Chaotic Exploration

I got a recommendation, recently, to check out Burton Malkiel's A Random Walk Down Wall Street. While I'm reasonably familiar with the market, it sounded like an interesting read.

While I'm not sure I'm going to use anything I read in it, it certainly gave me a lot to think about.

It started out with some theory (which, given my complete lack of any theoretical background, was nice) about how prices are derived. It started with a pair of theories, the firm foundation theory (which essentially states that there is a fundamentally correct price for any given stock based on business and dividends) and the Castles in the Air theory (which says prices are arbitrary).

Perhaps in defense of the latter, it then goes on to detail a number of historical value bubbles, starting with Dutch tulips in the seventeenth century. It then talks about how well the pros do, so you don't feel like you're at as big a disadvantage as it might seem. To do that, it walks through much of the tail end of the twentieth century, and caps it off with the internet bubble.

It then goes through a number of gyrations to show how stock movements are largely chaotic, despite introducing the Efficient Market Theory. Frankly, I think those are fairly contradictory, but *shrug*. There are several versions of the EFM, the latter two of which are, to me, completely ludicrous. The former states that issues are priced efficiently, taking into account all information about a stock immediately. This version, I think, has a kernel of truth, although I'm not sure I'd really endorse it, regardless. I'll come back to this.

He then moves on to what he calls Modern Portfolio Theory, which is all about dealing with risk. This is another section that was informative for me, but I'm skeptical about whether it was really useful. The skepticism mostly derives from a build-up to a new way to structure portfolios, called the Capital Asset Pricing Model. I suspect that this was endorsed in an earlier edition of the book (this is the tenth edition, from 2007. Yes, that year will become important later), and gave the book its subtitle. However, whether that guess is right or not, he now comes out and admits that CAPM doesn't work in practice.

The part of that section I was most happy to read was the section on Beta, which I'd heard of, and which I knew referred to riskiness in some sense, but knew nothing more specific about.

From there, he moves on to a field called Behavioral Finance, which talks about how psychology plays into investing. And I was glad he got to that part when he did, because towards the end of the chapter before, I was saying in my head, "That's missing a broad swath of what drives short-term changes". The reason I was glad was that Behavioral Finance got to exactly what was bothering me before.

This might turn out to be the part of the book that is genuinely useful, though. It mentions several unhealthy tendencies that people have (and yeah, I've seen several of them in myself), and a little bit about ameliorating them. Good stuff for anyone serious about investing.

He then talks about several theories for undercutting the Efficient Market Theory, and shows flaws (or potential flaws) in them.

So, to get back to that to which I was alluding earlier, here's the thing about EMT (based on my experience). I think that, in the long-term, what EMT says about driving stock value is correct. But the reason I have trouble really buying it (as stated, at least) is that there is so much volatility in the short to medium term. Many stocks fluctuate by 3-5% in a day on a regular basis. And that's without news announcements either for that company, or for the market as a whole. Heck, just last Friday, I had a stock gain more than 2% just in the last twenty minutes of trading. And there's just no way that that can be considered efficient.

But I will agree that ignoring the short-term churn in trying for long-term benefits is a good thing. And that, therefore, playing the market as if EMT is correct is the way to go.

And I guess the last thing I found useful was the chapter on derivatives. I'm a little surprised he didn't talk a bit more about some more exotic option strategies (collars, straddles, bear-put and bull-call debits, bear-call and bull-put credits, etc), but perhaps exotic is the key word there.

So where did the book fall down? Some of it had to do with new editions: leading into CAPM, it felt like that was going to be the best thing ever. But then, after introducing it, he's like, "So, does it work?" When the answer was so quickly and succinctly no, it felt like a let-down.

The section on risk was also informative, as I mentioned, but it still ended up feeling a bit... unsatisfying, I guess. I'm not sure what else should be there, but I did feel like something should.

I also wish there'd been a bit more discussion about when to sell stocks that you're holding long-term. That's what has bitten me in the butt a number of times, both on the down side and on the up side. I either held it too long, or not long enough.

I would really like to see a modern update on the derivatives chapter, also. He talks a bit about how derivatives have gotten a bad name, and how it's a silly concern. He ends that discussion with this gem:
But a systematic undermining of world financial stability caused by derivatives trading does not deserve to be on the top of anyone's worry list.

It's a bit of a throwaway statement, and a reasonable one at that, but it was less than two years later when that, essentially, happened. Banks who held a lot of money from depositors (not investors, depositors), made heavily leveraged derivatives bets, and blew those bets. There was other mischief involved, but that's what brought down the house of cards and brought about the TARP.

So I'd like to see some reaction to that. And to clarify, I'm not saying that his argument that derivatives aren't the problem is entirely wrong. What really made the problem huge in this case wasn't the heavily leveraged derivatives themselves, it was that they were making these bets with other people's money.

Ok, enough about that.

I feel like I'm forgetting something, but I'm going to move on anyway.

In short, I think this book is a good one for anyone seriously thinking about doing significant stock market trading. If you don't want to read it, I suggest you follow his top-line advice, and just invest in wide-market index funds. There's a lot of good information in here.

Update: I knew there was something I was forgetting. It was about company dividends. When talking about Firm Foundation, the value to be set is largely based on dividends that the company issues. So what is to be done about those companies that don't issue dividends? Given how prevalent that has become, I'd really like to see that addressed.

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