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A Random Walk Down Wall Street is a excellent guide that combines history, market theory, economics, and behavioral finance to recommend practical and actionable advice for investing and reaching financial freedom. Malkiel’s main point is quite clear – start a consistent savings plan as soon as possible and invest the bulk of your portfolio in low-cost, broad-based index funds.
Why do you need to invest?
“…it’s clear that if we are to cope with even a mild inflation, we must undertake investment strategies that maintain our real purchasing power; otherwise, we are doomed to an ever-decreasing standard of living.”
If there’s inflation of 2% each year, that means that you require a 2% return on your capital to retain your real purchasing power. If you recieve no return by leaving your savings in an account with no interest, your wealth is becoming less valuable over time. So you require an investment strategy that, at a bare minimum, keeps pace with inflation.
What are the investing theories
- The firm foundation theory: companies have an intrinsic value. They’re valued based on the net present value of their present and future cash flows. This is the theory Warren Buffet and Charlie Munger have applied to establish Berkshire Hathaway.
- Castle in the sky theory: companies have psychological value. Their value is about how others appraise their value. This theory is supported by Keynes. It’s also revealed by the numerous bouts of “irrational exuberance” that we’ve witnessed through history.
The numerous financial bubbles (bouts of irrational exuberance) evidence how asset bubbles kept forming through history. For example
- Dutch Tulip craze of the 1600s
- The British South Sea Company
- 1929 stock market bubble
- Conglomerate boom of the 1960s
- Blue chip booms of the 1970s
- 1980s biotech craze
- Japan in the 80s/90s
- 2000s dot com bubbles
- 2008 real estate bubble
Each of these periods of irrational exuberance share similar qualities. There are new technologies, business opportunities, or individual valuation criteria that elicit positive feedback loops that power stock prices higher. Following this is a 50-90% crash.
Technical Analysis (Castle in the Sky Theory)
- Frequently called “chartists,” individuals in this area believe that there are periods to buy/sell stocks based on their price movements. This theory suggests that stock values are around 90% psychological, and 10% rational. Usually traders, rather than long-term investors.
- Two central assumptions for this theory: all news is priced into stocks, and stocks move in trends.
- When you examine if prices really move in trends, you would see that price movement doesn’t provide information that will allow you to constantly beat the market, or a straightforward buy and hold strategy. Chartists don’t want to believe this theory since it puts their whole art in question. Plus, the randomness of prices is difficult to believe.
- Fundamentalists pick stocks based on a rigid premise of estimated intrinsic value. This theory puts forward that stock values are around 90% rational and 10% psychological.
- Stocks increase in value with four signals
- Expected growth rate (P/E signal of this)
- Expected dividend payout
- Degree of risk
- Level of market interest rates
- Invest in companies with average forecast earnings growth for 5+ years
- Never pay more than foundation of value
- Search for good stories of growth
- The drawback is that no individual can consistently assess value. There are many reasons for this, so the firm foundation theory does not work consistently.
Efficient market hypothesis
Technical and fundamental analysis is ineffective. All data is already priced into the market.
What is investing risk?
- The likelihood that a security will decrease in value. The greater the risk, the greater the variance. Risk is the variance in the standard deviation of returns.
- Beta is systemic or market risk – it measures how a stock moves with the overall market.
- Unsystematic risk – risk associated with a particular company
- Diversification won’t remove systemic risk, but it can lessen unsystemic risk.
Modern portfolio theory
Diversification generates good returns with less risk. It functions when you hold assets that are not perfectly correlated. For instance, domestic stocks are not perfectly correlated with foreign stocks, so adding them to your portfolio can lower risk while sustaining good returns. Assets have become increasingly correlated in recent years, but as long as they are not perfectly correlated, portfolio theory is still useful.
