A Random Walk Down Wall Street

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A Random Walk Down Wall Street

• Author Burton Markiel
• Presenter Fernando Boccanera

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Author

• Started career as a market professional with a
  leading investment firm
• Chemical Bank Chairmans Professorship in
  Economics at Princeton University
• Lifelong investor

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Book

• First edition 1973
• 15 chapters, 4 parts, 396 pages
• Mostly text, not many figures

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Basic Argument

• Market prices stocks so efficiently that its
  very unlikely that someone can outperform the
  market on a consistent basis
• Since the 1st edition was published 35 year ago,
  more than two-thirds of professional portfolio
  managers have been outperformed by the SP 500
  index
• Buying and holding an index fund is the most
  efficient investment strategy

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PART I STOCKS AND THEIR VALUE
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Random Walk

• A sequence of numbers produced by a random
  process
• Future steps or directions cannot be predicted on
  the basis of past actions
• In the stock market means that short-run changes
  in stocks prices cannot be predicted

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Investment Theory

• Investors are rational
• Make reasonable estimates of the present value of
  stocks
• Their buying and selling ensures stock prices
  fairly reflect future prospects
• Investors are risk-averse
• Efficient Market Theory
• Prices adjust quickly and efficiently to new
  information future prices can not be predicted

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Bubbles

• Essential feature greed run amok
• Market participants ignore firm foundations of
  value for the dubious but thrilling assumption
  that they too can make a kicking by building
  castles in the air.
• Skyrocketing markets that depend on purely
  psychic support have invariably succumbed to the
  financial law of gravity

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Bubble Examples

• Tulipmania Holland early 17th century
• South Sea 300 year ago in England
• US 1928 Caused the big depression
• Japan 1990s- Real Estate
• US 2000 - Internet

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Lessons

• Markets can be irrational for some time but
  eventually correct any irrationality

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PART IIHOW THE PROS PLAY THE BIGGEST GAME IN
TOWN
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Technical Analysis

• Studies have shown that past movements in stock
  prices cannot be used reliably to foretell future
  movements supports Random Walk Theory
• The cycles and patterns in a chart are the
  product of pure chance. Simulations of stock
  prices can produce charts that have patterns
• After the fact its always possible to find a
  technical rule that works
• Technical Analysis is a myth

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Buy-and-hold strategy

• Will perform at least as good as any technical
  analysis method
• More tax efficient because does not generate a
  lot of short-term capital gains

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Fundamental Analysis

• Growth rate in a particular period is not a good
  predictor of future growth rate there is no
  reliable pattern
• A study compared security analysts estimates or
  1-year and 5-year future earnings for a large
  sample of companies with the actual results. The
  estimates did no better than the forecast of
  naive models like the long-run rate of growth of
  national income. One-year forecast was even worse
  than 5-year.

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Fundamental Analysis

• Analysts have enormous difficulty in forecasting
  companies earnings prospects
• No reliable way to pick a winner fund
• Most academics dont believe in Fundamental
  Analysis

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Fundamental Analysis

• Author is not ready to throw away Fundamental
  Analysis entirely
• Investors might reconsider their faith in
  professional advisers
• Although there is strong evidence that markets
  are efficient, there are enough anomalies to make
  it impossible to state that the theory is
  conclusively demonstrated

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PART IIITHE NEW INVESTMENT TECHNOLOGY
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Modern Portfolio Theory

• Risk
• Studies show that investors have received higher
  rates of return for bearing greater risk
• Reducing Risk
• Diversification with securities that are
  uncorrelated or have little correlation can in
  fact reduce risk
• Diversification can not eliminate all risks

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Diversification

• REITs and bonds have low correlation with US
  stocks
• International diversification
• The correlation between US stocks and
  international stocks is lower than the
  correlation among US stocks
• Between 1970 and 2006, the least risky portfolio
  was comprised of 76 US stocks and 24
  international
• The correlation between emerging market stocks
  and US stocks is much lower than between US and
  developed markets like Europe and Japan.

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Evidence for the Efficient-Market Theory

• Most convincing tests of market efficiency are
  tests of the ability of professional fund
  managers to outperform the market
• Remarkable body of evidence suggests that
  professional money managers are not able to
  outperform index funds

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Evidence for the Efficient-Market Theory

• From 1986-2005 the average actively managed
  large-cap mutual fund underperformed the SP 500
  by 1.5 per year.
• Large-cap equity funds outperformed by the SP
  for periods ending 2005
• 1 year 3 years 5 years 10 years 20 years
• 48 68 68 79 82

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Evidence against the Efficient-Market Theory

• Also called market anomalies, irrationalities or
  ineficiencies
• January effect
• Short-term momentum
• Long-run return reversals
• Smaller is best
• Low Price to Earnings ratio
• Low Price to Book Value Ratio

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Short-term momentum

• Some studies have showed some degree of momentum
  where a positive return in one week is more
  likely to be followed by a positive return in the
  next week
• Statistically relevant but not economical
  significant after trading costs does not beat a
  buy-and-hold strategy

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Long-run return reversals

• Stocks that performed poorly during the past 3
  years are likely to give above-average returns
  over the next 3 years.
• Most believable pattern
• May be the reaction to fluctuations in interest
  rates
• May represent just reversion to the mean
• This contrarian approach if used together with a
  fundamental-value approach is potentially
  beneficial (value investing)

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Smaller is best

• Strongly documented in studies
• Small stocks generate returns larger than large
  stocks over long periods
• Did not work during the 1990s but worked during
  2000-2006
• Not a sure way to earn above-average,
  risk-adjusted returns

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Low Price to Earnings ratio

• Several studies have shown that low P/E stocks
  produce above-average returns even after
  adjusting for risk
• Vary over time, not dependable over every period
• Low P/E often justified on the basis of bad
  company financials
• Author sympathizes with this value strategy

