There is a sense of complexity today that has led many to believe the individual investor has little chance of competing with professional brokers and investment firms. However, Malkiel states this is a major misconception as he explains in his book “A Random Walk Down Wall Street”. What does a random walk mean? The random walk means in terms of the stock market that, “short term changes in stock prices cannot be predicted”. So how does a rational investor determine which stocks to purchase to maximize returns? Chapter 1 begins by defining and determining the difference in investing and speculating. Investing defined by Malkiel is the method of “purchasing assets to gain profit in the form of reasonably predictable income or appreciation over the long term”. Speculating in a sense is predicting, but without sufficient data to support any kind of conclusion. What is investing? Investing in its simplest form is the expectation to receive greater value in the future than you have today by saving income rather than spending. For example a savings account will earn a particular interest rate as will a corporate bond. Investment returns therefore depend on the allocation of funds and future events. Traditionally there have been two approaches used by the investment community to determine asset valuation: “the firm-foundation theory” and the “castle in the air theory”. The firm foundation theory argues that each investment instrument has something called intrinsic value, which can be determined analyzing securities present conditions and future growth. The basis of this theory is to buy securities when they are temporarily undervalued and sell them when they are temporarily overvalued in comparison to there intrinsic value One of the main variables used in this theory is dividend income. A stocks intrinsic value is said to be “equal to the present value of all its future dividends”. This is done using a method called discounting. Another variable to consider is the growth rate of the dividends. The greater the growth rate the more valuable the stock. However it is difficult to determine how long growth rates will last. Other factors are risk and interest rates, which will be discussed later. Warren Buffet, the great investor of our time, used this technique in making his fortune.
The second theory is known as the “castle in the ai...
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... while using the beta approach as a guide. Returns may also rely on general market swings, changes in interest rates and inflation, to changes in national income and other economic factors.
Chapter 11 closes our discussion with several insights into the efficient market theory. There have been many attempts to discredit the random walk theory, but none of the theories hold against empirical evidence. Any pattern that is noticed by investors will disappear as investors try to exploit it and the valuation methods of growth rate are far too difficult to predict. As we said before the random walk concludes that no patterns exist in the market, pricing is accurate and all information available is already incorporated into the stock price. Therefore the market is efficient. Even if errors do occur in short-run pricing, they will correct themselves in the long run. The random walk suggest that short-term prices cannot be predicted and to buy stocks for the long run. Malkiel concludes the best way to consistently be profitable is to buy and hold a broad based market index fund. As the market rises so will the investors returns since historically the market continues to rise as a whole.
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