Is the stock market predictable? No says Burton Malkiel author of A Random Walk Down Wall Street.
Like Graham's Intelligent Investor, A Random Walk is one of those books that seems to stand the test of time. First published in 1973, it's currently in its 23rd edition.
This book is readable. Unlike some other investing books I found myself turning the pages into the late hours of the night. Malkiel is at least an entertaining author, even if you don't agree with his theories.
Malkiel believes that stock prices rise and fall in a random walk pattern. That means that there is an equal chance every day that the price of an asset could either increase or decrease.
Technical Analysis
To illustrate this point imagine you have a stock valued at $50. Now everyday you flip a coin. Heads and the stock goes up half a point (50 cents), tails it goes down the same amount. If you did this every day for a month, year or more you would end up with an interesting chart of the price of this stock.
Malkiel contends this chart will look like your average stock price chart. In fact, if you flip a coin enough times you will see heads come up many times in a row (the same for tails). This can lead to the stock price going up and down in a pattern when in reality no pattern exists.
He uses this example to condemn "chartists" (practitioners of technical analysis). In fact, he had his students each perform this experiment. Then he showed the results to some of his technician friends. They instantly recognised some of the classic patterns (head and shoulders, etc) in the "stock" price. When Malkiel revealed that these charts were generated by random coin flips, the chartists were not too happy, especially since some of the patterns revealed classical bull patterns (which would indicate that you should buy and the chartists were eager to pick up the hot stock).
Fundamental Analysis
But while Malkiel seems to be most critical of technical analysts, he also believes that fundamental investors are not much better off.
Fundamental investors must be clairvoyant to determine whether a company is really worth buying. This is because a fundamental buy and hold investor much estimate the value of the company (no easy task) and the value of the future stream of earnings and then discount that back into the price of the stock today.
Because no one person has the ability to both accurately access current book value and future streams of income, especially when real world random events affect outcomes, fundamental buy and hold investing is also unreliable.
So if technical and fundamental investing are inadequate what kind of investing does Malkiel recommend? Actually he has a very simple formula for investing. He has a set of rules and corollaries that he uses to chose stocks.
I'll cover his investment framework and his deeper analysis of technical speculation and fundamental investing in a future article.
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