Incentives to understand
- Buy/Sell Ratings: Securities analysts have a strong bias in regard to “buy ratings.” Something like 10:1, and it even reached 100:1 before the dot com bubble. Analysts are employed by banks that have corporate clients that wouldn’t be happy with a low rating. So incentives are aligned to favor buy ratings.
- CNBC employs more bulls than bears. Pessimistic skeptics don’t lead to high ratings.
- Sound investments don’t change the world. They make and sustain profits.
- Steering clear of mistakes is more critical than picking the big winners.
- Markets are irrational at times, but real value is always realized. Market is a weighing, not a voting machine.
- Investors are emotional – greedy, gambling, hope, fear – they’re not resistant to this.
Lessons from behavioral finance
“While a stock selling at $30 might be “worth only $15,” it would be a good buy if some greater fools would be willing to pay $60 for the stock at some future time.”
The efficient market hypothesis is established on the suggestion that investors are rational. Rational investors are individuals who make decisions that maximize their wealth, but are inhibited by their own risk tolerance. Behavioral finance questions the idea of the rational investors, emphasising that there are at least four factors producing irrational investor behavior:
Investors are overconfident about their beliefs/abilities and hubristic about their analyses of the future. Investors are also prone to overestimate their own competence and reject the role of chance in their outcomes. Most investors are too definite in their confidence intervals.
Frequently, investors associate good outcomes to their own skill (hindsight bias). They also associate bad outcomes to external incidents.
One display of overconfidence is the constant overvaluing of growth stocks.
Investors have several tools that cause them to imagine a greater degree of control than they have in reality. Majority of investors fail to accurately weight probability and use base rates.
“There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.” We all get captivated from stories of people making money through investing and of the hot new stock that we must invest in. This habit to get caught up in speculative, get-rich-quick schemes is characteristic of how we get astray in herd mentality when making investment decisions.
Losses sting more than the happiness we receive from equivalent gains. The pain we feel with a $100 loss is around the same as the happiness we feel from a $250 gain. Loss aversion justifies why so many investors sell the winners and hold on to the losers. Especially when facing a sure loss, we will hold on to losers for even longer. Losses also tap into the emotions of pride and regret. It’s difficult to talk about your losses, while it’s easy to talk about your gains.
Even if market participants are irrational, it doesn’t translate that the market isn’t efficient. That’s emphasised by the trouble of regularly spotting arbitrage opportunities in the market.
How to avoid the pitfalls of investor irrationality
“What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges.”
- Avoid herd behavior
- Avoid overtrading
- Sell losers, not the winners
- Don’t buy into IPOs or believe “hot tips”
Everyone wants to earn more with reduced output. Sometimes, there are “get-rich-quick” schemes or trends that are extremely attractive, but the best we can do is steer clear of these high-risk traps. It’s easier said than done.
How stocks and bonds are valued.
The value of a stock is ascertained by 3 factors:
- Initial dividend yield
- Growth rate of earnings
- Changes in valuation in terms of P/E or price/dividend ratios
The value of a bond is ascertained by 2 factors:
- Initial yield to maturity at time of purchase
- Changes in interest rates (yields) if you don’t hold bond to maturity
When interest rates/inflation are lower, higher P/Es and lower dividend yields are relatively warranted. The Schiller CAPE index is a good metric used to determine how the market is priced.
Asset allocation principles
- History shows that risk and return are connected
- The risk of investing in stocks/bonds is influenced by the length of time you hold the assets.
- The longer the holding period, the lower the likely deviation in asset returns.Dollar cost averaging can be a valuable, though contentious, technique to reduce risk.
- Rebalancing can lower risk, and in some cases, increase investment returns.
- You must differentiate between your attitude toward risk and your capacity for risk. The risks you can afford to take hinge on your financial situation, together with the types and sources of your income not including investment income.
- Certain needs require dedicated specific assets. If you require $30,000 for a house downpayment in 2 years, you will need an investment vehicle that matches your need for that capital at that time.
