Random Walk down wall street, Apuntes de Finanzas

¡Descarga Random Walk down wall street y más Apuntes en PDF de Finanzas solo en Docsity! Random Walk Down Wall Street Enviado por alejandrodlp, jun. 2012 | 60 Páginas (14986 Palabras) | 2 Visitas | • 4.5 • 1 • 2 • 3 • 4 • 5 | Denunciar | • • • 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 2. Slowly, tulipmaniaset 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 alltrade 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 apremium 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 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. Thetronics 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 twofactors. 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 inblue-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 thelargest 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, andAmerican 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 marketssuccumb 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 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 willbehave. Charts tell only what the other players have been doing in the past. The chartist’s hope, however, is that - 10 - By Zhipeng Yan a careful study of what the other players are doing will shed light on what the crowd is likely to do in the future. 3. Fundamental analysts believe the market is 90% logical and only 10% psychological. Fundamentalists believe that eventually the market will reflect accurately the security’s real worth. Perhaps 90% of the Wall Street security analysts consider themselves fundamentalists. II. What Can Charts tell you? 1. The first principle of technical analysis is that all info about earnings, dividends and the future performance of a company is automatically reflected in the company’s past market prices. 2. The second principle is that prices tend to move in trends: A stock that is rising tends to keep on rising, whereas a stock at rest tends to remain at rest. 3. As John Magee wrote in the bible of charting, Technical Analysis of Stock Trends, “Prices move in trends and trends tend to continue until something happens to change the supply-demand balance.” III. The Rationale for the Charting Method To me, the following explanations of technical analysis appear to be the most plausible. 1. Trends might tend to perpetuate themselves for either of two reasons. First, it has been argued that the crowd instinct of mass psychology makes it so. When investors see the prices of a speculative favorite going higher and higher, they want to jumpon the bandwagon and join the rise. 2. Second, there may be unequal access to fundamental info about the firm. When some favorable piece of news occurs, it is alleged that the insiders are the first to know and they act, buying the stock and causing its price to rise. The insiders then tell their friends, who act next. Then the professionals find out the news and the big institutions put blocks of the shares in their portfolios. Finally, the poor slobs get the info and buy. This process is supposed to result in a rather gradual increase/decrease in the price of the stock when the news is good/bad. 3. Chartists are convinced that even if they do not have access to this inside info, observation of price movements alone enables them to pick up the scent of the ‘smart money’ and permits them to get in long before the general public. IV. V. Why Might Charting Fail to Work? 1. First, the chartist buys in only after price trends have been established, and sells only after they have been broken. Because sharp reversals in the market may occur quite suddenly, the chartist often misses the boat. By the time an uptrend is signaled, it may already have taken place. 2. Second, such techniques should ultimately be self-defeating. As more and more people use it, the value of any technique depreciates. The Techniques of Fundamental analysis - 11 - By Zhipeng Yan Beware of very high multiple stocks in which future growth is already discounted. If growth doesn’t materialize, losses are doubly heavy – both earnings and the multiples drop. 3. Rule 3: Look for stocks whose stories of anticipated growth are of thekind on which investors can build castles in the air. The above rules seem sensible; the point is whether they really work? – Not really (However, the author uses these rules as advice for those investors who want to pick stocks by themselves, though he strongly recommend investors to buy index funds, please refer to Chapter 15)! Chapter 7. Technical analysis and the Random walk theory 1. I personally have never known a successful technician. Technical analysis is anathema to the academic world. 2. Chartists believe momentum exists in the market. The “technical rules” have been tested exhaustively. The results reveal that past movements in stock prices cannot be used reliably to foretell future movements. The stock market has little, if any, memory. While the market does exhibit some momentum from time to time, it does not occur dependably and there is not enough persistence in stock prices to overwhelm the substantial transactions costs involved in undertaking trend-following strategies. 3. For example, technical lore has it that if the price of a stock rose yesterday it is more likely to rise today. It turns out that the correlation of past price movements with present and future price movements is slightly positive but very close to zero. 4. Yes, history does tend to repeat itself in the stock market, but in an infinitely surprising variety of ways that confound any attempts to profit from a knowledge of past price patterns. 5. The market is not a perfect random walk. But anysystematic relationships that exist are so small that they are not useful for an investor. 