I realized that I’ve been taking some ignorant swings at “Random Walk” and the Efficient Market Hypothesis.  I hadn’t really read anything related to random-walk since Economics 101.  This realization, coupled with the fact that I literally live in the shadow of a wonderful public library that I have NEVER used, led me to take the short, direct walk to the library to get the book and review it.

All in all, the book is a good read and a valuable read in the sense that stock investors who take its recommendations to heart are far less likely to shoot themselves in the foot by overtrading, chasing performance, etc.

The basic premise of the book is that price movements in the stock market resemble a random walk, and that past price movements are not predictive of future price movements.  The book does make passing mention of a LONG TERM UP TREND in equity prices roughly equivalent to the long run rate of earnings growth, but rather curtly declares that transaction costs are prohibitively high, and therefore, short-term trend trading is not superior to a buy and hold approach.  In fact, it categorically goes through most widely followed methods of stock picking and explains why these are inferior to index investing.

Get it?  Two things : Future stock prices cannot be predicted, and nothing beats buying and holding a diversified portfolio that is primarily made up of US stock index funds.

Here are some important limitations to consider, however.

The conclusions about efficient pricing and long term upward bias apply to the STOCK MARKET ONLY.  Furthermore, while the book explains why fundamental and technical analysis “do not work”, it pre-supposes that an inability to predict the future movements of stock prices necessarily means that one should not be able to outperform the market over a long period of time.  Keep in mind that the book had already acknowledged the inconvenient trend phenomenon but managed to “normalize” it away.

My own evolution as a trader has taken me away from active stock investing.  In fact, the relatively small percentage of my assets that are currently held in stock funds are actually invested in index funds.  Why?  The risk-reward relationship for successful stock picking is relatively small due to the high costs and/or inavailability of high degrees of leverage.  I personally find my skill set more suited for forex trading, but this is by no means a recommendation that everyone run out and start changing their dollars for euros and pounds and whatnot.  Forex trading is purely speculative, and speculation and investing are really two entirely different animals.  Month after month, my forex trading results are convincing me that speculative, short term trend following in the forex market can and does produce returns that are not only outstanding, but also uncorrelated to the returns in my stock portfolio.  This is diversification at its best. 

Despite my rather facetious rant against index funds in a prior post, the vast majority of us will be investing in stock funds via tax advantaged accounts like IRAs and 401k’s…for this purpose, Random Walk’s advice is practical, easy to implement, and perhaps the best way to get rich slowly and enjoy a financially free future.
 

Other than a few odd conversations with relatives who would claim to be making money holding various stocks, I had no source of financial education.  I’m not sure how I found the Fool, but I’m immensely glad that I did.   

The Fool is a great place for absoulte beginners to learn the basics of investing.  They publish an online guide called Our 13 Steps to Investing.

If you know nothing about trading and investing, please go there and read the first 9 steps.  Yeah, that’s right, the first 9.  The last 4 steps are marketing fluff designed to get you to subscribe to newsletters. 

It’s easy for an experienced investor to dismiss the Motley Fool, because the information presented there is rather basic and light, but for newbies, it’s a gentle and fun introduction to self-directed investing.   Maybe someday you’ll be a snobby graduate of the Motley Fool like me.

 On another, related note, I worked at the Motley Fool as a database programming intern for 2 years while I was in college.  I managed to land the internship mostly because of my enthusiasm about the company.  I really didn’t have the necessary skills at the time of the interview, but I had the drive to contribute to the company, and a man by the name of Kevin Book gave me a chance.  For those of you who watch CBNC, you might see Kevin from time to time.  He’s moved on to Friedman Billings Ramsey, and now he gives talking head analysis to CNBC.  Go Kevin!

The article wisely reminds investors to compare their returns to their relevant benchmarks instead of focusing on an arbitrary benchmark like 10%.  The only point not covered by the article is how much volatility (Beta) did you endure in order to get to the absolute rate of return.  Many people claim that all they care about is the bottom line rate of return, but they cannot stomach the volatility that occurs in the interim, and they change investment strategies too often, chasing the hot performing sector, reducing their overall rate of return, and becoming frustrated in the process.  An investor can improve his results by mentally rehearsing for “normal” losses, staying the course when appropriate, and searching for investment strategies with the best risk adjusted rate of return for any given volatility level.

In modern portfolio theory, the number that describes risk-adjusted return is called alpha.

Alpha – A coefficient which measures risk-adjusted performance, factoring in the risk due to the specific security, rather than the overall market. A high value for alpha implies that the stock or mutual fund has performed better than would have been expected given its beta (volatility).

 Simply put, investors need to do some self-exploration in order to determine their personal risk tolerance (Beta tolerance), and then search out investment strategies with the least negative volatility that will carry them to their expected rate of return.  All else equal, fewer big swings in the account mean fewer sleepless nights.
 

The first step to success is to begin investing.  We should never let discussions about the “best” way to do something keep us from doing anything at all.

Readers of my site might already know that I am essentially a trend follower, and I do not believe that the market’s movements are random.  I don’t suppose I can prove it, but
while the academics are proving that I can’t “beat the market”, I’ll be here buying high and selling higher.