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Welcome to the Investing Section of Options Realm |
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Burton Malkiel's A Random Walk Down Wall Street is a classic investment text because it questions the very purpose of the enormous investment services sector. Malkiel's often-misinterpreted thesis is that investors cannot outperform the market without taking on additional risk, measured using beta. Beta shows a security's volatility relative to that of some benchmark, such as a broad market index. This benchmark will be given a volatility of 1, and the other security will have a beta that shows its relative aggressiveness compared to the benchmark. A security with the beta of 1.5 is expected to make moves 50% greater than the benchmark index, so if the index goes down 10% the security is expected to go down 15% - although if the index rises 10%, the security is expected to increase 15%. Understanding the role of volatility in Malkiel's Random Walk is important because ignoring risk, one can outperform the market by getting lucky with risky strategies such as options, leverage, or simply buying more volatile stocks. One important assumption of Malkiel's that I believe invalidates the entire Efficient Market Hypothesis (EMH) is that all investors are rational. Investors are assumed to be rational and acting in the way that the expect to make the most money, which is a reasonable expectation - however, research shows investors, particularly smaller investors, often act contrary to their best interests. Investors often chase returns with, and after, the herd and sell at the wrong time when they should be buying. Few investors actually take the time to sit down and read a company's financial statements and other SEC filings - which I consider essential to understanding the business. Fewer still do any sort of valuation, such as a discounted cash flow model. Many people just invest based off of what their broker is pushing, a hot stock tip they heard, or what products they use. Nonetheless, these people are buying and selling securities and therefore are impacting the price. How can an investor outperform the market without taking on proportionally high risk? It really depends on how risk is measured. Comparing returns with beta is generally a losing proposition, because a stock's gain in excess of the market will increase beta, which will then make the investment appear to be more risky, etc. I believe a better way to measure risk involves weighing the odds that the investment will lose money and/or be outperformed by other investments. I believe companies trading at a low price to cash flow (EV/FCF) multiple are less likely to be losing investments because they are unlikely to go bankrupt or experience cash flow crunches which lead to undesirable choices, and the high cash flow yield (which is the inverse of the original formula) will allow the company to buy back shares, pay dividends, or invest to (hopefully) earn a high return on capital. This strategy has been proven to significantly outperform the market in two-decades-long study, and is similar to that used by master value investor Warren Buffett. For the long-term investor, shrewd stock picking in good companies based on solid research and analysis should enable one to outperform the market, although the task is much more difficult for the short-term trader |
