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Castles in the Air
What is a cynic? A man who knows the price of everything, and the value of nothing.
—Oscar Wilde, Lady Windermere's Fan
In this book I will take you on a random walk down Wall Street, providing a guided tour of the complex world of finance and practical advice on investment opportunities and strategies. Many people say that the individual investor has scarcely a chance today against Wall Street's professionals. They point to techniques the pros use such as "program trading," "portfolio insurance," and investment strategies using complex derivative instruments, and they read news reports of mammoth takeovers and the highly profitable (and sometimes illegal) activities of well-financed arbitrageurs. This complexity suggests that there is no longer any room for the individual investor in today's institutionalized markets. Nothing could be further from the truth. You can do as well as the experts—perhaps even better. As I'll point out later, it was the steady investors who kept their heads when the stock market tanked in October 1987, and then saw the value of their holdings eventually recover and continue to produce attractive returns. And many of the pros lost their shirts during the 1990s using derivative strategies they failed to understand.
This book is a succinct guide for the individual investor. It covers everything from insurance to income taxes. It gives advice on shopping for the bestmortgage and planning an Individual Retirement Account. It tells you how to buy life insurance and how to avoid getting ripped off by banks and brokers. It will even tell you what to do about gold and diamonds. But primarily it is a book about common stocks—an investment medium that not only has provided generous long-run returns in the past but also appears to represent good possibilities for the years ahead. The life-cycle investment guide described in Part Four gives individuals of all age groups specific portfolio recommendations for meeting their financial goals.
What Is a Random Walk?
A random walk is one in which future steps or directions cannot be predicted on the basis of past actions. When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted. Investment advisory services, earnings predictions, and complicated chart patterns are useless. On Wall Street, the term "random walk" is an obscenity. It is an epithet coined by the academic world and hurled insultingly at the professional soothsayers. Taken to its logical extreme, it means that a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts.
Now, financial analysts in pin-striped suits do not like being compared with bare-assed apes. They retort that academics are so immersed in equations and Greek symbols (to say nothing of stuffy prose) that they couldn't tell a bull from a bear, even in a china shop. Market professionals arm themselves against the academic onslaught with one of two techniques, called fundamental analysis and technical analysis, which we will examine in Part Two. Academics parry these tactics by obfuscating the random-walk theory with three versions (the "weak," the "semi-strong," and the "strong") and by creating their own theory, called the new investment technology. This last includes a concept called beta, and I intend to trample on that a bit. By the 1990s, even some academics joined the professionals in arguing that the stock market was at least somewhat predictable after all. Still, as you can see, there's a tremendous battle going on, and it's fought with deadly intent because the stakes are tenure for the academics and bonuses for the professionals. That's why I think you'll enjoy this random walk down Wall Street. It has all the ingredients of high drama—including fortunes made and lost and classic arguments about their cause.
But before we begin, perhaps I should introduce myself and state my qualifications as guide. I have drawn on three aspects of my background in writing this book; each provides a different perspective on the stock market.
First is my employment at the start of my career as a market professional with one of Wall Street's leading investment firms. It takes one, after all, to know one. In a sense, I remain a market professional in that I currently chair the investment committee of an insurance company that invests more than $250 billion in assets and sit on the boards of several of the largest investment companies in the nation, which control a total of $400 billion in assets. This perspective has been indispensable to me. Some things in life can never fully be appreciated or understood by a virgin. The same might be said of the stock market.
Second is my current position as an economist. Specializing in securities markets and investment behavior, I have acquired detailed knowledge of academic research and findings on investment opportunities. I have relied on many new research findings in framing recommendations for you.
Last, and certainly not least, I have been a lifelong investor and successful participant in the market. How successful I will not say, for it is a peculiarity of the academic world that a professor is not supposed to make money. A professor may inherit lots of money, marry lots of money, and spend lots of money, but he or she is never, never supposed to earn lots of money; it's unacademic. Anyway, teachers are supposed to be "dedicated," or so politicians and administrators often say—especially when trying to justify the low academic pay scales. Academics are supposed to be seekers of knowledge, not of financial reward. It is in the former sense, therefore, that I shall tell you of my victories on Wall Street.
This book has a lot of facts and figures. Don't let that worry you. It is specifically intended for the financial layperson and offers practical, tested investment advice. You need no prior knowledge to follow it. All you need is the interest and the desire to have your investments work for you.
Investing as a Way of Life Today
At this point, it's probably a good idea to explain what I mean by "investing" and how I distinguish this activity from "speculating." I view investing as a method of purchasing assets to gain profit in the form of reasonably predictable income (dividends, interest, or rentals) and/or appreciation over the long term. It is the definition of the time period for the investment return and the predictability of the returns that often distinguish an investment from a speculation. An excellent analogy from the first Superman movie comes to mind. When the evil Luthor bought land in Arizona with the idea that California would soon slide into the ocean, thereby quickly producing far more valuable beach-front property, he was speculating. Had he bought such land as a long-term holding after examining migration patterns, housing-construction trends, and the availability of water supplies, he would probably be regarded as investing—particularly if he viewed the purchase as likely to produce a dependable future stream of cash returns.
Let me make it quite clear that this is not a book for speculators: I am not going to promise you overnight riches. I am not promising you stock-market miracles as one best-selling book of the 1990s claimed. Indeed, a subtitle for this book might well have been The Get Rich Slowly but Surely Book. Remember, just to stay even, your investments have to produce a rate of return equal to inflation.
Inflation in the United States and throughout most of the developed world fell to the 2 percent level in the late 1990s, and some analysts believe that relative price stability will continue indefinitely. They suggest that inflation is the exception rather than the rule and that historical periods of rapid technological progress and peacetime economies were periods of stable or even falling prices. It may well be that little or no inflation will occur during the first decades of the twenty-first century, but I believe investors should not dismiss the possibility that inflation will accelerate again at some time in the future. We cannot assume that the European economies will continue to have double-digit unemployment forever and that the deep recessions in Japan and many emerging markets will persist. Moreover, as our economies become increasingly service oriented, productivity improvements will be harder to come by. It still will take four musicians to play a string quartet and one surgeon to perform an appendectomy throughout the twenty-first century, and if musicians' and surgeons' salaries rise over time, so will the cost of concert tickets and appendectomies. Thus, it would be a mistake to think that upward pressure on prices is no longer a worry.
If inflation were to proceed at a 3 to 4 percent rate—a rate much lower than we had in the 1970s and early 1980s—the effect on our purchasing power would still be devastating. The following table shows what an average 4.8 percent inflation has done over the 1962-88 period. My morning newspaper has risen 1,100 percent. My afternoon Hershey bar has risen even more, and it's actually smaller than it was in 1962, when I was in graduate school. If inflation continued at the same rate, today's morning paper would cost more than one dollar by the year 2010. 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.
Investing requires a lot of work, make no mistake about it. Romantic novels are replete with tales of great family fortunes lost through neglect or lack of knowledge on how to care for money. Who can forget the sounds of the cherry orchard being cut down in Chekhov's great play? Free enterprise, not the Marxist system, caused the downfall of Chekhov's family: They had not worked to keep their money. Even if you trust all your funds to an investment adviser or to a mutual fund, you still have to know which adviser or which fund is most suitable to handle your money. Armed with the information contained in this book, you should find it a bit easier to make your investment decisions.
Most important of all, however, is the fact that investing is fun. It's fun to pit your intellect against that of the vast investment community and to find yourself rewarded with an increase in assets. It's exciting to review your investment returns and to see how they are accumulating at a faster rate than your salary. And it's also stimulating to learn about new ideas for products and services, and innovations in the forms of financial investments. A successful investor is generally a well-rounded individual who puts a natural curiosity and an intellectual interest to work to earn more money.
Investing in Theory
All investment returns—whether from common stocks or exceptional diamonds—are dependent, to varying degrees, on future events. That's what makes the fascination of investing: It's a gamble whose success depends on an ability to predict the future. Traditionally, the pros in the investment community have used one of two approaches to asset valuation: the firm-foundation theory or the castle-in-the-air theory. Millions of dollars have been gained and lost on these theories. To add to the drama, they appear to be mutually exclusive. An understanding of these two approaches is essential if you are to make sensible investment decisions. It is also a prerequisite for keeping you safe from serious blunders. During the 1970s, a third theory, born in academia and named the new investment technology, became popular in "the Street." Later in the book, I will describe that theory and its application to investment analysis.
The Firm-Foundation Theory
The firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects. When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected—or so the theory goes. Investing then becomes a dull but straightforward matter of comparing something's actual price with its firm foundation of value.
