A Random Walk Down Wall Street

by Burton G. Malkiel

What is a cynic? A man who knows the price of everything, and the value of nothing. —Oscar Wilde, Lady Windermere’s Fan

The firm-foundation theory argues that 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.

Skyrocketing markets that depend on purely psychic support have invariably succumbed to the financial law of gravitation. Unsustainable prices may persist for years, but eventually they reverse themselves. Such reversals come with the suddenness of an earthquake; and the bigger the binge, the greater the resulting hangover. Few of the reckless builders of castles in the air have been nimble enough to anticipate these reversals and to escape when everything came tumbling down.

Part of the genius of financial markets is that when there is a real demand for a method to enhance speculative opportunities, the market will surely provide it. The instruments that enabled tulip speculators to get the most action for their money were “call options” similar to those popular today in the stock market.

On April 12, 1720, five days after the bill became law, the South Sea Company sold a new issue of stock at £300. The issue could be bought on the installment plan—£60 down and the rest in eight easy payments. Even the king could not resist; he subscribed for stock totaling £100,000. Fights broke out among other investors surging to buy. To ease the public appetite, the South Sea directors announced another new issue—this one at £400. But the public was ravenous. Within a month the stock was £550. On June 15 yet another issue was floated. This time the payment plan was even easier—10 percent down and not another payment for a year. The stock hit £800. Half the House of Lords and more than half the House of Commons signed on. Eventually, the price rose to £1,000. The speculative craze was in full bloom.

Reliance stock issue circa June 2020?!

Another lesson that cries out for attention is that investors should be very wary of purchasing today’s hot “new issue.” Most initial public offerings underperform the stock market as a whole. And if you buy the new issue after it begins trading, usually at a higher price, you are even more certain to lose. Investors would be well advised to treat new issues with a healthy dose of skepticism.

If you can keep your head when all about you are losing theirs… Yours is the Earth and everything that’s in it… —Rudyard Kipling,

Robert Shiller, in his book Irrational Exuberance, describes bubbles in terms of “positive feedback loops.” A bubble starts when any group of stocks, in this case those associated with the excitement of the Internet, begin to rise. The updraft encourages more people to buy the stocks, which causes more TV and print coverage, which causes even more people to buy, which creates big profits for early Internet stockholders. The successful investors tell you at cocktail parties how easy it is to get rich, which causes the stocks to rise further, which pulls in larger and larger groups of investors. But the whole mechanism is a kind of Ponzi scheme where more and more credulous investors must be found to buy the stock from the earlier investors. Eventually, one runs out of greater fools.

Digiscents offered a peripheral you could plug into your computer that would make Web sites and computer games smell. The company ran through millions from venture capitalists trying to develop such a product.

Flooz offered an alternative currency—Flooz—that could be e-mailed to friends and family. It was not quite money, because there were only a few places you could use it, but it sure made a unique gift. In order to jump-start the company, Flooz.com turned to an old business school maxim that “any idiot can sell a one-dollar bill for eighty cents.” Flooz.com launched a special offer to American Express platinum card holders allowing them to buy $1,000 of Flooz currency for just $800. Shortly before declaring bankruptcy, Flooz itself was Floozed when Filipino and Russian gangs bought $300,000 of its currency using stolen credit card numbers.

While the party was still going strong in early 2000, John Doerr, a leading venture capitalist with the preeminent firm of Kleiner Perkins, called the rise in Internet-related stocks “the greatest legal creation of wealth in the history of the planet.” In 2002, he neglected to write that it was also the greatest legal destruction of wealth on the planet.

The key to investing is not how much an industry will affect society or even how much it will grow, but rather its ability to make and sustain profits. And history tells us that eventually all excessively exuberant markets succumb to the laws of gravity. 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. It is not hard, really, to make money in the market. As we shall see later, an investor who simply buys and holds a broad-based portfolio of stocks can make reasonably generous long-run returns. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.

I am also persuaded by the wisdom of Benjamin Graham, author of Security Analysis, who wrote that in the final analysis the stock market is not a voting mechanism but a weighing mechanism. Valuation metrics have not changed. Eventually, every stock can only be worth the present value of the cash flow it is able to earn for the benefit of investors. In the final analysis, true value will win out.

Rule 1: A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings. To this is added an important corollary: Corollary to Rule 1: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.

Rule 2: A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company’s earnings that is paid out in cash dividends.

Rule 3: A rational (and risk-averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.

Rule 4: A rational investor should be willing to pay a higher price for a share, other things being equal, the lower the interest rates.

The four valuation rules imply that a security’s firm-foundation value (and its price-earnings multiple) will be higher the larger the company’s growth rate and the longer its duration; the larger the dividend payout for the firm; the less risky the company’s stock; and the lower the general level of interest rates.

Caveat 1: Expectations about the future cannot be proven in the present.

Caveat 2: Precise figures cannot be calculated from undetermined data.

The point to remember from such examples is that the mathematical precision of fundamental-value formulas is based on treacherous ground: forecasting the future. The major fundamentals for these calculations are never known with certainty; they are only relatively crude estimates—perhaps one should say guesses—about what might happen in the future. And depending on what guesses you make, you can persuade yourself to pay any price you want to for a stock.

Caveat 3: What’s growth for the goose is not always growth for the gander.

WHY MIGHT FUNDAMENTAL ANALYSIS FAIL TO WORK? Despite its plausibility and scientific appearance, there are three potential flaws in this type of analysis. First, the information and analysis may be incorrect. Second, the security analyst’s estimate of “value” may be faulty. Third, the market may not correct its “mistake,” and the stock price may not converge to its value estimate.

