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By Zhipeng Yan A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel “Not more than half a dozen really good books about investing have been written in the past fifty years. This one may well be the classics category.” ----- FORBES This is a detailed abstract of the book. The opinions in the abstract only reflect those of the author’s not mine, though I largely agree with most of his opinions. The “I” in the abstract refers to the author. If you are only interested in how to make investment, you can read Part four directly. However, I strongly suggest you read the whole abstract. At least, you don’t need to read the 400-page book. Part One: Stocks and Their Value .................................................................................. 2 Chapter 1. Firm Foundations and Castles in the Air .................................................... 2 Chapter 2. The Madness of Crowds................................................................................ 3 Chapter 3. Stock Valuation from the sixties through the Nineties............................... 5 Chapter 4. The Biggest Bubble of All: Surfing on the Internet.................................... 8 Chapter 5. The Firm-foundation Theory of Stock Prices ............................................. 9 Part Two: How the Pros Play the Biggest Game in Town .......................................... 10 Chapter 6. Technical and Fundamental analysis......................................................... 10 Chapter 7. Technical analysis and the Random walk theory ..................................... 13 Chapter 8. How good is Fundamental analysis? .......................................................... 14 Part Three: The New Investment Technology ............................................................. 15 Chapter 9. A New Walking Shoe: Modern Portfolio Theory ..................................... 15 Chapter 10. Reaping Reward by Increasing Risk ....................................................... 16 Chapter 11. Potshots at the Efficient-Market Theory and Why they Miss............... 18 Part Four: A Practical Guide for RANDOM WALKers and other Investors.......... 21 Chapter 12. A Fitness manual for RANDOM WALKers ........................................... 21 Chapter 13. Handicapping the Financial Race: A Primer in Understanding and Projecting Returns form Stocks and Bonds. ................................................................ 26 Chapter 14. A life-Cycle Guide to Investing................................................................. 27 Chapter 15. Three Giant steps down Wall street......................................................... 29 -1- By Zhipeng Yan Preface 1. Investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds. 2. The basis thesis of the book: the market prices stocks so efficiently that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that performs as well as those managed by the experts. 3. Through the past 30 years, more than two-thirds of professional portfolio managers have been outperformed by the unmanaged S&P 500 Index. 4. One’s capacity for risk-bearing depends importantly upon ones’ age and ability to earn income from noninvestment sources. It is also the case that the risk involved in most investments decreases with the length of time the investment can be held. Thus, optimal investment strategies must be age-related. Part One: Stocks and Their Value Chapter 1. Firm Foundations and Castles in the Air I. What is a random walk? 1. A random walk is one in which future steps or directions cannot be predicted on the basis of past actions. When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted. Investment advisory services, earnings predictions, and complicated chart patterns are useless. 2. Market professionals arm themselves against the academic onslaught with one of two techniques, called fundamental analysis and technical analysis. Academics parry these tactics by obfuscating the RANDOM WALK theory with three versions (the “week”, the “semi-strong,” and the “strong”). II. Investing as a way of life today 1. I view investing as a method of purchasing assets to gain profit in the form of reasonably predictable income (dividends, interest, or rentals) and/or appreciation over the long term. It is the definition of the time period for the investment return and the predictability of the returns that often distinguish an investment from a speculation. 2. Just to stay even, your investments have to produce a rate of return equal to inflation. 3. Even if you trust all your funds to an investment adviser or to a mutual fund, you still have to know which adviser or which fund is most suitable to handle your money. 4. Most important of all is the fact that investing is fun. It’s fun to pit your intellect against that of the vast investment community and to find yourself rewarded with an increase in assets. III. Investing in theory 1. All investment returns are dependent, to varying degrees, on future events. Investing is a gamble whose success depends on an ability to predict the future. Traditionally, the pros in the investment community have used one of two approaches to asset valuation: the firm foundation theory or the castle-in-the-air theory. -2- By Zhipeng Yan 2. The Firm-foundation theory: each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected. The theory stresses that a stock’s value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends. It stands to reason that the greater the present dividends and their rate of increase, the greater the value the stock; thus, differences in growth rates are a major factor in stock valuation. 