A Random Walk Down Wall Street

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A Random Walk Down Wall Street

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Title: A Random Walk Down Wall Street


1
A Random Walk Down Wall Street
  • Author Burton Markiel
  • Presenter Fernando Boccanera

2
Author
  • Started career as a market professional with a
    leading investment firm
  • Chemical Bank Chairmans Professorship in
    Economics at Princeton University
  • Lifelong investor

3
Book
  • First edition 1973
  • 15 chapters, 4 parts, 396 pages
  • Mostly text, not many figures

4
Basic Argument
  • Market prices stocks so efficiently that its
    very unlikely that someone can outperform the
    market on a consistent basis
  • Since the 1st edition was published 35 year ago,
    more than two-thirds of professional portfolio
    managers have been outperformed by the SP 500
    index
  • Buying and holding an index fund is the most
    efficient investment strategy

5
PART I STOCKS AND THEIR VALUE
6
Random Walk
  • A sequence of numbers produced by a random
    process
  • Future steps or directions cannot be predicted on
    the basis of past actions
  • In the stock market means that short-run changes
    in stocks prices cannot be predicted

7
Investment Theory
  • Investors are rational
  • Make reasonable estimates of the present value of
    stocks
  • Their buying and selling ensures stock prices
    fairly reflect future prospects
  • Investors are risk-averse
  • Efficient Market Theory
  • Prices adjust quickly and efficiently to new
    information future prices can not be predicted

8
Bubbles
  • Essential feature greed run amok
  • Market participants ignore firm foundations of
    value for the dubious but thrilling assumption
    that they too can make a kicking by building
    castles in the air.
  • Skyrocketing markets that depend on purely
    psychic support have invariably succumbed to the
    financial law of gravity

9
Bubble Examples
  • Tulipmania Holland early 17th century
  • South Sea 300 year ago in England
  • US 1928 Caused the big depression
  • Japan 1990s- Real Estate
  • US 2000 - Internet

10
Lessons
  • Markets can be irrational for some time but
    eventually correct any irrationality

11
PART IIHOW THE PROS PLAY THE BIGGEST GAME IN
TOWN
12
Technical Analysis
  • Studies have shown that past movements in stock
    prices cannot be used reliably to foretell future
    movements supports Random Walk Theory
  • The cycles and patterns in a chart are the
    product of pure chance. Simulations of stock
    prices can produce charts that have patterns
  • After the fact its always possible to find a
    technical rule that works
  • Technical Analysis is a myth

13
Buy-and-hold strategy
  • Will perform at least as good as any technical
    analysis method
  • More tax efficient because does not generate a
    lot of short-term capital gains

14
Fundamental Analysis
  • Growth rate in a particular period is not a good
    predictor of future growth rate there is no
    reliable pattern
  • A study compared security analysts estimates or
    1-year and 5-year future earnings for a large
    sample of companies with the actual results. The
    estimates did no better than the forecast of
    naive models like the long-run rate of growth of
    national income. One-year forecast was even worse
    than 5-year.

15
Fundamental Analysis
  • Analysts have enormous difficulty in forecasting
    companies earnings prospects
  • No reliable way to pick a winner fund
  • Most academics dont believe in Fundamental
    Analysis

16
Fundamental Analysis
  • Author is not ready to throw away Fundamental
    Analysis entirely
  • Investors might reconsider their faith in
    professional advisers
  • Although there is strong evidence that markets
    are efficient, there are enough anomalies to make
    it impossible to state that the theory is
    conclusively demonstrated

17
PART IIITHE NEW INVESTMENT TECHNOLOGY
18
Modern Portfolio Theory
  • Risk
  • Studies show that investors have received higher
    rates of return for bearing greater risk
  • Reducing Risk
  • Diversification with securities that are
    uncorrelated or have little correlation can in
    fact reduce risk
  • Diversification can not eliminate all risks

19
Diversification
  • REITs and bonds have low correlation with US
    stocks
  • International diversification
  • The correlation between US stocks and
    international stocks is lower than the
    correlation among US stocks
  • Between 1970 and 2006, the least risky portfolio
    was comprised of 76 US stocks and 24
    international
  • The correlation between emerging market stocks
    and US stocks is much lower than between US and
    developed markets like Europe and Japan.

