Random Walks and Rationality

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Random Walks and Rationality
Malkiels Random Walk Down Wall Street Michael
Smitka Economics 101 Fall 2000
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Malkiel's Basic Models

• Castle-in-the-Sky
• Firm Foundation
• Query Is Following One of These Theories
  Rational??

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Neither model workable in practice

• Competence of analysts
• Technical training
• Access to appropriate tools time
• Incentives of analysts
• Their own career
• Their employers success
• In order Fundamental, Technical

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Devil's Advocate (I) Fundamental Analysis is
Irrational

• Requires Applying Net Present Value
• Formal use requires predicting the future
• Price
• This is impossible even in
  theory!
• Empirical Evidence
• Even the pros are certifiably incompetent at
  the detailed level
• Professional management performs poorly at any
  aggregate level and by any standards!

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Devil's Advocate (II)Technical Analysis is
Irrational

• "Charting" is absurd in theory
• The madness of crowds is -- well, madness!
• What do charts have to do with mobs, anyway?
• Denies "micro" concepts are meaningful
• Techies fail in practice ( empirical )
• Can't explain their own logic - no shared
  theories or unified vision!
• Great for stockbrokers - self-serving motivations
• Loses money for practitioners

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Analysis in Practice- it still offers insights -

• Growth prospects give a higher price, everything
  else being equal
• Hence firms with good prospects have lower yields
  (and higher P/Es, ceteris paribus)
• Risk and payout ratios matter, too
• GM can only improve, Ford more likely must fall
• DaimlerChrysler is risky - future uncertain
• Toyota pays almost no dividends
• Ford before after Visteon spin-off when did
  prices move??
• Automotive Yields and Prospects
• Click to jump to quotes

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Analysis in Practice (II)- things can still go
awry -

• SONE S-1 Corporation, the leader in internet
  financial software
• Rush to internet banking but who has the
  expertise? S-1 does!
• In-house expensive and prone to failure S-1
• Business model of royalties low up-front costs
  for customers encourages adoption
• Performance C-School anecdotes
• Alumnus as CEO (children as students.)
• 1,000s of shares on campus - some at 100
• Todays price . . . HERE.

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Random Walk Doesn't It

• Disprove both basic theories?
• Deny all value to analysis?
• so
• Is Malkiel a nihilist??
• Can rational investors (C-School Profs) make
  money?

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Malkiel's Theme

• What is his principal theme?
• Technical analysis?
• NO!
• Fundamental analysis?
• NO!
• Why did he title his book "Random Walk?"

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Even if analysis is competent...

• Any technical rule, once applied shifts prices
• Rules are self-defeating
• Fundamental analysis also shifts prices
• Higher profits are reflected in prices
  immediately
• Stock prices are thus unpredictable
• Prices follow a Random Walk

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The Logic of Random Walks

• Todays price is the best predictor of tomorrow
• Why does RW work?
• Efficiency in financial markets
• New info reflected (very) quickly in prices!
• Applying rules renders them useless

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Strong, Weakvarieties of models

• The Random Walk hinges on efficiency
• Efficient Market Hypothesis- Information!
• Strong Version
• All information - even inside info - is useless
• Can you beat both insiders AND the 100,000 bright
  and motivated analysts out there? - dont try
• Regular flavor
• Public information has no value (but insiders)

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Lessons

• Malkiel stands accused of equating Wall Street
  professionals with monkeys.
• This is an accurate assessment of his view, once
  you add an additional sentence "Unfortunately
  for investors, Wall Street professionals pay
  themselves a lot more than monkeys."

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Lessons

• Don't let a broker make you a greater fool!
• But stocks do pay off over time
• Basic rules of thumb
• Diversify
• Know your risk tolerance
• Dont ignore transaction costs and taxes
• Dont be greedy

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Beating the Random Walk!

• When should you try?
• Once you have a reasonable amount in safe
  investments
• Your house
• Your retirement fund / pension account
• Rainy-day liquid savings
• Then you can play the market

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What first?

• Index funds let you
• Diversify
• With low transaction costs
• While cutting taxes
• No-load mutual funds are more adventurous
• But keep away from full-load funds
• They dont outperform cheap funds!

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Buying stocks yourself

• Its fun to try
• Use discount brokers - Why pay for analysis?
• Buy several stocks in small amounts
• DRIPs (Dividend Reinvestment Plans)
• let you start with very small investment
• So diversification is easy
• But not all companies have
• All these can generate a LOT of mail

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Beating the market

• Information is the key to efficient markets
• Sometimes you do have superior info
• Example a small company you encounter
• with superior management
• and room to grow.

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Warning!!

• Even then, don't expect quick riches
• Dont put all your eggs in one basket!
• your employer is no exception
• problems there hit both current income and
  wealth!! Bad move!!

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Warnings, continued

• You may spot trends -- like the next Internet.
• But remember, that only works if
• (i) you do so early and
• (ii) sell out early.
• Its hard to beat the crowd
• Its harder to sell out in time (cf. SONE).

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Finally

• Relax!
• Youre young, so always buy some stock
• If you're losing sleep, play it safe!
• Index funds
• Low-costs mutual funds

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Again, finally

• If youre losing sleep
• Dont watch CNN!
• Dont check Yahoo! Finance regularly
• Dont read the Wall Street Journal. (Thats old
  information by the time you get it!)

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Rationality in Financial MarketsThe New Finance
Theory

• Remember our assumptions
• No unused possibilities for arbitrage
• Profit-making rules are utilized
• Opportunities cannot be hidden
• No irrational exuberance
• New behavioral finance examines these

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Behavioral Finance

• Arbitrage is limited in the real world
• So prices can move too much
• But you wont learn of new rules
• until theyre useless
• (Andrei Schleifer)
• Prices are too volatile
• crowds are mad
• Prices move a lot even with no news
• (Robert Shiller)

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Economics retains value

• You can apply fundamental analysis
• You may have superior knowledge
• The models - P/E ratios etc - arent hard
• Plus playing the market can be fun!
• And using Malkiel you can limit your risks.

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THE END