3. The castle-in-the-air theory: it concentrates on psychic values. John Maynard Keynes argued that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd. 4. Keynes described the playing of the stock market in terms readily understandable: It is analogous to entering a newspaper beauty-judging contest in which one must select the six prettiest faces out of a hundred photographs, with the prize going to the person whose selections most nearly conform to those of the group as a whole. The smart player recognizes that personal criteria of beauty are irrelevant in determining the contest winner. A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. Thus, the optimal strategy is not to pick those faces the player thinks are prettiest, or those the other players are likely to fancy, but rather to predict what the average opinion is likely to be about what the average opinion will be, or to proceed even further along this sequence. 5. The newspaper-contest analogy represents the ultimate form of the castle-in-the-air theory. An investment is worth a certain price to a buyer because she expects to sell it to someone else at a higher price. 6. The castle-in-the-air theory has many advocates, in both the financial and the academic communities. Robert Shiller, in his best-selling book Irrational Exuberance, argues that the mania in Internet and high-tech stocks during the late 1990s can only be explained in terms of mass psychology. Chapter 2. The Madness of Crowds The psychology of speculation is a veritable theater of the absurd. Although the castle-in-the-air theory can well explain such speculative binges, outguessing the reactions of a fickle crowd is a most dangerous game. Unsustainable prices may persist for years, but eventually they reverse themselves. I. the Tulip-Bulb Craze 1. In the early 17th century, tulip became a popular but expensive item in Dutch gardens. Many flowers succumbed to a nonfatal virus known as mosaic. It was this mosaic that helped to trigger the wild speculation in tulip bulbs. The virus caused the tulip petals to develop contrasting colored stripes or “flames”. The Dutch valued highly these infected bulbs, called bizarres. In a short time, popular taste dictated that the more bizarre a bulb, the greater the cost of owning it. -3- By Zhipeng Yan 2. Slowly, tulipmania set in. At first, bulb merchants simply tried to predict the most popular variegated style for the coming year. Then they would buy an extra large stockpile to anticipate a rise in rice. Tulip bulb prices began to rise wildly. The more expensive the bulbs became, the more people viewed them as smart investments. 3. People who said the prices could not possibly go higher watched with chagrin as their friends and relatives made enormous profits. The temptation to join them was hard to resist; few Dutchmen did. In the last years of the tulip spree, which lasted approximately from 1634 to early 1637, people started to barter their personal belongings, such as land, jewels, and furniture, to obtain the bulbs that would make them even wealthier. Bulb prices reached astronomical levels. 4. The tulip bulb prices during January of 1637 increased 20 fold. But they declined more than that in February. Apparently, as happens in all speculative crazes, prices eventually got so high that some people decided they would be prudent and sell their bulbs. Soon others followed suit. Like a snowball rolling downhill, bulb deflation grew at an increasingly rapid pace, and in no time at all panic reigned. II. 1. 2. 3. 4. 5. 6. The South Sea Bubble The South Sea Company had been formed in 1711 to restore faith in the government’s ability to meet its obligations. The company took on a government IOU ( I owe you: debt) of almost 10 million pounds. As a reward, it was given a monopoly over all trade to the South Seas. The public believed immense riches were to be made in such trade, and regarded the stock with distinct favor. In 1720, the directors decided to capitalize on their reputation by offering to fund the entire national debt, amounting to 31 million pounds. This was boldness indeed, and the public loved it. When a bill to that was introduced in Parliament, the stock promptly rose from ￡130 to ￡300. On April 12, 1720, five days after the bill became law, the South Sea Company sold a new issue of stock at ￡300. The issue could be bought on the installment plan - ￡60 down and the rest in eight easy payments. Even the king could not resist; he subscribed for stock totaling ￡100,000. Fights broke out among other investors surging to buy. The price had to go up. It advanced to ￡340 within a few days. The ease the public appetite, the company announced another new issue – this one at ￡400. But the public was ravenous. Within a month the stock was ￡550, and it was still rising. Eventually, the price rose to ￡1,000. Not even the South See was capable of handling the demands of all the fools who wanted to be parted from their money. Investors looked for the next South Sea. As the days passed, new financing proposals ranged from ingenious to absurd. Like bubbles, they popped quickly. The public, it seemed, would buy anything. In the “greater fool” theory, most investors considered their actions the height of rationality as, at least for a while; they could sell their shares at a premium in the “after market”, that is, the trading market in the shares after their initial issue. Realizing that the price of the shares in the market bore no relationship to the real prospects of the company, directors and officers of the South Sea sold out in the summer. The news leaked and the stock fell. Soon the price of the shares -4- By Zhipeng Yan collapsed and panic reigned. Big losers in the South Sea Bubble included Isaac Newton, who exclaimed, “I can calculate the motions of heavenly bodies, but no the madness of people.” III. 1. 