6. Not one has consistently outperformed the placebo of a buy-and-hold strategy. Technical methods cannot be used to make useful investment strategies. This is the fundamental conclusion of the random walk theory. 7. Chartists recommend trades – almost every technical system involves some degree of in-and-out trading. Trading generates commissions, and commissions are the lifeblood of the brokerage business. The technicians do not help produce yachts for the customers, but they do help generate the trading that provides yachts for the brokers. 8. Even if markets were dominated during certain periods by irrational crowd behavior, the stock market might still well be approximated by a random walk. 9. All that can be said is that the small amount of info contained in stock market pricing patterns has not been shown to be sufficient to overcome the transactions costs involved in acting on that info. 10. No technical scheme whatever could work for any length of time. Any regularity in the stock market that can be discovered and acted upon profitably is bound to destroy itself. This is the fundamental reason why I am - 13 - By Zhipeng Yan convinced that no one will be successful in using technical methods to get aboveaverage returns in the stock market. 11. Using technical analysis for market timing is especially dangerously. Because there is a long-term uptrend in the stock market, it can be veryrisky to be in cash. A study by Seybun found that 95% of the significant market gains over the 30 year period from the mid-1960s through the mid-1990s came on 90 of the roughly 7500 trading days. If you happened to miss those 90 days, just over 1 percent of the total, the generous long-run stock market returns of the period would have been wiped out. The point is that market timers risk missing the infrequent large sprints that are the big contributors to performance. Chapter 8. How good is Fundamental analysis? Two opposing views about the efficacy of fundamental analysis. Wall streeters feel that fundamental analysis is becoming more powerful and skillful at the time. People in academic community have argued that fund managers and their fundamental analysts can do no better at picking stocks than a rank amateur. 1. Analysts can’t predict consistent long-run growth because it does not exist. 2. The careful estimates of security analysts do little better than those that would be obtained by simple extrapolation of past trends, which we have already seen are no help at all. Indeed, when compared with actual earnings growth rates, the five-year estimates of security analysts were actually worse than the predictions from several naïve forecasting models. 3. Of course, in each year some analysts did much better than average, but no consistency in their pattern of performance was found. Analysts who did better than average one year were no more likely than the others to make superiorforecasts in the next year. 4. Five factors that help explain why security analysts have such difficulty in predicting the future: a. The influence of random events. b. The production of dubious reported earnings through “creative” accounting procedures by companies. c. The basic incompetence of many of the analysts themselves. d. The loss of the best analysts to the sales desk or to portfolio managements e. The conflicts of interest facing securities analysts at firms with large investment banking operations: to be sure, when an analyst says “buy” he may mean “hold”, and when he says “hold” he probably means this as a euphemism for “dump this piece of crap as soon as possible.” Researchers found that stock recommendations of Wall Street firms without investment banking relationships did much better than the recommendations of brokerage firms that were involved in profitable investment banking relationships with the companies they covered. 5. Many at the funds are the best analysts and portfolio managers in the business. However, investors have done no better with the average mutual fund than they could have done by purchasing and holding an unmanaged broad stock index. 6. There are many funds beating the averages – some by significant amounts. The problem is that there is no consistency to performances. Many of the top funds of the 1970s ranked close to the bottom over the next decade. - 14 - By Zhipeng Yan stock prices that results from factors peculiar to an individual company. The risk associated with such variability is precisely the kind that diversification can reduce. 2.The whole point of portfolio theory is that, to the extend that stocks don’t move in tandem all the time, variations in the returns from any one security tend to be washed away or smoothed out by complementary variation in the returns from other securities. 3. The beta calculation is essentially a comparison between the movements of an individual stock (or portfolio) and the movements of the market as a whole. Professionals call high-beta stocks aggressive investments and label low-beta stocks as defensive. 4. Risk-averse investors wouldn’t buy securities with extra risk without the expectation of extra reward. But not all of the risk of individual securities is relevant in determining the premium for bearing risk. The unsystematic part of the total risk is easily eliminated by adequate diversification. The only part of total risk that investors will get paid for bearing is systematic risk, the risk that diversification cannot help. II. CAPM 1. Before the advent of CAPM, it was believed that the return on each security was related to the total risk inherent in that security. 2. The theory says that the total risk of each individual security is irrelevant. It is only the systematic component that counts as far as extra rewards go. The beta is the measure of the systematic risk. 3. As the systematic risk (beta) of an individual stock (or portfolio) increases, so does the return an investor can expect. 