Burton Malkiel | Efficient Market Hypothesis ?
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A Random Walk Down Wall Street, by Burton Malkiel.
Malkiel, a Princeton economist, argues that asset prices exhibit signs of a ‘random walk’, which later popularized the random walk hypothesis.
He believes that an investor cannot consistently outperform market averages.
Although, I must say I raised an eyebrow when I read this statement, nonetheless I offer an impartial review of the book for those looking to learn from some of the key topics presented.
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The random walk theory discussed by Malkiel is similar to the efficient market theory. Both suggest that the price reflects all known information about an asset, and both advocate that the only consistent approach to investing is a strategy of buy and hold.
In fact Malkiel went on to say:-
Conversely, on the opposing camp, we have the approach of technical and fundamental analysis, each looking for opportunities conflicting with the concept of random and efficient theories. But which is right? Or can they all be right?
Malkiel does however align all theories and strategies to a common purpose, that is, improving upon a return better than inflation. He said :-
“It is clear that if we are to cope with even a mild inflation, we must undertake investment strategies that maintain our real purchasing power; otherwise, we are doomed to an ever-decreasing standard of living”.
An example of how inflation can slowly erode purchasing power is provided with a Mcdonalds double burger, in 1962 the burger would have cost 28 cents, in 2018 the same burger cost almost five dollars. An increase of 1610%.
Malkiel segregates investing theories into two buckets; The firm foundation theory, and the Castle in the sky theory.
The firm foundation theory argues that stocks or even a piece of real estate have a firm anchor of value, also known as intrinsic value.
For example, fundamental analysts fall into this bucket, they might look for current and future earnings or dividend yields, and then work backwards to determine the intrinsic value of a stock.
Benjamin Graham and Warren Buffet typically follow this firm foundation approach.
Next, the castles in the sky theory looks at what Malkiel calls ‘psychic values’. He alluded that investors were more inclined at analyzing crowd behavior, known by technical analysts and traders as trend following, often without any consideration of the stocks value.
“In this kind of world, a sucker is born every minute—and he exists to buy your investments at a higher price than you paid for them, any price will do as long as others may be willing to pay more”.
In theory, the investor looks to buy high but sell higher, the opposite of the firm foundation investors looking to buy low and sell high.
Growth and momentum stocks are the likely selections in this bucket.
In my opinion however you do not need to choose between either, my strategy is a combination of both, which I will call the hybrid theory.
Malkiel expands upon his castles in the sky theory by discussing the madness of crowds.