2. 3. 4. 5. Wall street lays an egg From early March 1928 through early September 1929, the market’s percentage increase equaled that of the entire period from 1923 through early 1928. Price manipulation by “investment pools”: The pool manager accumulated a large block of stock through inconspicuous buying over a period of weeks. Next he tried to enlist the stock’s specialist on the exchange floor as an ally. Through “wash-sales” (buy-sell-buy-sell between manager’s allies), the manager created the impression that something big was afoot. Now, tip-sheet writers and market commentators under the control of the pool manager would tell of exciting developments in the offing. The pool manager also tried to ensure that the flow of news from the company’s management was increasingly favorable – assuming the company management was involved in the operation. The combination of tape activity and managed news would bring the public in. once the public came in, the free-for-all started and it was time discreetly to “pull the plug”. Because the public was doing the buying, the pool did the selling. The pool manager began feeding stock into the market, first slowly and then in larger and larger blocks before the public could collect its senses. At the end of the roller-coaster ride the pool members had netted large profits and the public was left holding the suddenly deflated stock. On September 3, 1929, the market averages reached a peak that was not to be surpassed for a quarter of a century. The “endless chain of prosperity” was soon to break. On Oct 24 (“Black Thursday”), the market volume reached almost 13 million shares. Prices sometimes fell $5 and $10 on each trade. Tuesday, Oct 29, 1929, was among the most catastrophic days in the history of the NYSE. More than 16.4 million shares were traded on that day. Prices fell almost perpendicularly. History teaches us that very sharp increases in stock prices are seldom followed by a gradual return to relative price stability. It is not hard to make money in the market. What is hard to avoid is the alluring temptation to throw your money away on short, get-rich-quick speculative binges. Chapter 3. Stock Valuation from the sixties through the Nineties By the 1990s, institutions accounted for more than 90% of the trading volume on the NYSE. And yet professional investors participated in several distinct speculative movements from the 1960s through the 1990s. In each case, professional institutions bid actively for stocks not because they felt such stocks were undervalued under the firmfoundation principles, but because they anticipated that some greater fools would take the shares off their hands at even more inflated prices. I. The Soaring Sixties 1. The New “New Era”: The growth-stock/New-issue craze: -5- By Zhipeng Yan a. Growth was the magic work in those days, taking on an almost mystical significance. More new issues were offered in the 1959-62 period than at any previous time in history. It was called the “tronics boom”, because the stock offering often included some garbled version of the word “electronics” in their title, even if the companies had nothing to do with the electronics industry. b. Jack Dreyfus commented on the mania as follows: a shoelace making firm (P/E ratio is 6) changed the name from Shoelaces, Inc. to Electronics and Silicon Furth-Burners. In today’s market, the words “electronics” and “silicon” are worth 15 times earnings. However, the real play comes from the word “furth-burners,” which no one understands. A word that no on understands entitles you to double your entire score. Therefore, after the name change, the new P/E ratio = (6 + 15)*2=42! c. The SEC uncovered many evidence of fraudulence and market manipulation in this period. Many underwriters allocated large portions of hot issues to insiders of the firms such as partners, relatives, officers, and other securities dealers to whom a favor was owed. The tronics boom came back to earth in 1962. 2. Synergy Generates Energy: The conglomerate Boom. a. Part of the genius of the financial market is that if a product is demanded, it is produced. The product that all investors desired was expected growth in earnings per share. By the mid-1960s, creative entrepreneurs had discovered that growth meant synergism, which is the quality of having 2 plus 2 equal 5. b. In fact, the major impetus for the conglomerate wave of the 1960s was the acquisition process itself could be made to produce growth in earnings per share. The trick is the ability of the acquiring firm to swap its high-multiple stock for the stock of another firm with a lower multiple. The targeting firm can only “sell” its earnings at multiple of 10, say. But when these earnings are packaged with the acquiring firm, the total earnings could be sold at a multiple of 20. c. As a result of such manipulations, corporations are now required to report their earnings on a “fully diluted” basis, to account for the new common shares that must be set aside for potential conversions. The music slowed drastically for the conglomerates on January 19, 1968. On that day, the granddaddy of the conglomerates, Litton Industries, announced that earnings for the second quarter of that year would be substantially less than had been forecast. In the selling wave that followed, conglomerate stocks declined by roughly 40% before a feeble recovery set in. d. The aftermath of this speculative phase revealed two factors. First, conglomerates were mortal and were not always able to control their far-flung empires. Second, the government and the accounting profession expressed real concern about the pace of mergers and about possible abuses. Few mutual or pension funds were without large holdings of conglomerate stocks. They were hurt badly. During the 1980s and 1990s deconglomeration came into fashion. Many of the old conglomerates began to shed their unrelated, poor-performing acquisitions to boost their earnings. 