolio, you can reduce the
amount of risk and still earn a good return. Diversification can be attained as long as there
is some lack of parallelism in the fortunes of the individual companies. But the rub will
not help your diversification if your companies’ stock prices move in tandem. There is a
point at which the number of stocks in your investment portfolio does not reduce your risk
amount anymore. The author suggests investing in 50 equal-sized U.S. and International
stocks to become fully diversified. He also suggests investing in other asset classes such
as bonds.
In chapter ten the author discusses the rewards of investing by increasing risk.
Based on the capital-asset pricing model, there is no premium for bearing the risks that can
be diversified away. Therefore, the author believes an investor should be substantially
rewarded for increasing the amount of risk. This is where beta is introduced. Beta is the
numerical description of systematic risk. The beta measurement is a comparison between
the movements of an individual stock and the market as a whole. As shown in an example
in the book, as the systematic risk (beta) of an individual stock increases, so does the
expected return on investment. After all this talk and use of beta, the author then takes an
unexpected turn into how beta is not a useful measure to capture relationship between risk
and return. Reading this I thought to myself, “Then why did you show us all this first.”
Then as I am reading more he starts talking about situations that beta was useful. This
chapter left me a bit frustrated at the author, but he did do an excellent job on the summary.
Chapter eleven deals with the methods that people try to discredit the efficientmarket theory. The author introduces the term of behavioral finance that states many
investors are strongly influenced by behavioral characteristics such as overconfidence,
overreaction, attraction fashions, and fads. From personal experiences in the banking
industry, I have seen how people are with their money. The psychological aspect of losing
money or making money very easily can have strong behavioral effects. Some of the
methods that people have tried to discredit the efficient-market theory are: Dogs of the
Dow, January Effect, “Thank God It’s Monday Afternoon”, Hot New Response, the
Divided Jackpot Approach, Initial P/E Indicator, Long-Run Return Reversals, The Smaller
the Better Effect, “Value Will Win”, and more. I really did not want to list them all since I
am running out of room in this paper. The author gives the reasons why people believe
these methods work and he gives them credit, but he shows that they do not hold up in the
long run. He goes on to compare the returns generated by “top-dog” fund managers versus
the S&P 500 index and it proves that the S&P 500 index outperforms the majority of
funds. Summing up the chapter the author stated, “The theory of valuation depends on the
projection of a long-term stream of dividends whose growth rate is extraordinarily difficult
to estimate.” He also ultimately discredits all paper techniques used to try to discredit the
efficient-market theory because when investing using real money, large transaction costs
are incurred.
To sum up this book from chapters one through eleven, I thought I knew what I
have been doing in running my 401k. I have yet to invest in any stocks directly and am
very glad to have read this book before I have done so. I plan to invest in stocks and hold
on to them for the long haul. In all the examples he talked about for the methods to beat
the market, I have been guilty of wanting to use a number of them. I also witness people
using these methods at work. Overall, thank you for introducing this book to this class. I
look forward to finishing it and becoming a wiser investor.
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