4. If the realized return is larger than that predicted by the overall portfolio beta,the manager is said to have produced a positive alpha. III. Look at the record 1. Fama and French found that the relationship between beta and return is essentially flat. 2. The author believes that “the unearthing of serious cracks in the CAPM will not lead to an abandonment of mathematical tools in financial analysis and a return to traditional security analysis. There are many reasons to avoid a rush to judgment of the death of beta: a. The beta measure of relative volatility does capture at least some aspects of what we normally think of as risk. b. It is very difficult to measure beat with any degree of precision. The S&P 500 Index is not “the market”. The total market contains many additional stocks in the US and thousands more in foreign countries. Moreover, the total market includes bonds, real estate, precious metals, and also human capital. c. Investors should be aware that even if the long-run relationship between beta and return is flat, beta can still be a useful investment management tool. IV. Arbitrage Pricing Theory - 17 - By Zhipeng Yan 1. It is fair to conclude that risk is unlikely to be captured adequately by a single beta statistic. It appears that several other systematic risk measures affect the valuation of securities. 2. In addition, there is some evidence that security returns are related to size, and also to P/E multiples and price-book value ratios. 3. If one wanted for simplicity to select the one risk measure most closely related toexpected returns, the best single risk proxy turned out to be the extent of disagreement among security analysts’ forecast for each individual company. Companies for which there is a broad consensus with respect to the growth of future earnings in dividends seem to be considered less risky than companies for which there is little agreement among security analysts. To sum up, the stock market appears to be an efficient mechanism that adjusts quite quickly to new info. Neither technical analysis, nor fundamental analysis seems to yield consistent benefits. It appears that the only way to obtain higher long-run investment returns is to accept greater risks. Unfortunately, a perfect risk measure does not exist. The actual relationship between beta and rate of return has not corresponded to the relationship predicted in the theory during long periods of the twentieth century. Moreover, betas for individual stocks are not stable over time, and they are very sensitive to the market proxy against which they are measured. Chapter 11. Potshots at the Efficient-Market Theory and Why they Miss Robert Shiller concluded from a longer history of stock market fluctuations that stock prices show far “too much variability” to be explained by an efficient-market theory of pricing, and that one must look to behavioral considerations and to crowd psychology to explain the actual process of price determination in the stock market. The author reviewed all the recent research proclaiming the demise of theefficient- market theory and purporting to show that market prices are, in fact, predictable. His conclusion is that such obituaries are greatly exaggerated and that the extent to which the stock market is usefully predictable has been vastly overstated. He shows that following the tenets of the efficient-market theory – that is, buying and holding a broad-based market index fund – is still the only game in town. Although market may not always be rational in the short run, it always is over the long haul. I. What do we mean by saying markets are efficient? 1. Markets can be efficient even if they sometimes make egregious errors in valuation. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends. 2. Economists view markets as amazingly successful devices for reflecting new info rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn aboveaverage returns without accepting above-average risks. - 18 - points larger than the returns from large stocks. But, small stocks may be riskier than larger stocks and deserve to give investors a higher rate of return. Thus, even if this effect was to persist in the future, it’s not at all clear that such a finding would violate market efficiency. Moreover, this effect may due to “survivorship bias”. And in most world markets it was the larger capstocks that produced larger rates of return. - 20 - By Zhipeng Yan IV. Why even close shots miss 1. Regarding to internet bubble, when we know ex post that major errors were made, there were certainly no clear ex ante arbitrage opportunities available to rational investors. And even when clear mispricing arbitrage opportunities seem to have existed, there was no way to exploit them. 2. To me, the most direct and most convincing tests of market efficiency are direct tests of the ability of professional fund managers to outperform the market as a whole. But the fact is that professional investment managers are not able to outperform index funds that simply buy and hold the broad stock-market portfolio. During the past 30 years, about two-thirds of the funds proved inferior to the market as a whole. The same result also holds for professional pensionfund managers. There are some funds which beat index. But the problem for investors is that at the beginning of any period they can’t be sure which funds will be successful and survive. V. A Summing Up 1. Market valuation rest on both logical and psychological factors. 2. Stock prices display a remarkable degree of efficiency. Info contained in past prices or any publicly available fundamental info is rapidly assimilated into market prices. Prices adjust so well to reflect all-important info that a randomly selected and passively managed portfolio of stocks performs as well as or better than the portfolios selected by the experts. 