A random walk down wallstreet Essay

This essay has a total of 3872 words and 14 pages.

A random walk down wallstreet

"A Random Walk Down Wall Street"
There is a sense of complexity today that has led many to believe the individual investor
has little chance of competing with professional brokers and investment firms. However,
Malkiel states this is a major misconception as he explains in his book "A Random Walk
Down Wall Street". What does a random walk mean? The random walk means in terms of the
stock market that, "short term changes in stock prices cannot be predicted". So how does a
rational investor determine which stocks to purchase to maximize returns? Chapter 1 begins
by defining and determining the difference in investing and speculating. Investing defined
by Malkiel is the method of "purchasing assets to gain profit in the form of reasonably
predictable income or appreciation over the long term". Speculating in a sense is
predicting, but without sufficient data to support any kind of conclusion. What is
investing? Investing in its simplest form is the expectation to receive greater value in
the future than you have today by saving income rather than spending. For example a
savings account will earn a particular interest rate as will a corporate bond. Investment
returns therefore depend on the allocation of funds and future events. Traditionally there
have been two approaches used by the investment community to determine asset valuation:
"the firm-foundation theory" and the "castle in the air theory". The firm foundation
theory argues that each investment instrument has something called intrinsic value, which
can be determined analyzing securities present conditions and future growth. The basis of
this theory is to buy securities when they are temporarily undervalued and sell them when
they are temporarily overvalued in comparison to there intrinsic value One of the main
variables used in this theory is dividend income. A stocks intrinsic value is said to be
"equal to the present value of all its future dividends". This is done using a method
called discounting. Another variable to consider is the growth rate of the dividends. The
greater the growth rate the more valuable the stock. However it is difficult to determine
how long growth rates will last. Other factors are risk and interest rates, which will be
discussed later. Warren Buffet, the great investor of our time, used this technique in
making his fortune.

The second theory is known as the "castle in the air theory". This method is more
psychological in nature rather than value based. Investors using this theory would buy
securities early when exciting news and growth is speculated, then sell them when the
securities temporarily increased in value. I used the term speculated because often times
these forecasts were not based on any kind of asset valuation or operating game plan. It
was purely based on the "hype" surrounding the security. These were short-term investments
and were based on the premise "that a buyer could pay any price for a stock as long as
they expected future buyers to assign a higher value". This theory is also known as the
"greater fool" theory.

Now that the two theories have been explained, let's look at some historical examples from
Malkiel that really paint the picture in chapter 2. The first speculative craze noted was
over tulips in the seventeenth century in Holland. The tulips were brought from Turkey and
the Dutch valued the beauty and rarity of the new flowers. Thus the prices for the flowers
inflated. As the prices rose merchants would by stockpiles to sell to the public. The more
expensive they got the more the public believed they were making smart investments. People
would sell off the personal belongings to get their hands on the bulbs. The mania
surrounding the bulbs created a bubble that would soon burst. The prices got so high some
people decided to cash in and sell them to make a handsome profit. Soon others joined in
causing a snowball effect and the prices tumbled. Eventually there was no demand and they
were worthless. Many went bankrupt. So what happened? The speculative craze increased
prices well beyond any reasonable level, and at some point prices had to regain stability.
I believe prices can remain high as long as demand supports it, but demand is not constant
and will rise and fall until equilibrium is reached.

A more modern version of the bubble is known as Black Thursday. During little more than a
year period from 1928 to 1929 the market experienced unprecedented growth, more than that
of the prior five years combined. There was a speculative market and everyone was getting
in. Stocks were being bought on margin, thus exemplifying the crazes. Furthermore, the
investment pool strategy became popular around this time. This involved a group of traders
banding together to manipulate a stock. The process entailed a pool manager who would buy
large portions of stock over a period of time. The pool manager would recruit a stock's
specialist on the exchange floor. The specialist had excess to all the buy and sell prices
above and below the current market price. Then the pool members would trade among
themselves at slightly higher prices, therefore manipulating the stock price. It gave the
appearance that the stocks had a lot of activity and rising prices. Also, the media would
play a part as pool managers would tell of ground breaking news and exciting new
developments Once the public saw the activity they jumped in thinking this was a hot
stock. Then the public did all the buying and the pool did the selling. Thus the pool was
rewarded significant profits. This manipulation of stock prices is only partly to blame
for the crash of 1929. Business had slowed for months yet stock prices were steadily
increasing. This was the set-up for disaster. How could prices be increasing when business
in general was slowing down? It would catch up with them. Soon prices began to decline as
company's earning and projections faltered. The declines in price had caused margin calls
and customers were forced to sell there stock. As the prices dipped lower, more and more
of the public sold shares. Finally, the volume of shares being sold dropped prices so low
the market crashed. Malkiel states, "history teaches us that very sharp increases in stock
prices are seldom followed by a gradual return to relative price stability", thus a sharp

Chapter 3 expands more on stock valuation from the sixties through the nineties. Most
people today including myself have put their money in the hands of professionals at
institutions whose sole purpose is to manage money. The perception would be that the
professionals would not be induced to act on the speculative crazes and schemes that the
general public would naively dive into. However, past history shows this is not the case.

