Walking the talk of Wall Street

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#1
Business Times - 26 Mar 2012

Walking the talk of Wall Street


The latest edition of A Random Walk Down Wall Street discusses ETFs, money market funds, Reits, new trading techniques

THE rules of the game on Wall Street may be ever changing but a professor of economics at Princeton University, Burton Malkiel, has stuck to his views on how the game should be played for almost four decades.

In the latest edition of his 1973 book, A Random Walk Down Wall Street, financial innovations such as exchange traded funds (ETFs), money market funds, equity real estate investment trusts (Reits), asset-backed securities and new trading techniques such as portfolio insurance and flash trading are discussed.

Updating his data sets to include lessons from the Internet bubble and the 2008 financial crisis, Prof Malkiel validated his fundamental thesis of diversification through investments in indexes.

He also drew on the insights of behavioural finance, and finished the book with strategies for investors, examining where they are in their life-cycles, and offering practical measures for them to safeguard and to grow their assets.

In the first part of his book, Prof Malkiel walks the reader through the major financial bubbles that all ultimately had the same ending: wealth destruction for its participants.

Be it the tulip mania of the 16th century; the South Sea bubble which imploded in the 18th century; or the more recent episodes of the soaring 'New Era' 60s; the Nifty Fifty; the Japan real estate and stock market boom (and bust); or the Internet and the US housing bubble over the last decade - they were all built like castles in the air.

Otherwise known as the 'greater fool' theory, investors buy into an asset with the expectation that someone down the line will be willing to pay even more for it. Such a departure from the 'firm foundation' of the intrinsic value of the assets leads to a market correction.

'The market eventually corrects any irrationality - albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic, and often, they attract unwary investors. But eventually, true value is recognised by the market, and this is the main lesson investors must heed,' Prof Malkiel explained.

He believed that the efficient market eventually prevails. He used the 'random walk' analogy, which draws on the idea of a drunken sailor staggering around in an open space. The trajectory of his next steps cannot be predicted, and where he ends up after many such random steps is unknown. Prof Malkiel postulated that short-run changes in stock prices are no different from the random walk of the drunken sailor.

Naturally, market professionals take umbrage at the audacity of such a suggestion that market movements are random and unpredictable, expounding the merits of fundamental and technical analysis techniques in predicting the direction of the prices of financial assets. Prof Malkiel spends the second part of his book critiquing these techniques.

Refuting the charts

Technical analysis is the study of charts in the belief that all information - be it earnings, dividends or future performance - is all reflected in the past performance of the prices. Fundamental analysis takes a different approach. It attempts to determine a stock's proper value by studying the assets and growth rate of the company, along with interest rates and risks. If the number that they arrive at is above the market price, this indicates that they should buy.

Prof Malkiel attacked the logic of each technical analysis method and showed why the charts' seemingly repetitive patterns are a statistical illusion.

He got his students at Princeton University to create charts of a hypothetical stock by flipping coins. If the toss was a head, the stock moved up half a point, and if it was a tail, it moved down half a point.

Continuing this process over a large number of flips, they produced a chart that resembled a 'normal' stock price chart, with pronounced up and down cycles. Some even exhibited the head and shoulders formation, triple tops and bottoms, and other chart patterns that often mean something to the technicians.

Prof Malkiel then showed a technician one of the more bullish patterns, which got him very excited, with the technician calling for an immediate buy. Imagine the technician's reaction when Prof Malkiel told him that the chart was created purely from random coin flips.

Prof Malkiel wrote: 'When events sometimes do come in clusters and streaks, people look for explanations and patterns. They refuse to believe that they are random, even though such clusters and streaks do occur frequently in random data such as are derived from a tossing of a coin. So it is in the stock market as well.'

As for fundamental analysis, Prof Malkiel suggested that clairvoyance is required to be able to forecast future earnings. Random events often put a spanner in their detailed calculations, while 'creative' accounting procedures can create dubious earnings reports. Conflict of interests might arise from firms with investment banking operations that do not want to jeopardise client relationships with a negative report.

Analysts also make unforced errors, while the best of them tend to be lost to the more lucrative sales or portfolio management departments.

Even if the analysts foul up their earnings forecast, do the professionals make money for their customers? Examining the track records of mutual funds, Prof Malkiel concluded that the answer is a resounding no.

Mutual funds, on the average, lose to their benchmarks. Even occasional superior performances of managers are inconsistent, leaving investors no way to predict which fund might outperform. Prof Malkiel cited an academic study which suggested that market timers would have to make correct decisions 70 per cent of the time to beat buy-and-hold investors. Portfolio managers on average fail to time the market correctly, holding the most cash in their allocations at market bottoms, and the least at market peaks.

Practical steps for the walk

The third part of the book is the centre of Prof Malkiel's treatise, containing the efficient market hypothesis (EMH) and the modern portfolio theory (MPT).