3. Performance comes to the market: the Bubble in Concept stocks a. With conglomerates shattering about them, the managers of investment funds found another magic word: performance in the late 1960s. The commandments -6- By Zhipeng Yan for fund managers were simple: Concentrate your holdings in a relatively few stocks and don’t hesitate to switch the portfolio around if a more desirable investment appears. And because near-term performance was important it would be best to buy stocks with an exciting concept and a compelling and believable story. Hence, the birth of the so-called concept stock. b. Cortess Randall was the founder of National Student Marketing (NSM). His concept was a youth company for the youth market. Blocks of NSM were bought by 21 institutional investors. Its highest price was 35.25. However, in 1970, its lowest price was 7/8. II. The Sour Seventies 1. In the 1970s, Wall Street’s pros vowed to return to “sound principles.” Concepts were out and investing in blue-chip companies was in. They were called the “Nifty fifty”, also “one decision” stocks. You made a decision to buy them, once, and your portfolio-management problems were over. 2. Hard as it is to believe, the institutions had started to speculate in blue chips. In 1972, P/E for Sony is 92, for Polaroid is 90, for McDonald’s is 83. Institutional managers blithely ignored the fact that no sizable company could ever grow fast enough to justify an earnings multiples of 80 or 90. 3. The end was inevitable. The Nifty fifty were taken out and shot one by one. III. The Roaring Eighties 1. The Triumphant Return of New issues: the high-technology, new-issue boom of the first half of 1983 was an almost perfect replica of the 1960s episodes, with the names altered to include the new fields of biotechnology and microelectronics. The total value of new issuers in 1983 was greater than the cumulative total of new issues for the entire preceding decade. 2. Concepts Conquer Again: the Biotechnology Bubble: valuation levels of biotechnology stocks reached an absurd level. In 1980s, some biotech stocks sold at 50 times sales. 3. From the mid-1980s to the late 1980s, most biotechnology stocks lost three-quarters of their market value. What does it all mean? – Styles and fashions in investors’ evaluations of securities can and often do play a critical role in the pricing of securities. The stock market at times confirms well to the castle-in-the-air theory. IV. The Nervy Nineties 1. One of the largest booms and busts of the late twentieth century involved the Japanese real estate and stock markets. From 1955 to 1990, the value of Japanese real estate increased more than 75 times. By 1990, Japan’s property was appraised to be worth 5 times as much as all American property. 2. Stock prices increased 100-fold from 1955 to 1990. At their peak in Dec 1989, Japanese stocks had a total market value of about $4 trillion, almost 1.5 times the value of all U.S. equities and close to 45% of the world’s equity market cap. -7- By Zhipeng Yan Stocks sold at more than 60 times earnings, almost 5 times book value, and more than 200 times dividends. 3. The financial laws of gravity know no geographic boundaries. The Nikkei index reached a high of almost 40,000 on the last trading day of the decade of the 1980s. By mid-August 192, the index had declined to 14,309, a drop of about 63%. In contrast, the DJIA fell 66% from Dec 1929 to its low in the summer of 1932. Chapter 4. The Biggest Bubble of All: Surfing on the Internet 1. The NASDAQ Index, an index essentially representing high-tech New Economy companies, more than triples from late 1998 to March 2000. The P/E ratios of the stocks in the index that had earnings soared to over 100. 2. Amazon sold at prices that made its total market cap larger than the total market values of all the publicly owned booksellers such as Barnes & Noble. Priceline sold at a total market cap that exceeded the cap of the major carriers United, Delta, and American Airlines combined. 3. Cooper, Dimitrov and Rau found that 63 companies that changed their names to include some Web orientation enjoyed a 125% greater increase in price during 10 day period than that of their peers. In the post-bubble period, they found that stock prices benefited when dot-com was deleted from the firm’s name. 4. The relationship between profits and share price had been severed. 5. Security analysts $peak up: a. Mary Meeker was dubbed by Barron’s the “Queen of the Net.” Henry Blodgett was known as “King Henry”. Henry flatly stated that traditional valuation metrics were not relevant in “the big-bang stage of an industry.” Meeker suggested that “this is a time to be rationally reckless.” b. Traditionally, ten stocks are rated “buys” for each on that is rated “sell.” But during the bubble, the ratio of buys to sells reached close to 100 to 1. 6. The writers of the media: the bubble was aided and abetted by the media – which turned us into a nation of traders. Journalism is subject to the laws of supply and demand. Since investors wanted more information about Internet investing opportunities, the supply of magazines increased to fill the need. 7. The result was that turnover reached an all-time high. The average holding period for a typical stock was not measured in years but rather in days and hours. Redemption ratios of mutual funds soared and the volatility of individual stock prices exploded. 