20
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21
Evidence for the Efficient-Market Theory
  • Most convincing tests of market efficiency are
    tests of the ability of professional fund
    managers to outperform the market
  • Remarkable body of evidence suggests that
    professional money managers are not able to
    outperform index funds

22
Evidence for the Efficient-Market Theory
  • From 1986-2005 the average actively managed
    large-cap mutual fund underperformed the SP 500
    by 1.5 per year.
  • Large-cap equity funds outperformed by the SP
    for periods ending 2005
  • 1 year 3 years 5 years 10 years 20 years
  • 48 68 68 79 82

23
Evidence against the Efficient-Market Theory
  • Also called market anomalies, irrationalities or
    ineficiencies
  • January effect
  • Short-term momentum
  • Long-run return reversals
  • Smaller is best
  • Low Price to Earnings ratio
  • Low Price to Book Value Ratio

24
Short-term momentum
  • Some studies have showed some degree of momentum
    where a positive return in one week is more
    likely to be followed by a positive return in the
    next week
  • Statistically relevant but not economical
    significant after trading costs does not beat a
    buy-and-hold strategy

25
Long-run return reversals
  • Stocks that performed poorly during the past 3
    years are likely to give above-average returns
    over the next 3 years.
  • Most believable pattern
  • May be the reaction to fluctuations in interest
    rates
  • May represent just reversion to the mean
  • This contrarian approach if used together with a
    fundamental-value approach is potentially
    beneficial (value investing)

26
Smaller is best
  • Strongly documented in studies
  • Small stocks generate returns larger than large
    stocks over long periods
  • Did not work during the 1990s but worked during
    2000-2006
  • Not a sure way to earn above-average,
    risk-adjusted returns

27
Low Price to Earnings ratio
  • Several studies have shown that low P/E stocks
    produce above-average returns even after
    adjusting for risk
  • Vary over time, not dependable over every period
  • Low P/E often justified on the basis of bad
    company financials
  • Author sympathizes with this value strategy

28
Low Price to Book Value Ratio
  • Value strategy that tend to produce above-average
    returns
  • Documented in famous study by Fama and French
  • Hold for both US and many foreign stock markets

29
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30
Part IVPractical Guide
31
Fitness Manual
  • Save enough money
  • Cover yourself
  • Reduce taxes
  • Understand your investment objectives
  • Consider buying your home instead of renting it
  • Consider bonds
  • Consider gold because the returns have little
    correlation with stocks, but only for a very
    small part of portfolio
  • Consider commissions and other transaction costs
  • Diversify

32
Projecting Returns
  • Determinants of Returns of Stocks over the long
    run
  • Dividend yield at time of purchase
  • Future growth rate of earnings and dividends

Long-run projected return Initial Dividend
Yield Growth Rate
33
Projecting Returns
  • Over the short term (a few years), third factor
    is critical
  • Risk premium, or change in valuation relationship
  • Can be measured by the change in Price/Earnings
    ratio

34
Projecting Returns
  • Average P/E ratio
  • Vary widely from year to year
  • In times of optimism, such as March 2000, P/E was
    well above 30
  • In times of pessimism, such as 1982, P/E was 8
  • When interest rates are low, stocks tend to sell
    at high P/E. When rates are high, P/E decreases

35
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36
Estimating returns for years after 2006
  • Unrealistic to expect the generous 18.3 stock
    return or 13.6 bond returns of the 1982-2000
    period
  • Bonds
  • Good-quality corporate will earn about 6 if held
    until maturity
  • Treasury will earn about 5 if held until maturity

37
Estimating returns for years after 2006
  • Stocks
  • 2006 dividend yield of SP 500 about 2, well
    below the 4.5 historical average.
  • Reasonable estimate for earnings growth 5.5
    (consistent with historical rates during periods
    of restrained inflation and similar to Wall
    Street firms estimates in the late 2006)
  • P/E ratio in late 2006 were in the upper teens,
    just slightly higher than the long-run historical
    average
  • P/E changes can not be predicted. If the risk
    premium (P/E ratio) does not change, the expected
    return is 7.5
  • When interest rates and inflation are low, like
    they were in 2006, higher P/E are justified
    consequently the return could be greater than 7.5

