by Alexander Cain
A Random Walk Down Wall Street, written by former Wall Street executive and avid stock trader Burton G. Malkiel, shares Wall Street insider secrets about the world of stock and finance. While Wall Street has often been looked upon as stable and orderly, in reality, the finance world at times can be a random chain of events that can lead to great profit or loss. The author’s goal throughout the book is to share knowledge to those unfamiliar with finance and empower them with the tools to make investing fun and helping anyone start to expand their savings and investment portfolio.
Stocks and Their Value
In order to begin the road to establishing a personal portfolio, Mankiel wanted to share knowledge of how financial analysts value stocks. With the knowledge of many financial analysts, it becomes much easier to invest for yourself. There are two main schools of thought for how stocks are valued: firm foundation theory and castle-in-the-air theory. The best investors are able to select stocks that support growth using both valuation methods.
Most Wall Street analysts are supporters of the firm foundation theory. The firm foundation theory is the belief that profit arises in the stock market, because the stock price is either higher or lower than the intrinsic value of a stock.
The intrinsic value of a stock is based on a few factors. First, it’s based on the expected growth rate of a company. The stock price reflects the stock market’s expectation for companies’ growth in the foreseen future. Depending on how a company projects their growth in the foreseen future, stock prices will fluctuate. The next factor is the expected dividend payments of the company. The higher dividend payments of a company, the higher the stock is valued.
Market interest rates also play a major factor in the valuation of stock. When market rates are low, stocks prices are priced higher, because investors value stocks with higher returns over their bond counterparts. The final factor for value stocks is risk. The higher the risk, the lower the price. While higher risks mean higher returns, it also means higher fluctuations in price, which may be unattractive for some investors.
The premise of firm foundation theory is that investors profit when the present value of stocks based on those few factors exceed the current stock market price. Analysts believe the market will eventually adjust to this intrinsic value.
The castle-in-the-air theory is more focused on the psychological side of the stock market. Also known as the ‘greater-fool’ theory, the idea to profiting from the stock market is buying stock, which are set at prices lower than what you expect other people to buy at.
“It’s their (castle-in-the air supports) opinion that professional investors should analyze how the crowd of investors is likely to behave in the future and how during periods of optimism they tend to build their hopes into castles in the air.”
As long as there are people willing to buy stock at a higher price, the stock should be invested in. The greatest investor, as Malkiel explains, is able to combine both theories and follow these general guidelines:
1) Buy Companies with above-average earnings growth for 5 or more years
2) Never pay more for a stock than its firm foundation of value. In other words, don’t buy stocks that don’t meet the basic factors as discussed earlier.
3) Look for stocks whose stories of anticipated growth are of the kind on which investors can build ‘castles-in-the-air’
Practical Guide for Random Walkers
With this newfound knowledge of the stock market, Malkiel imparts his basic knowledge for the non-investor. Malkiel shares vital exercises to insure financial stability for the typical non-investor.
Exercise 1: Cover Thyself with Protection. Invest in a good life insurance policy. Malkiel encourages non-investors to buy low premium life insurance plans and invest any extra money in a tax-deferred plan such as an IRA
Exercise 2: Know Your Investment Objectives. In order to build a portfolio, one must know their willingness to accept risk. If investing in a more risky portfolio can keep you up at night in stress, then a portfolio of safe securities with lower returns such as bonds and government securities.
Exercise 3: Dodge Uncle Sam Whenever You Can. Obtain extra investment funds while avoiding taxes legally. Invest in items such as Individual Retirement Account (IRA), which can delay tax payments.
Exercise 4: Be Competitive- Let the Yield on Your Cash Reserve Keep Pace with Inflation. The interest rate you receive in your local bank savings account are actually losing money for you. This is because saving account interest rates are typically below the rate of inflation. This means when by saving money in only a bank’s savings account you are actually losing purchasing power. Malkiel encourages four short-term investment instruments: money market mutual funds, money-market deposit accounts, bank certificates, and tax-exempt money-market funds.All four tools offer the same security as a savings account, but offer higher returns to keep pace with inflation.
Exercise 5: Investigate a Promenade through Bond Country. The bond market also offers lucrative opportunities for non-investors. Malkiel recommends four kinds of bond purchases: Zero-Coupon bonds (which allow its buyers to lock in high yields for a predetermined length of time), no-load bond mutual funds (which permit you to buy bond portfolios), tax-exempt bonds and bond funds (for those in high tax brackets), U.S. Treasury inflation-protection securities (bonds with inflation-related incentives).
Exercise 6: Begin Your Walk At Your Own Home. Focus on owning rather than renting.
Exercise 7: Diversify Your Investment Steps. The last step is to focus on diversifying your investment portfolio, which further reduces risk.
With these steps in mind, a non-investor can begin their journey to financial security and wealth. While Wall Street sometimes follows a random path, there are ways to ensure the lowest risk and drive the profitability of your portfolio. Malkiel provides a good starting tool with his book for non-investors looking to start their investment portfolio.