The soaring sixties was the time of the IPO. Also called the tronics boom. As long a
company had the word tronics in its name it was considered a good buy. Some of these
companies had nothing to do with the electronics industry. The IPO's would rise fast and
fall even faster. There was market manipulation as well. Investment bankers would only
issue small amounts of IPO into the market, thus making the stocks price rise quickly.
When the stock price rose the remaining shares were then issued and sold at an inflated
price. There was also insider trading. Officers, relatives, and friends of the firm were
given large portions of the IPO's. The general public was last to get in. The main problem
however was that the public would go for any stock that promised to be next big thing. The
companies usually had not even made a single sale. Again, speculation took hold of the
general public. Prices could not be justified on firm foundation principles.

Then there was the concept of synergism which I can only describe using the same example
as Malkiel. Synergism is the notion that "2 plus 2 equals 5". Companies somehow believed
that by acquiring another company and consolidating, the businesses would produce greater
profits than if both were run separately. It was this practice that also gave rise to the
term conglomerate. Companies were acquiring businesses however they knew nothing about.
For example, a pharmaceutical company might purchase a textile company to increase
profits, but they knew nothing about operating in this industry. Eventually management
would figure this out and be forced to sell the company to avoid further losses.

In the seventies, blue chip stocks were the hot ticket, as investors believe these were
safe bets they could purchase and hold on to for life not worrying about a decline in
stock price. Yet again the institutions began to speculate over the blue chip stocks and
crowds followed, prices rose. These companies were believed to be infallible. Again,
prices rose to high and were greatly overpriced. Economic conditions eventually hit the
blue chip companies one by one and prices fell.

The eighties were similar to past decades, but the new hot spot was biotechnology stocks
and new issues. Prices were reflected in a speculative fashion, as many companies had no
earnings. Stock valuation was based on products in development that could take years to
complete and might never actually be produced. There was no rational explanation as to why
the prices were so high, but the institutions and public invested heavily.

Then there was the nineties and the one the biggest bust was in Japanese real estate.
"Stock prices were 5 times the value of assets." The Japanese explained this "by both the
density of the Japanese population and the various regulations and tax laws restricting
the use of habitable land". Some factors that played a part in the collapse were that
"profitability had been declining in Japan and the strong yen was making it difficult to
export". "Rental income had been rising far more slowly than land values, and finally
interest rates were on the rise." The low interest rates allowed many to borrow, but when
the bank of Japan raised the interest rates to help curb rising property prices it caused
the market to crash. The crash returned inflated prices back to book values, but caused
severe financial damage around the world.

Chapter 4 explains the bubble of the Internet that most everyone today is familiar with.
New technological advances were unprecedented, but speculation led to financial disaster
for many investors. It has been said many times already and proven historically that by
"building castles in the air" tragedy will likely follow. Internet companies sprang up
around every corner promising to be the next corporate giant. The investment firms ate it
up and marketed the companies heavily thus supporting the speculative spirit. How were the
company's stock prices determined? Analysts developed new ways to validate the
ever-increasing prices of the Internet companies. Valuation methods such as "price to
earnings, price to book value, and even price to sales were abandoned". Measurements were
now made based on the "number of people viewing a page" or usage per month. However, many
of the web surfers were not actually buying anything and hundreds of dot com's declared
bankruptcy. The media also played an important part in the frenzy as the "Internet became
a media outlet in it self". Information was but a click of the mouse away. Online brokers
became popular and offered instant research, charts, and graphs. But "customers orders
were not always routed to the market where the best price could be obtained but rather to
the market that paid the online broker the most for routing the order flow". The online
brokerage firms boasted to be cheaper, but did not always have the investor's interest at
mind. The online trading system also marked an enormous increase in day traders. Many quit
their jobs in order to make quick riches, but only few succeeded.

The speculative market also influenced many of the fraudulent cases of the early 2000's,
the biggest being Enron. As analysis looked for firms that could forecast high short-term
earnings to boost stock prices, companies were eager to comply. Enron for example
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