A Random Walk Down The Wall Street
Summary
Chapter 8
In this chapter, the author is talking about stocks portfolio selection. He looks at the fundamental analytical system of stocks selection, and the amateur view. The writer is cynical about the efficacy of the fundamental analysis system of stock selection, whereby, the selection is assisted by the professional fundamental, stock analysts. He argues that there is limited difference in performance between portfolios selected by fundamental analysts, and those selected by amateurs.
First of all, the author criticizes fundamental stock analysts on the view that, they cannot predict the long-run performance of the stocks in the market, because the long-run view on stock performance does not even exist; the market for stocks experiences rampant, radical and random changes, hence making it difficult for fundamental, stock analysts to predict the prices of the stocks in the long run. The author argues that this dynamism in the shares market incapacitates stocks analysts from the ability to predict the future share indices; therefore, the advice the y provide is more similar to the amateur selection technique.
The rank amateur and the professional fundamental analysts are also more or less similar, because this fact has been proven through the test of time. A through time analysis model on the applicability of the two techniques in stock portfolio selection indicates that a careful estimation of the performance of stocks is no better than the naïve forecasting models applied by rank amateurs; who base their selection on the simple extrapolation of the past performance of the stocks. A portfolio selection done with use of fundamental analysts advice, does not portray any difference in performance, if any to the portfolio selected by an amateur, the author, therefore, discredits the effectiveness of a professional guided portfolio selection technique.
The author argues that the fundamental analysts’ predictions are rendered inefficient by several factors in the stock market. To begin with, he postulates that faces dynamic random events. The events he is talking about here include, for example, the political climate in a country; insecurity is a random event which may utterly influence a country’s political climate, take, for example, a terrorists attack in a country, this may instigate fear to stockholders, who may think that their investments may be lost at once, if the investments of their share holdings is bombed down by terrorists, for example, they may, therefore, shy away from buying the shares of the country facing insecurity, the trading of shares in such a situation is placed at adverse. Therefore, the share prices will come crumbling down, because of such random events, the reliability of professional advice on portfolio selection is incapacitated.
Another view the author discredits the information from professional stock analysts, is the dubious reported earnings of businesses due to what he calls ‘creative accounting procedures by companies.’ The accounting profits generated by organizations, do not give the actual financial performance of an organization. Accounting profits pass through a lot of accounting procedures before they are generated take, for example, the profits may be utterly underestimated by provisions and reserves.
The accounting profits reported, therefore, do not essentially reflect what was earned by a company. When the reported profits are low, this will be reflected in the share prices, the earnings per share will go down, and the share price is expected to drop. Therefore, financial advice on stock portfolio selection based on the accounting profits is unreliable. The stock analysts’ advice basing the stock prices on the accounting prices when the reserves and provisions are exceptionally high or particularly low may mislead potential investors; because the share prices may vary substantially in the subsequent years and make the credibility of the analyst’s advice to be in doubt.
The author states also that the predictions of the fundamental analysts are inconsistent, due to incompetence of some fundamental analysts. Lack of the relevant financial market knowledge, such as, for example, the correlation techniques, applied when selecting a portfolio, may misguide the advice provided by the stock analysts, investors, therefore, base their investment plans on such information at their own peril, because their investments will be doomed to fail.
The author argues that there are unscrupulous and unqualified providers of investment information to prospective investors; this causes inconsistencies in the financial advice provided by them, and, therefore, he places the advice provided by the professional analyst in doubt and being as good as that provided by an arbitral rank amateur. He argues that the fundamental portfolio analysis field has suffered significant blow in the recent past, due to the loss of considerable and critical, qualified fundamental advisors to the sales and portfolio management fields. Because of this he argues, therefore, that much of the information provided by analysts on portfolio selection is daunted.
The author states that currently there are many funds, beating the average, as compared to the funds which were there, in the seventies; he further argues that, in the eighties, the funds which ranked at the top, in the seventies, ranked at the bottom in the eighties. The presence of various funds makes stock portfolio selection difficult to conduct, because the investor does not know which fund to choose and which one to leave, the analysts face the same problem too, the ability of fund managers to properly manage the funds is also low; making it difficult to know which fund may do better than the other.
The board forms of efficient market theory also makes the insights of the professional analysts and those of the rank amateurs more or less similar, a look at the past stock prices is useless to base the portfolios on, fundamental analyst are not helpful either. The author also argues that the efficient market theory that share prices do not just move aimlessly and erratically, has been rendered useless. The exact opposite of the theory is true. The market is so efficient that share prices move so fast when new information arises.
The author says that investors should reconsider professional and amateur advice in selecting their portfolios. There is nothing like perfect pricing and news do not travel as instantaneously as provided by the efficient market theory. Therefore, investors should not solely rely on the information provided by the professional stock analysts in making their investment decisions, Malkiel (2007).
Chapter 9
In this chapter, called the new walking shoe, the writer m discusses about the modern portfolio theory (MPT). The new walking shoe in making investment plans regarding shareholding is the investment risk aspect of risk; the higher the inherent risk, the higher the ROI. The author argues that stock investment plans ought to be highly guided by how risky an investment is, because risk is the determinant of the rate of return of an investment. The greater the risk assumed, the higher the rate of return on an investment.
The investors should then focus on reducing the risks inherent in the selected investments. He provides insights on how the investment risks could be reduced. He notes first, that all investors are known to be risk averse; they avoid risks at the slighted instance. Portfolio selection itself should be used to reduce the risk of the selected investment. He argues that diversification is one sure method to reduce the risk inherent in a portfolio. Investors should, therefore, diversify their portfolios, however, the diversification should not be done arbitral, and there are correlation techniques available which should be used in portfolio selection.
The author states that fifty equal well diversified US stocks reduce the risk in the portfolio, by an overwhelming sixty percent. Stocks from emerging markets should also be included in the portfolio as a risk reduction tool; he argues that such stocks reduce the risk further. The author states also that the investor should select different asset classes in his/her investment decisions. Shares of behave assets differently in the market.
When one class of shares is deteriorating in value, the other class shares may be rising in value; therefore, selection of different classes of assets to investment will have a compensatory effect, such that the investor will not suffer a total loss at one particular time. For example, real estate shares do better during inflation, while the other shares are adversely affected by inflation; this class of shares’ price remains constant. This reduces the overall volatility of the portfolio, and investors should, therefore, be keen on the selection of their portfolios. All the same the author remarks that diversification is a paramount aspect to factor in during portfolio decisions, Malkiel (2007).
My understanding
My understanding of the arguments of the author is that, the professional advice provided by stocks analysts are has with time been rendered irrelevant. Potential awry can result when investors solely base their investment decisions on such advice. Some of the factors that have daunted the advice provided by the professional analysts include, for example, incompetence of some of the analysts in the market, the share market has also been established very dynamic and; therefore, basing the investment plans on past price experiences is inadequate. The share market is also stormed by random events, making it rather unpredictable. Professional analysts’ advice has consequently been reduced to similar level as amateur ranking procedures.
The main aspect that prospective share investors should base their portfolios on is the risk factor. Once they establish the inherent risk they should then embark on a move to reduce the risk. Diversification is an effective tool for risk reduction. A well diversified portfolio does not have the inefficiencies posed by volatility of the share market; therefore, investors should ensure that their portfolios are diversified in the right way. A well diversified portfolio should include a wide range of classes of assets. The real estate shares should exceptionally not be left out in the portfolio because their volatility is minimal.
Reference
Malkiel, B.G. A random walk down the Wall Street: The time-tested strategy for successful investing. New York, NY: W.W Norton & Company (2007).
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