3.With respect to the evidence indicating that future returns are, in fact, somewhat predictable, there are several points to make. a. There are considerable questions regarding the long-run dependability of these effects. Many could be the result of “data snooping”. b. Even if there is a dependable predictable relationship, it may not be exploitable by investors (e.g. high transaction costs). Part Four: A Practical Guide for RANDOM WALKers and other Investors Chapter 12. A Fitness manual for RANDOM WALKers I. Exercise 1: cover Thyself with Protection 1. Disraeli once wrote that “patience is a necessary ingredient of genius.” It’s also a key element in investing; you can’t afford to pull your money out at the wrong time. You need staying power to increase your odds of earning attractive long-run returns. Therefore, you have to have noninvestment resources, such as medical and life insurance, to draw on should any emergency strike you or your family. 2. Two categories of life insurance: a. High-premium policies that combine an insurance scheme with a type of savings plan. They do have some advantages. Earnings on the part of the - 21 - By Zhipeng Yan insurance premiums that go into the savings plan accumulate tax-free. But they entail high sales charges. b. Low premium term insurance that provides death benefits only, with no buildup of cash value. Malkiel’s advice: buy term insurance for protection – invest the difference yourself. To buy renewable term insurance. You cankeep renewing your policy without the need for a physical examination. So-called decreasing term insurance, renewable for progressively lower amounts, should suit many families best, because as time passes, the need for protection usually diminishes. However, term-insurance premiums escalate sharply when you reach the age of sixty or seventy. 3. Take the time to shop around for the best deal. You do not buy insurance from any company with an A.M. Best rating of less than A. 4. In addition, you should keep some reserves in safe and liquid investments. Every family should have a reserve of several months of living expenses to provide a cushion during an emergent/hard time. II. Exercise 2: Know your investment Objectives You must decide at the outset what degree of risk you are willing to assume and what kinds of investments are most suitable to your tax bracket. 1. J.P. Morgan once had a friend who was so worried about his stock holdings that he could not sleep at night. The friend asked, “What should I do about my stocks?” Morgan replied, “Sell down to the sleeping point.” Every investor must decide the trade-off he is willing to make between eating well and sleeping well. High investment rewards can be achieved only at the cost of substantial risk-taking. 2. Step One: find your risk-tolerant level. a sleeping scale on investment risk and expected rate of return (P282-3): bank account money market deposit accounts Money-market funds special six-month certificates Treasuryinflation-protection securities (TIPS) high-quality corporate bonds (prime-quality public utilities) Diversified portfolios of blue-chip US or developed foreign country common stocks Real estate Diversified portfolios of relative risky stocks of smaller growth companies Diversified portfolios of emerging market stocks. 3. It is critical that you understand yourself before choosing specific securities for investment. Perhaps the most important question to ask yourself is how you felt during a period of sharply declining stock markets. If you became physically ill and even sold out all your stocks rather than staying the course with a diversified investment program, then a heavy exposure of common is not for you. 4. Step Two: identify your tax bracket and income needs. You have to check how much tax you have to pay for your investment returns. For those in a high marginal tax bracket there is a substantial tax advantage from tax-exempt (e.g. municipal) bonds and stocks that have low dividend yields but promise favorably taxed long-term capital gains. If you are in a low tax bracket and need a high current income, you will be better off with taxable bonds and - 22 - By Zhipeng Yan guarantees return of your original deposit at any time. But do check the fee tables. In general,annuities are more expensive than IRAs and Keogh invested in mutual funds. Therefore, you should invest in an annuity only after you have placed the maximum amount in a regular retirement plan, such as a 410(k), 403(b)7, Keogh, or IRA. IV. 1. 2. 3. 4. Exercise 4: Let the Yield on your cash reserve keep pace with inflation Four short-term investment instruments that can at least help you stand up to inflation. Money-market mutual funds: in my judgment, they provide the best instrument for many investors’ needs. They combine safety, high yields, and the right to withdraw money with no penalty attached. Most funds allow you to write large checks against your fund balance, generally in amounts o fat least $250. Money-market deposit accounts: provided by banks. Money funds’ yields tend to higher than the bank accounts. In addition, the money funds allow an unlimited number of checks to be written against balances. Bank Certificates: you need at least $10,000 before you can buy. And you can’t write checks against the certificates. There is a substantial penalty for premature withdrawal. Finally, the yield on bank certificates is subject to state and local taxes. Tax-exempt money-market funds: they are useful for investors in high tax brackets. V. Exercise 5: Investigate a Promenade through bond county There are four kinds of bond purchases you may want to consider. 