A Random Walk Spoiled

As a golfer, you learn early on the old adage of Mark Twain: "Golf is a good walk spoiled." While Twain was harsh on the sport of golf, Burton G. Malkiel was equally harsh on the world of investing in his book A Random Walk Down Wall Street. Malkiel attempts to "spoil" some of the old, strongly held notions about stock market investing: specifically that individuals (and more importantly) fund managers cannot outperform a broad basket of diversified stocks over the long run.

He shows that old techniques of technical analysis—using charts and movement analysis to predict future stock movements—and fundamental analysis—using projections to project some sort of growth rate to give an "actual" value of a company—simply do not give excessive returns. Malkiel continues in his argument putting the test to supposed market anomalies that have created significant returns in the past. Such anomalies, such as the "January Effect", the "Dogs of the Dow", or the "Monday Afternoon effect", are also proven to fail in the face of increased scrutiny, especially when trading costs and short-term taxes are taken into account.

I have a tendency to agree with much of what Malkiel says. On the point that there is no "magic" formula that will allow investors to somehow earn excessive returns consistently. The idea seems to collapse on itself: as soon as it is widely accepted by the market, the anomaly will be traded out of the market as investors attempt to preempt is movement. I also agree with his harsh words against technical analysis, but the points he uses to illustrate this are interesting. He illustrates the fact that people cannot understand random patterns by looking at a classroom experiment involving coin flips, showing that people try to use probability to explain something that they cannot understand.

However, I disagree with Malkiel's opinions on fundamental analysis. It seems as though Malkiel holds a double standard when comparing supposed "efficient" markets and the returns of those relying on fundamental analysis. Malkiel outlines his five rules for why security analysts have trouble predicting the future:

(1) the influence of random events, (2) the producing of dubious reported earnings through "creative" accounting procedures, (3) errors made by the analysts themselves, (4) the loss of the best analysts to the sales desk or to portfolio management, and (5) the conflicts of interest facing securities analysts at firms with large investment banking operations.

The most important factor that I take issue with is the first factor. He handicaps the work of the equity researcher to the random movements of the markets, explaining how a significant portion of poor performance of the predictive power of equity researchers is due to the pure random movement of the market. However, when taken in the prospective of the market as a whole, this random movement only indicates an increased risk and only provides the added benefit of increased returns for the amount of risk. It does not make sense that a penalty for the equity researchers should be a benefit for followers of efficient markets.