Rule 1: Buy only companies that are expected to have above-average earnings growth for five or more years.

Rule 2: Never pay more for a stock than its firm foundation of value.

What is proposed, then, is a strategy of buying unrecognized growth stocks whose earnings multiples are not at any substantial premium over the market. Of course, it is very hard to predict growth. But even if the growth does not materialize and earnings decline, the damage is likely to be only single if the multiple is low to begin with, whereas the benefits may double if things do turn out as you expected. This is an extra way to put the odds in your favor.

Look for growth situations with low price-earnings multiples. If the growth takes place, there’s often a double bonus—both the earnings and the multiple rise, producing large gains. Beware of very high multiple stocks in which future growth is already discounted. If growth doesn’t materialize, losses are doubly heavy—both the earnings and the multiples drop.

Things are seldom what they seem. Skim milk masquerades as cream. —Gilbert and Sullivan, H.M.S. Pinafore

The past history of stock prices cannot be used to predict the future in any meaningful way.

At heart, the Wall Street pros are fundamentalists. The really important question is whether fundamental analysis is any good.

Again, the evidence from several studies is remarkably uniform. Investors have done no better with the average mutual fund than they could have done by purchasing and holding an unmanaged broad stock index. In other words, over long periods of time, mutual-fund portfolios have not outperformed randomly selected groups of stocks. Although funds may have very good records for certain short time periods, superior performance is not consistent, and there is no way to predict how funds will perform in any given future period.

the method of beating the market, they say, is not to exercise superior clairvoyance but rather to assume greater risk. Risk, and risk alone, determines the degree to which returns will be above or below average.

part of total risk or variability may be called the security’s systematic risk and that this arises from the basic variability of stock prices in general and the tendency for all stocks to go along with the general market, at least to some extent. The remaining variability in a stock’s returns is called unsystematic risk and results from factors peculiar to that particular company—for example, a strike, the discovery of a new product, and so on.

Basically, there are four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion.

If You Do Trade: Sell Losers, Not Winners

My advice is that you should not buy IPOs at their initial offering price and that you should never buy an IPO just after it begins trading at prices that are generally higher than the IPO price. Historically, IPOs have been a bad deal. In measuring all IPOs five years after their initial issuance, researchers have found that IPOs underperform the total stock market by about four percentage points per year. The poor performance starts about six months after the issue is sold. Six months is generally set as the “lockup” period, where insiders are prohibited from selling stock to the public. Once that constraint is lifted, the price of the stock often tanks. The investment results are even poorer for individual investors. You will never be allowed to buy the really good IPOs at the initial offering

Wonder what he thinks of the indian IPO scenario in 2020. Especially PSU stocks and the IPO mechanism.

buy a broad-based index fund that simply bought and held all the stocks in the market and that charged very low expenses.

EXERCISE 2: DON’T BE CAUGHT EMPTY-HANDED: COVER YOURSELF WITH CASH RESERVES AND INSURANCE Remember Murphy’s Law: What can go wrong will go wrong. And don’t forget O’Toole’s commentary: Murphy was an optimist. Bad things do happen to good people. Life is a risky proposition, and unexpected financial needs occur in everyone’s lifetime. The boiler tends to blow up just at the time that your family incurs whopping medical expenses. A job layoff happens just after your son has totaled the family car. That’s why every family needs a cash reserve as well as adequate insurance to cope with the catastrophes of life.

The only reason you should even consider a variable annuity is if you are super wealthy and have maxed out on all the other tax-deferred savings alternatives. And even then you should purchase such an annuity directly from one of the low-cost providers such as the Vanguard Group.

Money-Market Mutual Funds (Money Funds)

Liquid & Arbitrage Funds?

Bank Certificates of Deposit (CDs)

FDs?

If you are close to retirement and your tax bracket is likely to be lower in retirement, you probably shouldn’t convert, especially if conversion will push you into a higher bracket now. On the other hand, if you are far from retirement and are in a lower tax bracket now, you are very likely to come out well ahead with a Roth IRA. If your income is too high to allow you to take a tax deduction on a regular IRA but low enough to qualify for a Roth, then there is no question that a Roth is right for you, since your contribution is made after tax in any event.

Own your own home if you can possibly afford it.

There is no sure and easy road to riches. High returns can be achieved only through higher risk-taking (and perhaps through acceptance of lesser degrees of liquidity).

A futures, or forward, contract involves the obligation to purchase (or deliver) a specified commodity (or financial instrument) at a specified price at some specific future period. For example, suppose it is now June, and I want to get a delivery of 42,000 gallons of heating oil (the typical contract size) in December. I might buy a December heating oil future at a price of $2.50. This commits me to take delivery of 42,000 gallons of heating oil in mid-December at a price of $2.50 per gallon. The seller of the futures contract commits to make delivery of the oil at that time.*

A stock option, just as the name implies, gives the buyer the right (but not the obligation) to buy or sell a common stock (or group of stocks) at a specific price on or before a set date. For example, a call option on IBM might cost the buyer $15 a share (the option premium) expiring the third Friday in July (the expiration date) with an exercise price of $150 a share (the striking price). Thus, for a premium of $15, the buyer of this call option has the right to purchase a share of IBM at $150 at any time up through the third Friday in July. The seller (or writer) of the option receives the premium and takes on the corresponding potential obligation to sell the share at the contract price. A put option reverses the situation. A put on IBM gives the holder the right to sell IBM shares at a specific price. The seller of the put (called the writer) takes on the potential obligation to buy the shares.