ARTICLE REVIEW 7
A Review of “A Random Walk Down Wall Street: The Time-TestedStrategy for Successful Investing.”
The Issue Investigated
Many investors are likely to question how the past of stock pricesis applicable in predicting their future. Malkiel, In “A RandomWalk Down Wall Street: The Time-Tested Strategy for SuccessfulInvesting” addresses this issue. The author ponders on whetherstocks follow an unsystematic and irregular path such that thepossibility that the future price of a stock rising compares to thestock price dropping. Malkiel uses the random walk theory, a stockmarket assumption, to support his argument. The theory argues thatprevious movements of stock prices or the market in general are notapplicable in foretelling the prospect movement of a stock (Malkiel,2007). This is because changes in stock prices are self-determiningin addition to having similar possibility distribution.
The book focuses on different investment methods hence, the authoranalyzes an array of data on investment. These includes data onstocks, insurance, tangible assets like gold, bonds, money markets,home ownership and insurance. However, I think more emphasis is oninvesting in buying and selling stocks.
In analyzing the issue of stock prices, the book is divided into fourparts. The first section is an analysis of two fundamental valuationmodels. These are the castle-in-the-air and firm-foundation theory.The firm-foundation theory views every investment as influenced byintrinsic value because when prices drop below the intrinsic valuepeople buy, and vice versa. The castle-in-the-air theory supposesthat the prices of assets are influenced by a herd mentality as wellas the investors that purchase them. This means that the value of astock depends on what the next investor wills to pay. Hence, thesuccessful investor is one that manages to invest, for instance bybuying stocks prior to other people.
The second section analyzes two camps used in stock valuation, whichare fundamental and technical analysis. These are the most commontypes of analysis, which happen on Wall Street. Technical analysisreferring to the study of market prices behavior through the use offormer performance to predict future performance. The analysisdepends on the use of charts as well as trend lines. Contrary,fundamental analysis focuses on the study of the wellbeing of abusiness, through articulately scrutinizing its financial statements,the business environment and competitors. Malkiel favors fundamentalanalysis as a better approach to analyzing the market prior to makingany investments.
The third section of the book focuses on modern portfolio theory. Thetheory refers to the use of the diverse risk levels orunpredictability amid asset classes with the objective of increasingthe total return of a diversified portfolio. In regard to stocks, theauthor depicts that having 50 diversified American stocks decreasesthe general portfolio risk. Increasing international stocks alsodecreases risk. Investment risk is categorized into systematic orunsystematic. Systematic risk derives from the market, whileunsystematic risk applies to a specific company. When a portfolio isdiversified with additional stock, unsystematic risk is reduced.However, it is not possible to do away with the general systematicmarket risk.
In the last section of the book, Malkiel offers practical advice aswell as approaches, which can be used in creating an investmentportfolio. The section comprises of various warm up exercises forpreparing an investor. These exercises include the management of cashreserves have clear objectives and making tax considerations.Malkiel also discusses how stocks have altered over the past decades.He offers rules to follow when planning to buy stock. These areconfining the purchase of stock to companies, which seem capable ofsustaining above-average earnings growth for a minimum of five yearsone should not pay extra for a stock trade minimally and it isadvisable to purchase stocks with the anticipation of growth.
I think the author argues that it is not possible to use theprevious history of stock prices in predicting the future of stocks.By using the random walk theory, Malkiel acknowledges that stocksfollow a random as well as unpredictable path. This means that thepossibility that the price of a stock will increase in future, alsoapplies to the same stock declining. Hence, while a stock may haveperformed well historically, an investor cannot merely buy suchstocks with the hope that they will continue to perform well. Thestock can as well decrease in value. The random walk theory makes itclear that it is not possible to make assumptions that there will beno additional risks when purchasing stock.
Although Malkiel discusses the use of fundamental and technicalanalysis prior to purchasing stock, his argument seems to dismissboth valuation approaches, as time consuming and not proven tooutperform the markets. Instead, I think he supports a buy-and-holdapproach when investing. Through this approach people do not make anyattempts at timing markets, as is the case with fundamental andtechnical analysis. The disadvantages of timing markets are that manymutual funds do not beat set averages, as is the illustration of S&P500.
Malkiel uses the efficient market theory to support his argumentthat it is not possible to predict how stocks will trade. Accordingto the theory, stocks seem to trade fairly. Hence, it is not possibleto state that stocks can be bought when they are undervalued or thatthe most suitable time to sell stocks is when they are overvalued.There is some level of truth in the theory, because provided that noone is able to read the future, then it becomes impossible to makeassumptions on how stocks will behave in future. On the other hand,the theory cannot outwardly be said to be true, because whilepredicting the future is difficult, it is common for stocks to eitherbecome overvalued or undervalued.
There is some level of truth in Malkiel’s argument. When investingin stocks an individual should be prepared to make a risk. However,currently, people are able to easily and at a fast rate accesssignificant news as well as stock quotes. As such, investing instocks is no longer preserved for those that are privileged. Whenanalyzing how Wall Street works, it is clear that random walk theorydoes not apply. The theory condemns technical and fundamentalanalysis as stock valuation strategies, which act as the basis of howWall Street functions. Hence, it is not possible to completely statethat the author’s argument is completely correct. There is somelevel of truth in the fact that it is not possible to use the historyof a stock as the basis that the stock will progress to rise invalue. When buying a stock that has always performed well in themarket, an investor should be aware that the stock could as welldecrease in value in prospect.
The author introduces new terms in his discussion. These are “Dogsof the Dow”, “January Effect” and “Technical analysis.”
I think “Dogs of the Dow” refers to a strategy of selectingstocks. However, in this strategy the person intending to investselects the best rated stocks. The stocks are likely to be rated in aDOW, meaning they have the greatest possibility of an investorearning dividends. Investors assume that because these companies havemanaged to maintain a position as top ten, then they are likely tocontinue increasing in price, which resonates to more dividends forthe investor.
“January Effect” is the assumption that during the first twoweeks of the year, the prices of stocks are overvalued. As the yearcomes to an end, many people sell their stocks. As a result, stockprices drop for many companies. However, these companies anticipatethat as the year starts, stocks are on demand. Hence, they are ableto regain as the year starts. The “January effect” also impliesthat because small companies have more volatility, it is possible forthem to have greater rebounds.
“Technical analysis” is a new term due to the way the authorintroduces it in the text. I think the phrase refers to the move byinvestors to ensure that they make the most appropriate investmentdecision. In doing so, the investors make a critical analysis of thestocks that they intend to buy. The analysis entails looking at thehistory of how the stock has performed for a certain period andpossibly what other investors think about the stock. It is only aftersuch an analysis that an investor may decide to buy the stocks.
Malkiel, B. G. (2007). A random walk down Wall Street: Thetime-tested strategy for successful investing. New York: W. W.Norton.