38
Life-Cycle Investing
  • The most important decision you will probably
    ever make concerns the asset allocation between
    asset classes (stocks, bonds, real estate, cash,
    etc)
  • According to Roger Ibbotson, who has spent a
    lifetime measuring returns, more than 90 of an
    investors total return is determined by the
    asset categories and their allocation

39
Five Asset-allocation principles
  • Risk and reward are positively related -
    fundamental law of finance
  • Actual risk in stocks and bonds depend on the
    length of the holding period
  • Dollar-cost averaging can reduce risk
  • Rebalancing can reduce risk and possibly increase
    returns
  • Distinguishing between attitude toward risk and
    capacity for risk

40
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41
Life-cycle
42
Stock Buying Methods
  • No-brainer
  • Do-it yourself
  • Hire a professional

43
No-brainer
  • Buy shares in broad-based index funds designed to
    track the asset classes in your portfolio
  • Rationale efficient-market theory
  • Index funds advantages
  • Have on average returned 1.5 above active funds
  • Low management fees because its passively
    managed
  • Low trading costs because of low turnover
  • Tax friendly, do not produce as much short-term
    taxable gains
  • Allow small investor to diversify

44
No-brainer
  • If investor can only afford one fund, then invest
    in an index in a total market fund
  • Diversify internationally with index funds
  • ETFs
  • Tax-managed index funds for taxable accounts
    (Vanguard tax-managed fund SP 500)

45
No-brainer
  • Close-end funds
  • Buy those selling at a discount from net asset
    value
  • During much of the 1970, CE funds sold at
    substantial discounts
  • Discounts can be explained as an unexploited
    market inefficiency
  • Urged reads of earlier editions to take advantage
  • If buy shares at 25 discount, still have 4 of
    dividend-paying assets for each 3 invested. Even
    if fund equaled the market return, investor still
    would beat the market because of dividends.
  • Discounts have narrowed significantly in US
    funds, most funds no longer attractive

46
Closed-end Fund Discounts as of mid 2006
47
Do-it yourself method
  • Pick your own stocks
  • Only use money that can risk, the rest of the
    money should be indexed
  • Takes a lot of work and consistent winners are
    very rare
  • Growth at a reasonable price (GARP) strategy

48
GARP
  • Companies that appear able to sustain
    above-average earnings growth for at least 5
    years - growth
  • Never pay more than justifiable by a fundamental
    assessment. P/E ratio not much higher than the
    Market P/E
  • Buy stocks with stories of anticipated growth
    that can catch the interest of the crowd
  • Trade as little as possible
  • High turnover produces high costs
  • Sell when the circumstances that led you to buy
    have changed for the worse
  • Should sell when market is in a bubble but its
    very difficult to time
  • Author sells before the end of each calendar year
    any stock with a loss. Losses are deductible from
    taxable gains

49
Hire a professional method
  • Purchase managed mutual funds
  • Past records of funds are not good predictors of
    future success.
  • Two best factors for predicting performance
  • Expense ratio
  • Turnover ratios
  • High expenses and high turnover depress
    returns-especially after-tax returns.
  • 50-50 rule
  • Buy only funds with expense ratios lt 0.5 and
    with turnover less than 50.

50
Summary
  • Projected stock market returns beyond 2006 7.5
  • Buying and holding an index fund is the most
    efficient investment strategy
  • Index most or all of your portfolio
  • Asset allocation the most important decision
  • Assets stocks, bonds, REITs, cash
  • Use a life cycle scheme
  • Diversify internationally

51
Summary
  • Buying stocks
  • Company can sustain above average earnings growth
    for at least 5 years
  • PE not much higher than the market PE
  • Selling Stocks
  • When favorable conditions change for worse
  • Author sells losers at the end of calendar year
  • Be aware of the long-run return reversals
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