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Low Price to Book Value Ratio

• Value strategy that tend to produce above-average
  returns
• Documented in famous study by Fama and French
• Hold for both US and many foreign stock markets

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Part IVPractical Guide
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Fitness Manual

• Save enough money
• Cover yourself
• Reduce taxes
• Understand your investment objectives
• Consider buying your home instead of renting it
• Consider bonds
• Consider gold because the returns have little
  correlation with stocks, but only for a very
  small part of portfolio
• Consider commissions and other transaction costs
• Diversify

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Projecting Returns

• Determinants of Returns of Stocks over the long
  run
• Dividend yield at time of purchase
• Future growth rate of earnings and dividends

Long-run projected return Initial Dividend
Yield Growth Rate
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Projecting Returns

• Over the short term (a few years), third factor
  is critical
• Risk premium, or change in valuation relationship
• Can be measured by the change in Price/Earnings
  ratio

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Projecting Returns

• Average P/E ratio
• Vary widely from year to year
• In times of optimism, such as March 2000, P/E was
  well above 30
• In times of pessimism, such as 1982, P/E was 8
• When interest rates are low, stocks tend to sell
  at high P/E. When rates are high, P/E decreases

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Estimating returns for years after 2006

• Unrealistic to expect the generous 18.3 stock
  return or 13.6 bond returns of the 1982-2000
  period
• Bonds
• Good-quality corporate will earn about 6 if held
  until maturity
• Treasury will earn about 5 if held until maturity

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Estimating returns for years after 2006

• Stocks
• 2006 dividend yield of SP 500 about 2, well
  below the 4.5 historical average.
• Reasonable estimate for earnings growth 5.5
  (consistent with historical rates during periods
  of restrained inflation and similar to Wall
  Street firms estimates in the late 2006)
• P/E ratio in late 2006 were in the upper teens,
  just slightly higher than the long-run historical
  average
• P/E changes can not be predicted. If the risk
  premium (P/E ratio) does not change, the expected
  return is 7.5
• When interest rates and inflation are low, like
  they were in 2006, higher P/E are justified
  consequently the return could be greater than 7.5

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Life-Cycle Investing

• The most important decision you will probably
  ever make concerns the asset allocation between
  asset classes (stocks, bonds, real estate, cash,
  etc)
• According to Roger Ibbotson, who has spent a
  lifetime measuring returns, more than 90 of an
  investors total return is determined by the
  asset categories and their allocation

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Five Asset-allocation principles

• Risk and reward are positively related -
  fundamental law of finance
• Actual risk in stocks and bonds depend on the
  length of the holding period
• Dollar-cost averaging can reduce risk
• Rebalancing can reduce risk and possibly increase
  returns
• Distinguishing between attitude toward risk and
  capacity for risk

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Life-cycle
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Stock Buying Methods

• No-brainer
• Do-it yourself
• Hire a professional

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No-brainer

• Buy shares in broad-based index funds designed to
  track the asset classes in your portfolio
• Rationale efficient-market theory
• Index funds advantages
• Have on average returned 1.5 above active funds
• Low management fees because its passively
  managed
• Low trading costs because of low turnover
• Tax friendly, do not produce as much short-term
  taxable gains
• Allow small investor to diversify

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No-brainer

• If investor can only afford one fund, then invest
  in an index in a total market fund
• Diversify internationally with index funds
• ETFs
• Tax-managed index funds for taxable accounts
  (Vanguard tax-managed fund SP 500)

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No-brainer

• Close-end funds
• Buy those selling at a discount from net asset
  value
• During much of the 1970, CE funds sold at
  substantial discounts
• Discounts can be explained as an unexploited
  market inefficiency
• Urged reads of earlier editions to take advantage
• If buy shares at 25 discount, still have 4 of
  dividend-paying assets for each 3 invested. Even
  if fund equaled the market return, investor still
  would beat the market because of dividends.
• Discounts have narrowed significantly in US
  funds, most funds no longer attractive

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Closed-end Fund Discounts as of mid 2006
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Do-it yourself method

• Pick your own stocks
• Only use money that can risk, the rest of the
  money should be indexed
• Takes a lot of work and consistent winners are
  very rare
• Growth at a reasonable price (GARP) strategy

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GARP

• Companies that appear able to sustain
  above-average earnings growth for at least 5
  years - growth
• Never pay more than justifiable by a fundamental
  assessment. P/E ratio not much higher than the
  Market P/E
• Buy stocks with stories of anticipated growth
  that can catch the interest of the crowd
• Trade as little as possible
• High turnover produces high costs
• Sell when the circumstances that led you to buy
  have changed for the worse
• Should sell when market is in a bubble but its
  very difficult to time
• Author sells before the end of each calendar year
  any stock with a loss. Losses are deductible from
  taxable gains

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Hire a professional method

• Purchase managed mutual funds
• Past records of funds are not good predictors of
  future success.
• Two best factors for predicting performance
• Expense ratio
• Turnover ratios
• High expenses and high turnover depress
  returns-especially after-tax returns.
• 50-50 rule
• Buy only funds with expense ratios lt 0.5 and
  with turnover less than 50.

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Summary

• Projected stock market returns beyond 2006 7.5
• Buying and holding an index fund is the most
  efficient investment strategy
• Index most or all of your portfolio
• Asset allocation the most important decision
• Assets stocks, bonds, REITs, cash
• Use a life cycle scheme
• Diversify internationally

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Summary

• Buying stocks
• Company can sustain above average earnings growth
  for at least 5 years
• PE not much higher than the market PE
• Selling Stocks
• When favorable conditions change for worse
• Author sells losers at the end of calendar year
• Be aware of the long-run return reversals