8. History tells us that eventually all excessively exuberant markets succumb to the laws of gravity. In the early days of automobile, we had close to 100 automobile companies, and most of them became roadkill. The key to investing is not how much industry will affect society or even how much it will grow, but rather its ability to make and sustain profits. 9. The lesson here is not that markets occasionally can be irrational and, therefore, that we should abandon the firm foundation theory. Rather, the clear conclusion is that, in every case, the market did correct itself. The market eventually corrects any irrationality – albeit in its own slow, inexorable fashion. Anomalies can crop up, markets can get irrationally optimistic, and often they attract unwary investors. But -8- By Zhipeng Yan eventually, true value is recognized by the market, and this is the main lesson investors must heed. Chapter 5. The Firm-foundation Theory of Stock Prices Firm-foundation theorists view the worth of any share as the present value of all dollar benefits the investor expects to receive from it. The starting point focuses on the stream of cash dividends the company pays. The worth of a share is taken to be the present or discounted value of all the future dividends the firm is expected to pay. The price of a common stock is dependent on several factors: I. Determinant 1: the expected growth rate: 1. Dividend growth does not go on forever. Corporation and industries have life cycles similar to most living things. Furthermore, there is always the fact that it gets harder and harder to grow at the same percentage rate. 2. Rule 1: A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings. 3. Corollary: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last. II. Determinant 2: The expected dividend payout. 1. The higher the payout, other things being equal, the greater the value of the stock. The catch is “other things being equal.” Stocks that pay out a high percentage of earnings in dividends may be poor investments if their growth prospects are unfavorable. Conversely, many companies in their most dynamic growth phase often pay out little or none of their earnings in dividends. 2. Rule 2: A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company’s earnings that is paid out is cash dividends. III. Determinant 3: Rule 3: A rational (and risk-averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock. IV. Determinant 4: the level of market interest rates: Rule 4: A rational investor should be willing to pay a higher price for a share; other things being equal, the lower are interest rates. V. Two Caveats Caveat 1: expectations about the future cannot be proven in the present. Predicting future earnings and dividends requires not only the knowledge and skill of an economist but also the acumen of a psychologist. And it is extremely difficult to be objective. Caveat 2: Precise figures cannot be calculated from undetermined data. You can’t obtain precise figures by using indefinite factors. VI. Testing the rules -9- By Zhipeng Yan 1. The 2002 data shows that high P/E ratios are associated with high expected growth rates. 2. Fundamental considerations do have a profound influence on market prices. P/E ratios are influenced by expected growth, dividend payouts, risk, and the rate of interest. Higher anticipations of earnings growth and higher dividend payouts tend to increase P/E. Higher risk and higher interest rates tend to pull them down. There is logic to the stock market, just as the firm foundationists assert. 3. It appears that there is a yardstick for value, but one that is a most flexible and undependable instrument. Stock prices are in a sense anchored to certain “fundamentals,” but the anchor is easily pulled up and then dropped in another place. The standards of value are the more flexible and fickle relationships that are consistent with a marketplace heavily influenced by mass psychology. 4. The most important fundamental influence on stock prices is the level and duration of the future growth of corporate earnings and dividends. But, future earnings growth is not easily estimated, even by market professionals. 5. Dreams of castles in the air may play an important role in determining actual stock prices. And even investors who believe in the firm-foundation theory might buy a security on the anticipation that eventually the average opinion would expect a larger growth rate for the stock in the future. 6. It seems that both views of security pricing tell us something about actual market behavior. Part Two: How the Pros Play the Biggest Game in Town Chapter 6. Technical and Fundamental analysis The efficient market theory (from academics) has three versions – the “weak,” the “semi-strong,” and the “strong.” All three forms espouse the general idea that except for long-run trends, future stock prices are difficult, if not impossible, to predict. The weak form attacks the underpinnings of technical analysis, and the semi-strong and strong forms argue against many of the beliefs held by those using fundamental analysis. I. Technical versus fundamental analysis: 1. Technical analysis is the method of predicting the appropriate time to buy or sell a stock used by those believing in the castle-in-the-air view of stock pricing. Fundamental analysis is the technique of applying the tenets of the firm-foundation theory to the selection of individual stocks. 2. Technical analysis is essentially the making and interpreting of stock charts. Thus its practitioners are called chartists. Most chartists believe that the market is only 10% logical and 90% psychological. They generally subscribe to the castle-in-the-air school and view the investment game as one of anticipating how the other players will behave. Charts tell only what the other players have been doing in the past. The chartist’s hope, however, is that - 10 -