A Random Walk Down Wall Street by Burton G. Malkiel
Malkiel’s central message is that one should begin a consistent savings plan as early as possible and invest the core of your portfolio in low-cost, broad-based index funds.
Why do You Need to Invest?
Inflation runs at around 2% yearly which means that you need at least a 2% return on your capital to maintain your real purchasing power. Saving accounts practically have no return so your money is becoming less valuable over time on them. Therefore you need an investment strategy that, at the very least, keeps up with inflation.
The firm foundation theory (a.k.a. fundamental analysis): companies have an intrinsic value. They valued based on the net present value of their current and future cash flows. This is the theory behind value investing.
Castle in the sky theory (a.k.a. technical analysis): companies have psychological value. Their value is about how others perceive their value. This theory is purported by Keynes and exhibited by the many periods of “irrational exuberance” throughout history.
Many financial bubbles (periods of irrational exuberance) have occurred over time:
Dutch tulip craze of the 1600s
The British South Sea Company
1929 stock market bubble
Conglomerate boom of the 1960s
Blue chip company booms of the 1970s
1980s biotech craze
Japan in the 80s/90s
2000s dot com bubble
2008 real estate bubble
All of these periods of irrational exuberance share similar characteristics. There are new technologies, business opportunities, or unique valuation criteria that lead to positive feedback loops that drive stock prices through the roof. Then there’s a 50-90% crash.
The belief is that there are times to buy/sell stocks based on their price movements as stock values are roughly 90% psychological, and 10% rational.
The two important assumptions for this theory are:
All news is priced into stocks
Stocks move in trends
In reality, price movement doesn't really tell you information that will allow you to reliably beat the market, or a simple buy and hold strategy. Chartists don’t want to accept this theory because it puts their entire art in question. Plus, the randomness of prices is hard to accept.
Fundamentalists select stocks based on their estimated intrinsic value. This theory suggests that sock values are roughly 90% rational and 10% psychological.
Stocks increase in value with 4 signals:
Expected growth rate
Expected dividend payout
Degree of risk
Level of market interest rates
The rationale is to buy companies with average expected earnings growth for 5+ years, never pay more than foundation of value, and look for good stories of growth.
The problem is that no one can reliably assess value. There are many factors for that, so the firm foundation theory does not work reliably.
Efficient Market Hypothesis
The EMH states that technical and fundamental analysis don’t work since all information is already priced into the market. This is a highly controversial theory.
What is Investing Risk?
The probability 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 which means that it measures how a stock moves with the overall market. Unsystematic risk is risk associated with a particular company.
Diversification cannot eliminate systemic risk, but it can reduce unsystematic risk.
Modern Portfolio Theory
Diversification leads to good returns with lower risk. It works when you have assets that are not perfectly correlated. For example, foreign stocks are not perfectly correlated with domestic stocks, so adding them to your portfolio can lower risk while maintaining good returns. Assets have become increasingly correlated in recent years, but as long as they are not perfectly correlated, portfolio theory is still helpful.
Incentives to Understand
Good investments don’t change the world. They make and sustain profits.
Avoiding mistakes is more important than picking the big winners.
Investors are emotional and influenced by greed, hope, and fear.
Markets can be irrational, but true value is always recognized.
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” — Benjamin Graham
Lessons From Behavioral Finance
The EMH is built on the idea that investors are rational beings who make decisions that maximize their wealth, but are constrained by their individual risk tolerance. Behavioral finance debunks this idea and highlight four factors that cause irrational investor behavior:
Overconfidence: investors tend to overestimate their own skill and deny the role of chance in their outcomes. Typically, they attribute good outcomes to their own abilities (hindsight bias) and bad outcomes to external events. One manifestation of overconfidence is the consistent overvaluation of growth stocks.
Biased Judgments: investors tend to assume to have a greater degree of control than they have in reality. Most fail to properly weight probability and use base rates.
Herd Mentality: there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich. We all get lured into tales of the hot new stock that we need to invest in. This tendency to get swept up in speculative, get-rich-quick schemes shows how easily we get lost in herd mentality when making investment decisions.
Loss Aversion: losses hurt more than the joy we receive from equivalent gains. This explains why so many investors sell the winners and hold on to the losers. Losses also tap into the emotions of pride and regret. Talking about your losses is tough but talking about your gains makes you look cool.
However, even if market participants are irrational, it doesn’t mean that the market is by default inefficient. That’s highlighted by the difficulty of consistently finding arbitrage opportunities.
How to Avoid the Pitfalls of Investor Irrationality
Avoid herd behavior
Sell losers, not the winners
Don’t buy into IPOs or trust “hot tips”
Everyone wants to earn more with less effort. That is why get-rich-quick schemes are so tempting. The avoid these traps, learn to recognise them and be aware of your emptions.
How Stocks and Bonds are Valued
The value of a stock is determined 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 determined by 2 factors:
Initial yield to maturity at time of purchase
Changes in interest rates (yields) if you don’t hold the bond to maturity
When interest rates/inflation are lower, higher P/Es and lower dividend yields are somewhat justified. The Schiller CAPE index is a good way to see how the market is priced
Asset Allocation Principles
History shows that risk and return are related.
The risk of investing in stocks/bonds depends on the holding period. The longer the holding period, the lower the likely variance in asset returns.
Dollar cost averaging can be a useful, though controversial, technique to reduce risk.
Rebalancing can reduce risk, and in some circumstances, increase investment returns.
You must distinguish between your attitude toward and your capacity for risk.
Specific needs require dedicated specific assets.
Be aware of your risk tolerance. Your investments should never disturb your sleep. So invest up to the point at which you can handle the day to day variance and still sleep just fine.
Persistent savings in regular amounts, no matter how small, pays off.
The longer your holding time, the greater should be the share of common stocks in your portfolio.
If you have a multi-decade investment horizon, you should be heavily invested in stocks. While stocks are more volatile than other asset classes over short investment horizons, in the long run, you’re likely to get a good return.
Portfolio for Your 20s
Real estate (10%)
Invest in index-funds (low cost), and get international exposure. The US is only one third of the world economy, and other areas are growing quickly. If you hold bonds, make sure you do it in a tax-deferred retirement account.
When you retire, spend no more than 4% of your investments annually to secure your nest egg. In most cases, this will allow you to make it through the point at which you die.
Rules to Stock Picking
Only invest in companies that appear able to sustain above-average earnings growth for at least 5 years.
Never pay more for a stock than can reasonably justified by a firm foundation of value. Avoid stocks with many years of high growth priced in.
Look for castle in the air stories that rest on a firm foundation (i.e. stories of anticipated growth). Try to be where other investors will be a few months from now.
Trade as little as possible. Ride the winners and sell the losers. Sell before end of each calendar year any stocks on which you have a loss.
On Stock Market Trends
Over short holding periods, momentum exists in the stock market: increases in stock prices are slightly more likely to be followed by further increases than by price declines. However, over the long term, reversion to the mean will play out: when large price rises have been experienced over long periods, they are often followed by sharp reversals.
What to Invest In
Because we cannot consistently beat the market, the core of every portfolio should consist of low-cost, tax-efficient, broad-based index funds. Not only is it simple, but it’s likely to give you the best outcome 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 because of the power of compound interest, we should begin this savings and investment program as early as possible.
Avoid actively managed funds with high expense ratios (above 0.5%) and turnover (above 50%). These funds are everywhere, and they consistently underperform index funds.
Rule of 72
Divide 72 by the interest rate you earn and you get the number of years it will take to double your money. For example, if interest rate is 15%, it takes 72 ÷ 15 = 4.8 years for your money to double.