Chapter 1. Firm Foundations and Castles in the Air
I. What is a random walk?
1. A random walk is one in which future steps or directions cannot be predicted on the basis of past actions. When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted. Investment advisory services earnings predictions, and complicated chart patterns are useless.
2. Market professionals arm themselves against the academic onslaught with one of two techniques, called fundamental analysis and technical analysis. Academics parry these tactics by obfuscating the RANDOM WALK theory with three versions (the “weak”, the “semi-strong,” and the “strong”).
II. Investing as a way of life today
1. I view investing as a method of purchasing assets to gain profit in the form of reasonably predictable income (dividends, interest, or rentals) and/or appreciation over the long term. It is the definition of the time period for the investment return and the predictability of the returns that often distinguish an investment from a speculation.
2. Just to stay even, your investments have to produce a rate of return equal to inflation.
3. Even if you trust all your funds to an investment adviser or to a mutual fund, you still have to know which adviser or which fund is most suitable to handle your money.
4. Most important of all is the fact that investing is fun. It’s fun to pit your intellect against that of the vast investment community and to find yourself rewarded with an increase in assets.
III. Investing in theory
1. All investment returns are dependent, to varying degrees, on future events. Investing is a gamble whose success depends on an ability to predict the future.
Traditionally, the pros in the investment community have used one of two approaches to asset valuation: the firm foundation theory or the castle-in-the-air theory.
2. The Firm-foundation theory: each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected. The theory stresses that a stock’s value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends. It stands to reason that the greater the present dividends and their rate of increase, the greater the value the stock; thus, differences in growth rates are a major factor in stock valuation.
3. The castle-in-the-air theory: it concentrates on psychic values. John Maynard Keynes argued that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.
4. Keynes described the playing of the stock market in terms readily understandable: It is analogous to entering a newspaper beauty-judging contest in which one must select the six prettiest faces out of a hundred photographs, with the prize going to the person whose selections most nearly conform to those of the group as a whole. The smart player recognizes that personal criteria of beauty are irrelevant in determining the contest winner. A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. Thus, the optimal strategy is not to pick those faces the player thinks are prettiest, or those the other players are likely to fancy, but rather to predict what the average opinion is likely to be about what the average opinion will be, or to proceed even further along this sequence.
5. The newspaper-contest analogy represents the ultimate form of the castle-in-the-air theory. An investment is worth a certain price to a buyer because she expects to sell it to someone else at a higher price.
6. The castle-in-the-air theory has many advocates, in both the financial and the academic communities. Robert Shiller, in his best-selling book Irrational Exuberance, argues that the mania in Internet and high-tech stocks during the late 1990s can only be explained in terms of mass psychology.
A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel