Random Walk Down Wall Street Book Summary You need to summarize the following chapters from “Random Walk Down Wall Street” 11ed. (2014 edition) by Burton M

Random Walk Down Wall Street Book Summary You need to summarize the following chapters from “Random Walk Down Wall Street” 11ed. (2014 edition) by Burton Malkiel, in about 2 single spaced pages per chapter.

Chapter 6; Technical analysis

Chapter 7: How good is fundamental analysis?

Chapter 10: Behavioral finance

Chapter 11: Is “Smart beta” really smart? –
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6
charts. To my great embarrassment, Ionce choked conspicu-
ously at the dinner table when a chartist made such a comment.
I have since made it a rule never to eat with a chartist. It’s bad for
digestion.
Although technicians might not get rich following their own
advice, their store of words is precious indeed. Consider this ad-
vice offered by one technical service:
o
TECHNICAL ANALYSIS AND
THE RANDOM-WALK THEORY
sustained upward move. One cannot look at a stock chart like
this without noticing the self-evidence of these statements.
How can the economist be so myopic that he cannot see whatis
so plainly visible to the naked eye?
The persistence of this beliefin repetitive stock-market pat-
terns is due to statistical illusion. To illustrate, let me describe
an experimentin which I asked my students to participate.
The students were asked to construct a stock chart showing
the movements of a hypothetical stock initially selling at $50.
For each successive trading day, the closing stock price would
be determined by the flip of a coin. If the toss was a head, the
students assumed that the stock closed 12 point higher than the
preceding close. If the flip was a tail, the price was assumed to
be down by 12. The chart below is the hypothetical stock chart
derived from one of these experiments.
Things are seldom what they seem.
Skim milk masquerades as cream.
– Gilbert and Sullivan, H.M.S. Pinafore
The market’s rise after a period of reaccumulation is a bullish sign.
Nevertheless, fulcrum characteristics are not yet clearly present and
a resistance area exists 40 points higher in the Dow, so it is clearly
premature to say the next leg of the bull market is up. If, in the coming
weeks, a test of the lows holds and the market breaks out of its flag, a
further rise would be indicated. Should the lows be violated, a contin-
uation of the intermediate term downtrend is called for. In view of the
current situation, it is a distinct possibility that traders will sit in the
wings awaiting a clearer delineation of the trend and the market will
move in a narrow trading range.
NOT EARNINGs, Nor dividends, nor risk, nor gloom of high
interest rates stay the technicians from their assigned task:
studying the price movements of stocks. Such single-minded
devotion to numbers has yielded the most colorful theories
and folklanguage of Wall Street: “Hold the winners, sell the
losers,” “Switch into the strong stocks,” “Sell this issue, it’s acting
poorly,” “Don’t fight the tape.” All are popular prescriptions of
technical analysts. They build their strategies upon dreams of
castles in the air and expect their tools to tell them which castle
is being built and how to get in on the ground floor. The question
is: Do they work?
that the pattern of wallpaper behind the mirror is the same as
the pattern above the mirror. The basic premise is that there are
repeatable patterns in space and time.
Chartists believe momentum exists in the market. Suppos-
edly, stocks that have been rising will continue to do so, and
those that begin falling will go on sinking. Investors should
therefore buy stocks that start rising and continue to hold their
strong stocks. Should the stock begin to fall, investors are ad-
vised to sell.
These technical rules have been tested exhaustively by using
stock-price data on the major exchanges going back as far as the
beginning of the twentieth century. The results reveal that past
movements in stock prices cannot be used reliably to foretell
future movements. The stock market has little, if any, memory.
While the market does exhibit some momentum from time
to time, it does not occur dependably, and there is not enough
persistence in stock prices to make trend-following strategies
consistently profitable. Although there is some short-term mo-
mentum in the stock market, as will be described more fully in
chapter 11, any investor who pays transactions costs and taxes
cannot benefit from it.
Economists have also examined the technician’s thesis that
there are often sequences of price changes in the same direc-
tion over several days (or several weeks or months). Stocks are
likened to fullbacks who, once having gained some momentum,
can be expected to carry on for a long gain. It turns out that
this is simply not the case. Sometimes one gets positive price
changes (rising prices) for several days in a row; but sometimes
when you are flipping a fair coin you also get a long string of
“heads” in a row, and you get sequences of positive (or negative)
price changes no more frequently than you can expect random
sequences of heads or tails in a row. What are often called “per-
sistent patterns” in the stock market occur no more frequently
than the runs of luckin the fortunes of any gambler. This is what
economists mean when they say that stock prices behave very
much like a random walk.
rawwodvorto
48
If you ask me what this means, I cannot tell you, but I think the
technician probably had the following in mind: “If the market
does not go up or go down, it will remain unchanged.” Even the
weather forecaster can do better than that.
Obviously, I’m biased. This is not only a personal bias but
a professional one as well. Technical analysis is anathema to
much of the academic world. We love to pickon it. We have two
main reasons: (1) after paying transactions costs and taxes, the
method does not do better than a buy-and-hold strategy; and (2)
it’s easy to pickon. And while it may seem a bit unfair, just re-
member that it’s your money we’re trying to save.
Although the computer perhaps enhanced the standing of the
technician for a time, and while charting services are widely
available on the Internet, technology has ultimately proved to
be the technician’s undoing. Just as fast as he or she) creates
charts to show where the market is going, the academic gets
busy constructing charts showing where the technician has
been. Because it’s so easy to test all the technical trading rules on
the computer, it has become a favorite pastime for academics to
see whether they really work.
friend of mine who practically jumped out of his skin. “What is
this company?” he exclaimed. “We’ve got to buy immediately.
This pattern’s a classic. There’s no question the stock will be up
15 points next week.” He did not respond kindly when I told him
the chart had been produced by flipping a coin. Chartists have
no sense of humor. I got my comeuppance when Business Week
hired a technician adept at hatchet work to review the first edi-
tion of this book
My students used a completely random process to produce
their stock charts. With each toss, as long as the coins used were
fair, there was a 50 percent chance of heads, implying an up-
ward move in the price of the stock, and a 50 percent chance of
tails and a downward move. Even if they flipped ten heads in
a row, the chance of getting a head on the next toss was still 50
percent. Mathematicians call a sequence of numbers produced
by a random process (such as those on our simulated stock
chart) a random walk. The next move on the chartis completely
unpredictable on the basis of what has happened before.
The stock market does not conform perfectly to the mathema-
tician’s ideal of the complete independence of present price
movements from those in the past. There is some momentum
in stock prices. When good news arises, investors often only
partially adjust their estimates of the appropriate price of the
stock Slow adjustment can make stock prices rise steadily
for a period, imparting a degree of momentum. The failure
of stock prices to measure up perfectly to the definition of a
random walkled the financial economists Andrew Loand A.
Craig MacKinlay to publish a book entitled A Non-Random Walk
Down Wall Street. In addition to some evidence of short-term
momentum, there has been a long-run uptrend in most averages
of stock prices in line with the long-run growth of earnings and
dividends.
But don’t count on short-term momentum to give you some
surefire strategy to allow you to beat the market. For one thing,
stock prices don’t always underreact to news—sometimes
they overreact and price reversals can occur with terrifying
suddenness. We shall see in chapter 11 that investment funds
managed in accordance with a momentum strategy started off
with subpar results. And even during periods when momentum
is present and the market fails to behave like a random walk),
the systematic relationships that exist are often so small that
they are not useful to investors. The transactions charges and
taxes involved in trying to take advantage of these dependencies
are far greater than any profits that might be obtained. Thus, an
accurate statement of the “weak” form of the random-walkhy-
pothesis goes as follows:
44
44
HOLES IN THEIR SHOES AND
AMBIGUITY IN THEIR FORECASTS
The chart derived from random coin tossings looks remark-
ably like a normal stock price chart and even appears to display
cycles. Of course, the pronounced “cycles” that we seem to ob-
serve in coin tossings do not occur at regular intervals as true
cycles do, but neither do the ups and downs in the stock market.
It is this lack of regularity that is crucial. The “cycles” in the
stock charts are no more true cycles than the runs of luckor
misfortune of the ordinary gambler. And the fact that stocks
seem to be in an uptrend, which looks just like the upward move
in some earlier period, provides no useful information on the
dependability or duration of the current uptrend. Yes, history
does tend to repeat itselfin the stock market, but in an infinitely
surprising variety of ways that confound any attempts to profit
from a knowledge of past price patterns.
In other simulated stockcharts derived from studentcoin-
tossings, there were head-and-shoulders formations, triple tops
and bottoms, and other more esoteric chart patterns. One chart
showed a beautiful upward breakout from an inverted head and
shoulders (a very bullish formation). I showed it to a chartist
University professors are sometimes asked by their students, “If
you’re so smart, why aren’t you rich?” The question usually ran-
kles professors, who think of themselves as passing up worldly
riches to engage in such an obviously socially useful occupation
as teaching. The same question is more appropriately addressed
to technicians. Since the whole point of technical analysis is to
make money, one would expect that those who preach it should
practice it successfully.
On close examination, technicians are often seen with holes
in their shoes and frayed shirt collars. I personally have never
known a successful technician, but I have seen the wrecks of
several unsuccessful ones. Curiously, however, the broke tech-
nician is never apologetic. If you commit the social error of
asking him why he is broke, he will tell you quite ingenuously
that he made the all-too-human error of not believing his own
JUST WHAT EXACTLY IS A RANDOM WALK?
IS THERE MOMENTUM IN THE STOCK MARKET?
The technician believes that knowledge of a stock’s past be-
havior can help predict its probable future behavior. In other
words, the sequence of price changes before any given day
is important in predicting the price change for that day. This
might be called “the wallpaper principle.” The technical ana-
lyst tries to predict future stock prices just as we might predict
To many people this appears to be errant nonsense. Even the
most casual reader of the financial pages can easily spot pat-
terns in the market. For example, look at the stock chart on page
138.
The chart seems to display obvious patterns. After an initial
rise the stock turned down, and then headed persistently down-
hill. Later, the decline was arrested and the stock had another
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The history of stock price movements contains no useful information
that will enable an investor consistently to outperform a buy-and-hold
strategy in managing a portfolio.
holding the representative list of stocks in the market averages,
the Dow follower actually comes out a little behind, because the
strategy entails a number of extra brokerage costs as the investor
buys and sells when the strategy decrees.
O
The Relative-Strength System
If the weak form of the random-walk hypothesis is valid, then, as
my colleague Richard Quandt says, “Technical analysis is akin
to astrology and every bit as scientific.”
I am not saying that technical strategies never make money.
They very often do make profits. The point is rather that a simple
buy-and-hold strategy (that is, buying a stockor group of stocks
and holding on for a long period of time) typically makes as
much or more money.
When scientists want to test the efficacy of some new drug,
they usually run an experiment in which two groups of patients
are administered pills—one containing the drug in question,
the other a worthless placebo (a sugar pill). The results of the
administration to the two groups are compared, and the drug is
deemed effective only if the group receiving the drug did better
than the group getting the placebo. Obviously, if both groups got
better in the same period of time, the drug should not be given
the credit, even if the patients did recover.
In the stock-market experiments, the placebo with which the
technical strategies are compared is the buy-and-hold strategy.
Technical schemes often do make profits for their users, but so
does a buy-and-hold strategy. Indeed, as we shall see later, a
simple buy-and-hold strategy using a portfolio consisting of all
the stocks in a broad stock-market index has provided investors
with an average annual rate of return of about 10 percent over
the past eighty years. Only if technical schemes produce better
returns than the market can they be judged effective. To date,
none has consistently passed the test.
moved down 5 percent from a peak is said to be in a downtrend.
You’re supposed to buy any stock that has moved up 5 percent
from its low and hold it until the price moves down 5 percent
from a subsequent high, at which time you sell and, perhaps,
even sell short. The short position is maintained until the price
rises at least 5 percent from a subsequentlow.
This scheme is very popular with brokers. Indeed, the filter
method lies behind the popular “stop-loss” order favored by
brokers, where the client is advised to sell his stockifit falls 5
percent below his purchase price to “limit his potential losses.”