1. Zero-coupon bonds: the purchaser is faced with no reinvestment risk. The main disadvantage is that IRSrequired that taxable investors declare annually as income a pro rata share of the dollar difference between the purchase price and the par value of the bond. 2. No-load bond funds: because bond markets tend to be at least as efficient as stock markets. I recommend low-expense bond index funds, which generally outperform actively managed bond funds. In no event should you even buy a load fund. For investors who are very risk averse, I favor GNMA funds. These funds invest exclusively in GNMA (Ginnie Mae) mortgage pass-through securities. Mortgage bonds have one disadvantage in that when interest rates fall, many homeowners refinance their high-rate mortgages and some high-yielding mortgage bonds get repaid early. It is that potential disadvantage that makes the yield on government-guaranteed mortgage bonds so high. 3. Tax-exempt bonds are useful for high-bracket investors. If you buy bonds directly (rather than indirectly through mutual funds), I suggest that you buy new issues rather than already outstanding securities. New-issue yields are usually a bit sweeter than the yields of seasoned outstanding bonds and you avoid paying transactions charges on new issues. And you should keep - 24 - By Zhipeng Yan inflation. Furthermore, the higher the rate of inflation, the more variable and unpredictable inflation becomes. Thus, more volatile levels of real output and higher inflation rates, as well as the accompanying greater volatility of interest rates, increased uncertainty throughout the economy. Chapter 14. A life-Cycle Guide to Investing The most important investment decision you will probably ever make concerns the balancing of asset categories (stocks, bonds, real estate, money-market securities, etc.) at different stage of your life. I. Four Asset – allocation principles 1. History shows that risk and return are positively related. 2. The risk of investing in common stocks and bonds depends on the length of time the investments are held. The longer an investor’s holding period, the lower the risk. a. Thus, your stage in the life cycle is a critical element indetermining the allocation of your assets. b. A substantial amount (but not all) of the risk of common stock investment can be eliminated by adopting a program of long-term ownership and sticking to it through thick and think (the buy-andhold strategy). c. The longer an individual’s investment horizon, the more likely it is that stocks will outperform bonds. Over any single-year period, there is a one-out-of-three chance that bonds or money-market funds will outperform stocks. But if one looks instead at different twentyor twenty-five-year holding periods, stocks are the performance winners every time. These data support the advice that younger people should have a larger proportion of their assets in stocks than older people. Total Annual Returns for Basic Asset Classes, 1926-2001 Average Annual Return Risk Index (year-to-year volatility of Returns) Small company common 12.1% 35.3% stocks Large company common 10.4 20.8 stocks Long-term corporate bonds 5.4 8.6 U.S. Treasury bills 3.7 3.4 3. Dollar-cost averaging can be a useful, though controversial, technique to reduce the risk of stock and bond investment. a. It means investing the same fixed amount of money in, for example, the shares of some mutual funds at regular intervals, say, every month, over a long period of time. It works because you bought more shares when they were cheap and fewer when they were dear. - 27 - By Zhipeng Yan a. For those in their twenties, a very aggressive investment portfolio is recommended. The portfolio is not only heavy in common stocks but also contains a substantial proportion of international stocks including the higher risk emerging markets. b. As investors age, they should start cutting back on riskier investments and start increasing the proportion of the portfolio committed to bonds and stocks that pay generous dividends such as REITs. By the age of 55, investors should start thinking about the transition toretirement and moving the portfolio toward income production. The proportion of bonds increases and the stock portfolio becomes more conservative and income-producing and less growth-oriented. In retirement, a portfolio heavily weighted in a variety of bonds is recommended. Nevertheless, even in one’s late sixties, 25% of the portfolio is committed to regular stocks and 15% to real estate equities (REITs) to give some income growth to cope with inflation. c. For most people, I recommend broad-based total stock-market index funds rather than individual stocks for portfolio formation. Do make sure that any mutual funds you buy are truly “no-load” and pick safer, income-producing funds later in life. d. Everyone should attempt to own his or her own home. I believe everyone should have substantial real estate holdings and, therefore, some part of one’s equity holdings should be in REIT index mutual funds. Chapter 15. Three Giant steps down Wall street I. The no-brainer step: investing in index funds: 1. The S&P 500 index beat approximately two-thirds of professional managed portfolios in the 1980s and 1990s. Index funds have regularly produced rates of return exceeding those of active managers by close to 2%. Two reasons: a. Much lower management fees: public index funds typically charge a fee of 0.2%, while actively managed public mutual funds charge annual management and market expenses that on average are 1.5%. b. Less trading costs: index funds trade only when necessary,whereas active funds typically have a turnover rate close to 100%, and often even more. Such turnover probably costs the fund at least another 0.5-1% of performance a year. 2. Index funds are also relatively predictable. When you buy an actively managed fund, you can never be sure how it will do relative to its peers. When you buy an index fund, you can be reasonably certain that it will track its index and that it is likely to beat the average manager handily. - 29 - By Zhipeng Yan 3. The index fund has another attraction for small investors. It enables you to obtain very broad diversification with only a small investment. It also allows you to reduce brokerage charges. 