- Recognize risk tolerance. Generally, your investments shouldn’t disrupt your sleep. So invest up to your sleeping point – the point at which you can stomach the day to day fluctuations and still sleep soundly.
- Sustained savings in regular amounts, no matter how small, pays off.
Portfolio for your mid-twenties
- Cash (5%)
- Bonds (15%)
- Stocks (70%)
- Real estate (10%)
Invest in index-funds (low cost), and recieve international exposure. The US is approximately one third of the global economy, and other regions are growing rapidly. If you hold bonds, ensure you do it in a tax-deferred retirement account.
When you retire, spend no more than 4% of your investments annually to hold onto your nest egg. In most scenarios, this will enable you to make it to the point at which you pass away.
Rules to stock picking
- Limit stock purchases to companies that look able to maintain above-average earnings growth for at least five years. Growth increases, earnings, dividends, and likely the multiple the market will pay for those earnings.
- Don’t pay more for a stock than can be reasonably validated by a sound foundation of value. No perfect measure, but scrutinise how stock trades relative to market and growth prospects. Stay away from stocks with many years of high growth priced in.
- It helps to purchase stocks with the sorts of stories of expected growth on which investors can build castles in the air. Aim to be where other investors will be a few months from now. Search for castle in the air stories that rest on a strong foundation.
- Avoid trading. Ride the winners and sell the losers. Sell prior to the end of every calendar year any stocks on which you have a loss. Hold if it will win, but don’t have restraint for losing stocks. Losses might help tax burden.
According to efficient market theory, you aren’t likely to win even with keeping these sensible rules. Nonetheless, those with a appetite for speculation, might still enjoy the game and avoid giving it away.
Consider investing in China
China is underweighted in nearly all international indices. That’s because 1) local shares only available to Chinese citizens are not included and 2) shares held by the Chinese government (large % of float) are not included. So to participate in China’s growth, which could be worth your while, you must invest in an index fund of Chinese companies.
Think about YAO (all Chinese companies accessible to international investors); HAO (small-capitalization index fund holds more entrepreneurial companies) and TAO (Chinese real estate fund.)
Rule of 72
“A useful rule, called “the rule of 72,” provides a shortcut way to determine how long it takes for money to double. Take the interest rate you earn and divide it into the number 72, and you get the number of years it will take to double your money. For example, if the interest rate is 15 percent, it takes a bit less than five years for your money to double (72 divided by 15 = 4.8 years).”
On stock market trends
“Over short holding periods, there is some evidence of momentum in the stock market. Increases in stock prices are slightly more likely to be followed by further increases than by price declines. For longer holding periods, reversion to the mean appears to be present. When large price increases have been experienced over a period of months or years, such increases are often followed by sharp reversals.”
Eventually, reversion to the mean will transpire.
What to invest in
“The core of every portfolio should consist of low-cost, tax-efficient, broad-based index funds.”
The above encapsulates Malkiel’s core point: we are unable to routinely beat the market or realize oversized returns, so invest in low-cost, tax-efficient, broad-based index funds. Not only is it straightforward, but it’s likely to give you the best result as an individual investor.
“The single most important thing you can do to achieve financial security is to begin a regular savings program and to start it as early as possible.”
And thanks to the power of compound interest, we should start this savings and investment strategy as early as possible.
“The longer the time period over which you can hold on to your investments, the greater should be the share of common stocks in your portfolio.”
If you have a multi-decade investment outlook, you need to be heavily invested in stocks. Although stocks are more volatile than other asset classes over short investment periods, over a long period of time, you’re likely to recieve a handsome return.
Avoid these investments
“…suggest that investors never buy actively managed funds with expense ratios above 50 basis points (½ of 1 percent) and with turnover of more than 50 percent.”
Malkiel recommends investing in index funds. Steer away from actively managed funds with high expense ratios and turnover. These funds are very common, and they often times underperform index funds.
A Random Walk Down Wall Street Summary Conclusion
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