It is difficult to ascribe to any one individual the credit for originating the firm-foundation theory. S. Eliot Guild is often given this distinction, but the classic development of the technique and particularly of the nuances associated with it was worked out by John B. Williams.
In The Theory of Investment Value, Williams presented an actual formula for determining the intrinsic value of stock. Williams based his approach on dividend income. In a fiendishly clever attempt to keep things from being simple, he introduced the concept of "discounting" into the process. Discounting basically involves looking at income backwards. Rather than seeing how much money you will have next year (say $1.05 if you put $1 in a savings bank at 5 percent interest), you look at money expected in the future and see how much less it is currently worth (thus, next year's $1 is worth today only about 95, which could be invested at 5 percent to produce approximately $1 at that time).
Williams actually was serious about this. He went on to argue that the intrinsic value of a stock was equal to the present (or discounted) value of all its future dividends. Investors were advised to "discount" the value of moneys received later. Because so few people understood it, the term caught on and "discounting" now enjoys popular usage among investment people. It received a further boost under the aegis of Professor Irving Fisher of Yale, a distinguished economist and investor.
The logic of the firm-foundation theory is quite respectable and can be illustrated best with common stocks. The theory stresses that a stock's value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends. It stands to reason that the greater the present dividends and their rate of increase, the greater the value of the stock; thus, differences in growth rates are a major factor in stock valuation. Now the slippery little factor of future expectations sneaks in. Security analysts must estimate not only long-term growth rates but also how long an extraordinary growth can be maintained. When the market gets overly enthusiastic about how far in the future growth can continue, it is popularly held on Wall Street that stocks are discounting not only the future but perhaps even the hereafter. The point is that the firm-foundation theory relies on some tricky forecasts of the extent and duration of future growth. The foundation of intrinsic value may thus be less dependable than is claimed.
The firm-foundation theory is not confined to economists alone. Thanks to a very influential book, Graham and Dodd's Security Analysis, a whole generation of Wall Street security analysts was converted to the fold. Sound investment management, the practicing analysts learned, simply consisted of buying securities whose prices were temporarily below intrinsic value and selling ones whose prices were temporarily too high. It was that easy. Of course, instructions for determining intrinsic value were furnished, and any analyst worth his or her salt could calculate it with just a few taps of the calculator or personal computer. Perhaps the most successful disciple of the Graham and Dodd approach was a canny midwesterner named Warren Buffett, who is often called "the sage of Omaha." Buffett has compiled a legendary investment record, allegedly following the approach of the firm-foundation theory.
The Castle-in-the-Air Theory
The castle-in-the-air theory of investing concentrates on psychic values. John Maynard Keynes, a famous economist and successful investor, enunciated the theory most lucidly in 1936. It was his opinion that professional investors prefer to devote their energies not to estimating intrinsic values, but rather to analyzing 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. The successful investor tries to beat the gun by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd.
According to Keynes, the firm-foundation theory involves too much work and is of doubtful value. Keynes practiced what he preached. While London's financial men toiled many weary hours in crowded offices, he played the market from his bed for half an hour each morning. This leisurely method of investing earned him several million pounds for his account and a tenfold increase in the market value of the endowment of his college, King's College, Cambridge.
In the depression years in which Keynes gained his fame, most people concentrated on his ideas for stimulating the economy. It was hard for anyone to build castles in the air or to dream that others would. Nevertheless, in his book The General Theory of Employment, Interest and Money, he devoted an entire chapter to the stock market and to the importance of investor expectations.
With regard to stocks, Keynes noted that no one knows for sure what will influence future earnings prospects and dividend payments. As a result, Keynes said, most persons are "largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public." Keynes, in other words, applied psychological principles rather than financial evaluation to the study of the stock market. He wrote, "It is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence."
Keynes described the playing of the stock market in terms readily understandable by his fellow Englishmen: It is analogous to entering a newspaper beauty-judging contest in which one must select the six prettiest faces out of a hundred photographs, with the prize going to the person whose selections most nearly conform to those of the group as a whole.
The smart player recognizes that personal criteria of beauty are irrelevant in determining the contest winner. A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. After all, the other participants are likely to play the game with at least as keen a perception. Thus, the optimal strategy is not to pick those faces the player thinks are prettiest, or those the other players are likely to fancy, but rather to predict what the average opinion is likely to be about what the average opinion will be, or to proceed even further along this sequence. So much for British beauty contests.