The argument is that presumably a stock that falls by 5 percent
will be going into a downtrend.
Exhaustive testing of various filter rules has been under-
taken. The percentage drop or rise that filters out buy and sell
candidates has been allowed to vary from 1 percent to 50 per-
cent. The tests covered different time periods and involved
individual stocks as well as stockindexes. The results are
remarkably consistent. When the higher transactions charges
incurred under the filter rules are taken into consideration,
these techniques cannot consistently beat a policy of simply
buying the individual stock (or the stockindex) and holdingit
over the period during which the testis performed. The individ-
ual investor would do well to avoid using any filter rule and, I
might add, any broker who recommends it.
In the relative-strength system, an investor buys and holds
those stocks that are acting well, that is, outperforming the
general market indexes. Conversely, the stocks that are acting
poorly relative to the market should be avoided or, perhaps,
even sold short. While there do seem to be some time periods
when a relative-strength strategy would have outperformed
a buy-and-hold strategy, there is no evidence that it can do so
consistently. As indicated earlier, there is some evidence of mo-
mentum in the stock market. Nevertheless, a computer test of
relative-strength rules over a twenty-five-year period suggests
that such rules are not, after accounting for transactions charges
and taxes, useful for investors.
the opposite direction.” Before the stock turns around, its price
movements are supposed to form one of a number of extensive
reversal patterns as the smart-money traders slowly “distrib-
ute” their shares to the “public.” Of course, we know some stocks
do reverse directions in quite a hurry (this is called an “unfortu-
nate V formation”), but perhaps some chart configurations can,
like the Roman soothsayers, accurately foretell the future. Alas,
the computer has even tested more arcane charting techniques,
and the technician’s tool has again betrayed him.
In one elaborate study, the computer was programmed to
draw charts for 548 stocks traded on the New York Stock Ex-
change over a five-year period. It was instructed to scan all the
charts and identify any one of thirty-two of the most popularly
followed chart patterns. The computer was told to be on the
lookout for heads and shoulders, triple tops and bottoms, chan-
nels, wedges, diamonds, and so forth. Because the machine is a
very thorough (though rather dull) worker, we can be sure that it
did not miss any significant chart patterns.
When the machine found that one of the bearish chart patterns
such as a head and shoulders was followed by a downward
move through the neckline toward décolletage (a most bearish
omen), it recorded a sell signal. If on the other hand, a triple bot-
tom was followed by an upside breakout (a most favorable au-
gury), a buy signal was recorded. The computer then followed
the performance of the stocks for which buy and sell signals
were given and compared them with the performance record of
the general market
Again, there seemed to be no relationship between the tech-
nical signal and subsequent performance. If you had bought
only those stocks with buy signals, and sold on a sell signal, your
performance after transactions costs would have been no better
than that achieved with a buy-and-hold strategy.
that the “hot hand” phenomenon is a myth.
The psychologists did a detailed study of every shot taken by
the Philadelphia 76ers over a full season and a half. They found
no positive correlation between the outcomes of successive
shots. Indeed, they found that a hit by a player followed by a
miss was actually a bit likelier than the case of making two
baskets in a row. Moreover, the researchers looked at sequences
of more than two shots. Again, they found that the number of
long streaks (that is, hitting of several baskets in a row) was no
greater than could have been expected in a random set of data
(such as flipping coins in which every event was independent
of its predecessor). Although the event of making one’s last two
or three shots influenced the player’s perception of whether
he would make his next shot, the hard evidence was that there
was no effect. The researchers then confirmed their study by
examining the free-throw records of the Boston Celtics and by
conducting controlled shooting experiments with the men and
women of the Cornell University varsity basketball teams.
These findings do not imply that basketball is a game of
chance rather than skill. Obviously there are some players who
are more adept at making baskets and free throws than others.
The point is, however, that the probability of making a shot isin-
dependent of the outcome of previous shots. The psychologists
conjecture that the persistent belief in the hot hand could be
due to memory bias. Iflong sequences of hits or misses are more
memorable than alternating sequences, observers are likely to
overestimate the correlation between…
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