4. Many people incorrectly equate indexing with a strategy of simply buying the S&P 500 index. The S&P 500 omits the thousands of small companies that are among the most dynamic in the economy. Thus, I now believe that if an investor is to buy only one U.S. index fund, the best general U.S. index to emulate is the broader Wilshire 5,000 – Stock Index – not the S&P 500. 5. Moreover, investors can reduce risk by diversifying internationally. E.g. Morgan Stanley Capital International (MSCI) index of European, Australian, and Far Eastern (EAFE) securities, and the MSCI emerging markets index. 6. There are index funds holding REITs and bonds. 7. Keep in mind: I am assuming here that you hold most if not all of your securities in tax-advantaged retirement plans. Certainly all of your bonds should be held in such accounts.Furthermore, you may want to alter the percentages somewhat depending on your personal capacity for and attitude toward risk. II. The do-it-yourself step: potentially useful stock-picking rules 1. Indexing is the strategy I most highly recommend for individuals and institutions. For those who insist on playing the game themselves, I proposed four rules for successful stock selection. 2. Rule 1: Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years. Consistent growth not only increases the earnings and dividends of the company but may also increase the multiples that the market is willing to pay for those earnings. 3. Rule 2: Never pay more for a stock than can reasonably be justified by a firm foundation of value. Although I am convinced that you can never judge the exact intrinsic value of a stock. I do feel that you can roughly gauge when a stock seems to be reasonably prices. The market price-earnings multiple is a good place to start: you should buy stocks selling at multiples in line with, or not very much above, this ratio. My strategy, then, is to look for growth situations that the market has not already recognized by bidding the stock’s multiple to a large premium. Some people call this a GARP (growth at a reasonable price) strategy. Buy stocks whose P/E’s are low relative to their growth prospects. 4. Rule 3: it helps to buy stocks with the kinds of stories of anticipated growth on which investors can buildcastles in the air. People are emotional – driven by greed, gambling instinct, hope, and fear in their stockmarket decisions. This is why successful investing demands both intellectual and psychological acuteness. Stocks are like people – some have more attractive personalities than others. The key to success is being where other investors will be, several months before they get there. 5. Rule 4: Trade as little as possible. My own philosophy leads me to minimize trading as much as possible. I am merciless with the losers, however. With few exceptions, I sell before the end of each calendar year any - 30 - By Zhipeng Yan stocks on which I have a loss. The reason for this timing is that losses are deductible for tax purposes, or can offset gains you may already have taken. III. The substitute-player step: hiring a professional Wall street walker Instead of trying to pick the individual winners (stocks), pick the best coaches (investment managers). But be very careful: 1. Many fund advertisements are quite misleading. The number one ranking is typically for a self-selected specific time period and compared with a particular (usually small) group of common stock funds. 2. It is simply impossible for investors to guarantee themselves above-average returns by purchasing those funds with the best recent records because there is no consistent long-run relationship between performance in one period and investment results in the next. 3. If you have to pick a fund, use the Morningstarmutual-fund information service, which is one of the most comprehensive sources of mutual-fund information an investor can find. The reports indicate whether the fund has nay sales charges (load fees) and shows the annual expense ratios for the fund and the percentage of the fund’s asset value represented by unrealized appreciation. If you buy actively managed funds you should look for no-load, low-expense funds with little unrealized appreciated to minimize future tax liability. 4. A Primer on Mutual-fund costs. There are two broad categories of costs: “load” fee charged when you buy or sell shares and “expense charges” that are taken out of your investment returns each year. Loading Fees: a. Front-end load: a commission charge that is paid when you purchase fund shares. Front-end loads are often as high as 5.75%. So-called low-load funds charge only a 1 to 3% sales charge. Best of all are no-load funds, which have no front-end sales charges at all. b. Back-end loads and exchange fee. Back-end loads are charges incurred when you redeem fund shares. The charge could be as much as 6% of the value of your redeemed shares if you sell out in the first year, with a declining percentage charge in subsequent years. Expense charges: a. Operating and investment management expenses. A fund’s expense ratio expresses the total operating and investment advisory fees incurred by the fund as a percentage of the fund’s average net assets. These expense ratios range from