The newspaper-contest analogy represents the ultimate form of the castle-in-the-air theory of price determination. An investment is worth a certain price to a buyer because she expects to sell it to someone else at a higher price. The investment, in other words, holds itself up by its own bootstraps. The new buyer in turn anticipates that future buyers will assign a still-higher value.
In this kind of world, there is a sucker 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. There is no reason, only mass psychology. All the smart investor has to do is to beat the gun—get in at the very beginning. This theory might less charitably be called the "greater fool" theory. It's perfectly all right to pay three times what something is worth as long as later on you can find some innocent to pay five times what it's worth.
The castle-in-the-air theory has many advocates, in both the financial and the academic communities. Keynes's newspaper contest is the same game played by "Adam Smith" in The Money Game. Mr. Smith also espouses the same view of stock price determination. On the academic side, so-called behavioral theories of the stock market, stressing crowd psychology, gained favor during the 1990s at leading economics departments and business schools across the developed world. Earlier, Oskar Morgenstern was a leading champion. The views he expressed in Theory of Games and Economic Behavior, of which he was co-author, have had a significant impact not only on economic theory but also on national security decisions and strategic corporate planning. In 1970 he co-authored another book, Predictability of Stock Market Prices, in which he and his colleague, Clive Granger, argued that the search for intrinsic value in stocks is a search for the will-o'-the-wisp. In an exchange economy the value of any asset depends on an actual or prospective transaction. Morgenstern believed that every investor should post the following Latin maxim above his desk:
Res tantum valet quantum vendi potest.
(A thing is worth only what someone else will pay for it.)
How the Random Walk Is to Be Conducted
With this introduction out of the way, come join me for a random walk through the investment woods, with an ultimate stroll down Wall Street. My first task will be to acquaint you with the historical patterns of pricing and how they bear on the two theories of pricing investments. It was Santayana who warned that if we did not learn the lessons of the past we would be doomed to repeat the same errors. Therefore, in the pages to come I will describe some spectacular crazes—both long past and recently past. Some readers may pooh-pooh the mad public rush to buy tulip bulbs in seventeenth-century Holland and the eighteenth-century South Sea Bubble in England. But no one can disregard the new-issue mania of the early 1960s, the "Nifty Fifty" craze of the 1970s, or the biotechnology bubble of the 1980s. The incredible boom in Japanese land and stock prices and the equally spectacular crash of those prices in the early 1990s, as well as the "Internet craze" of the late 1990s, provide continual warnings that we are not immune from the errors of the past.
These more recent speculative "bubbles" all involved the savvy institutions and investment pros. All too many investors are lazy and careless—a terrifying combination when greed gets control of the market and everyone wants to cash in on the latest craze or fad.
Then I throw in my own two cents' worth of experience. Even in the midst of a period of speculation, I believe, it is possible to find a logical basis for security prices. At the end of Part One I present some rules that should be helpful in giving investors a sense of value and in protecting you from the horrible blunders made by many professional investment managers.
|Acknowledgments from Earlier Editions||17|
|Pt. 1||Stocks and Their Value|
|1||Firm Foundations and Castles in the Air||23|
|2||The Madness of Crowds||35|
|3||Stock Valuation from the Sixties through the Nineties||55|
|4||The Firm-Foundation Theory of Stock Prices||95|
|Pt. 2||How the Pros Play the Biggest Game in Town|
|5||Technical and Fundamental Analysis||117|
|6||Technical Analysis and the Random-Walk Theory||138|
|7||How Good Is Fundamental Analysis?||165|
|Pt. 3||The New Investment Technology|
|8||A New Walking Shoe: Modern Portfolio Theory||199|
|9||Reaping Reward by Increasing Risk||220|
|10||The Assault on the Random-Walk Theory: Is the Market Predictable after All?||240|
|Pt. 4||A Practical Guide for Random Walkers and Other Investors|
|11||A Fitness Manual for Random Walkers||277|
|12||Handicapping the Financial Race: A Primer in Understanding and Projecting Returns from Stocks and Bonds||326|
|13||A Life-Cycle Guide to Investing||351|
|14||Three Giant Steps Down Wall Street||372|
|A Random Walker's Address Book and Reference Guide to Mutual Funds||409|
Posted December 22, 1999