He explained that the EMH states that the structure of market prices already takes into account any public information that may be contained in financial statements and reflect prevailing news and expectations. Because the market is so good at adjusting to new information, fundamental and technical analysis is, according to him, as useful as a random walk.

As for MPT, diversification in a 'market portfolio' will lower the overall risk because of the imperfect correlation between the various assets, implying that higher returns can only come about as a result of higher risks.

While the first three parts of his book create a foundation to make sense of his recommended investment strategies, Prof Malkiel steps through a series of practical measures in his conclusion, such as the importance of saving (start as soon or as young as possible); of having some cash reserve and insurance (he favours buying term insurance and investing the rest); being tax efficient; but most importantly, to understand your own investment objectives and risk tolerance.

Prof Malkiel also highlighted that asset allocation decisions accounted for 90 per cent of an investor's total returns. He recommended that common stocks make up a sizeable chunk of an investor's total portfolio - precisely how sizeable depending on the investor's age and risk tolerance, since the risk of investing in stocks decrease the longer it is held.

While his recommended mode of participating in stocks was through internationally diversified index funds, he did have some pointers for those wishing to stock pick. He suggested that most of the portfolio should be in core holdings comprising the index funds, with a small allocation to the stock picks.

He noted that it would require a lot of work, but for those game enough to do it, they should, among other things, confine their purchases to companies that are able to sustain above-average earnings growth; never pay more than what firm foundation values suggest; and trade as little as possible.

Perhaps the one important idea embedded in his book that can serve both as an encouragement and a warning is: 'If you want a get-rich-quick investment strategy, this is not the book for you. I'll leave that for the snake oil salesmen. You can only get poor quickly. To get rich, you will have to do it slowly, and you have to start now.'

This book review was first published on Knowledge@SMU, an online research portal of the Singapore Management University

My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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#2
Aha..Efficient Market Theory (EMT) - That is very sensitive topic for discussion.

Alot of laojiaos here rubbishes EMT though and i do believe they have a case (their own experience) to prove Prof Malkiel wrong.

I started out NOT believing in EMT - and of course paid a dear price for it. On hindsight, if there was 1 thing i would change in my investment journey, it would be to believe in the EMT as i started this journey. Until the day where one become a laojiao (in investment sense), it might be better to subscribe to EMT in the meanwhile..
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#3
(26-03-2012, 07:46 PM)weijian Wrote: Aha..Efficient Market Theory (EMT) - That is very sensitive topic for discussion.

Alot of laojiaos here rubbishes EMT though and i do believe they have a case (their own experience) to prove Prof Malkiel wrong.

I started out NOT believing in EMT - and of course paid a dear price for it. On hindsight, if there was 1 thing i would change in my investment journey, it would be to believe in the EMT as i started this journey. Until the day where one become a laojiao (in investment sense), it might be better to subscribe to EMT in the meanwhile..

The more people that believe in EMT the merrier.Tongue
The advantage of a small retail investor is immensed. Some stocks like Vicom, Viz Branz, Portek etc are typically not within the radar of the big mutual fund.
And these stocks give awesome returns for early investors.
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#4
From what very little knowledge i have about Mutual Fund a lot of stocks are not in their radar is because Mutual Fund company has to follow a kind of rules in their selection of stocks. They do not really have the liberty like us retailers. So you are right, retailers have immense advantage if we know how to use them
WB:-

1) Rule # 1, do not lose money.
2) Rule # 2, refer to # 1.
3) Not until you can manage your emotions, you can manage your money.

Truism of Investments.
A) Buying a security is buying RISK not Return
B) You can control RISK (to a certain level, hopefully only.) But definitely not the outcome of the Return.

NB:-
My signature is meant for psychoing myself. No offence to anyone. i am trying not to lose money unnecessary anymore.
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#5
(26-03-2012, 08:56 PM)yeokiwi Wrote:
(26-03-2012, 07:46 PM)weijian Wrote: Aha..Efficient Market Theory (EMT) - That is very sensitive topic for discussion.

Alot of laojiaos here rubbishes EMT though and i do believe they have a case (their own experience) to prove Prof Malkiel wrong.

I started out NOT believing in EMT - and of course paid a dear price for it. On hindsight, if there was 1 thing i would change in my investment journey, it would be to believe in the EMT as i started this journey. Until the day where one become a laojiao (in investment sense), it might be better to subscribe to EMT in the meanwhile..

The more people that believe in EMT the merrier.Tongue
The advantage of a small retail investor is immensed. Some stocks like Vicom, Viz Branz, Portek etc are typically not within the radar of the big mutual fund.
And these stocks give awesome returns for early investors.

hahaha..that's y i said u hv to be a laojiao, so as to hv higher probability to sniff out the undervalued gems. Without the necessary skillset or experience (and thinking u can beat the market - one downside of NOT believing EMT), one may easily fall for the value traps or those dubious companies running at low P/Es,high net cash etc..
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