Passive Investment Strategies and Efficient Markets - Book Report/Review Example

Burton Malkiel’s investment advice in A Random Walk down Wall Street is based on the underlying theory of the efficient market hypothesis, which was a widely accepted and influential idea in economics in the late 20th century. According to the hypothesis, securities markets are efficient in taking into account information about individual equities and regarding the security market as a whole. On this view, when information comes to light, those developments spread rapidly and are reflected in prices almost immediately. Accordingly, neither fundamental nor technical forms of analysis are capable of enabling investors to pick stocks with any more effectiveness than throwing darts at the investment section of The Wall Street Journal. Part of the efficient market hypothesis is the concept of a “random walk,” which refers to a progression of prices that are essentially random developments from previous prices, such that if information is directly echoed by stock prices, then tomorrow’s stock price will mirror only tomorrow’s news and so on[Bur03]. In the world of an efficient market hypothesis, where picking stocks is basically a game of chance, one must ask about the role of stock brokers, whose value proposition depends on their ability to pick successful stocks at rates better than chance. Throughout this paper, the role of stock brokers in an efficient market will be explored in light of the concepts explained and introduced in Malkiel’s A Random Walk down Wall Street, as well as developments in technology that have affected stock trading since the book’s original publication. A stock broker is a professional, usually part of a brokerage firm, who buys and sells stocks as well as other securities for individual and/or institutional clients in exchange for a fee or a commission. Just like a financial advisor or an investment advisor, stock brokers are responsible for managing money in a way that meets the best interests of clients, usually by investing that money in securities they feel will appreciate in value consistent with the client’s tolerance for risks and goals for returns. Because of their professional association with exchanges and trading stocks, stock brokers are regarded as being experts in picking the right ones. The methods that brokers use to pick “the right ones,” however, may vary considerably and, according to the efficient market hypothesis, there really is no uniform way to select good equities for investing, even from a professional perspective. However, stock brokers rely on the idea that their specialized and certified guidance is worth the cost they charge in fees or commissions. When Malkiel’s book was first published in 1971, stock brokers were retail investors’ primary connection to trading equities. Individual investors had no way to buy and sell stocks except through a professional with access to the stock exchange. In addition to serving in a consultative role similar to what most financial advisors do today, stock brokers served as the connection point between retail investors and their stock management. However, with technological developments that have opened up the connection between individuals and stock trading, particularly through the internet, the role of stock brokers has been reduced from being the primary manager of investments as well as an intermediary collecting a commission for executing a trade to being an advisor, or an expert, on where to put money in the form of investments. In their place, technology now serves as the intermediary and stock brokers are relied on more for the perceived advantage they give over investing in stocks randomly. Another challenge to the role of stock brokers in a technology-driven investment world is the advent of index funds, which allow investors to peg their dollars to the performance of the market as a whole[Bur031]. Providing both diversification and a low-overhead way to invest money in the market, index funds give retail investors the ability to bypass the need to run ideas by a stock broker, as stock markets tend to go up in the long-run. However, the main objection to index funds and similar investment vehicles is that they are not targeted enough at a specific group of securities, and investors might look at more specific funds for potentially higher returns. Supposing that an individual investor likes the idea of an index fund, but is looking for the potential of higher returns, in theory, an efficient market hypothesis would indicate that stock brokers are unnecessary. After all, if the market is following a random walk, whereby information is instantaneously reflected in stock prices and tomorrow’s price is a matter of chance based on what occurs tomorrow (not today), then what advantage would a supposed “expert” bring to the table for individual investors? So, in that case, the individual investor is faced with the choice between paying unnecessary fees to a broker or going down the path alone—ultimately, finding the same chance for success along both paths. Earlier, the issue of how stock brokers pick “the right ones” was approached as an issue of fundamental versus technical analysis, both of which Malkiel dismisses through the course of A Random Walk down Wall Street. In Chapter 5, Malkiel explores technical analysis, which is a technique based on using past prices to predict future market movements, and fundamental analysis, which looks at the overall health of a business through financial statements. Malkiel proceeds to deliver valuable arguments against technical analysis in Chapter 6, which center around the issue of how effective correlations are in a stock market context. For example, there is a correlation between the stock market and the average length of a hemline, which goes to show the reader that the reliability of a relationship is not necessarily equal to the validity of a relationship. Looking at charts alone, the author believes, cuts one off from the full context of the market. In Chapter 7, Malkiel explores fundamental analysis that too can be flawed by random events, suspicious financial data, incompetence, and other factors. Although more sound than technical analysis, fundamental analysis too has its problems[Bur73]. Nevertheless, there is some potential in using foundational logic to accept and analyze wide varieties of data to arrive at a sound conclusion about a company. Professionals such as stock brokers have an advantage over retail investors in the sense that they have more access to information used in fundamental analysis and materials that allow them to predict market movements marginally better. One can begin to make a two-part case for the value of stock brokers in an efficient market by looking at the advantage they gain by having more direct line of sight to the information that affects stock prices on a day-to-day basis. If, for example, a stock broker is better connected and can measure the potential impact of a piece of news on a stock on a particular day before the average investor, then the average investor has an incentive to trust that stock broker with investment capital—that is, to move it in or out of a stock in anticipation of the effect of said news on the stock’s price. Assuming the stock broker is good at fundamental analysis, and that random events or unreliable news sources do not interfere with such analysis, one can safely assume that a stock broker’s services would lead to higher returns than if the individual investor had decided to throw darts at The Wall Street Journal, as Malkiel suggests. While Malkiel feels the advantage of having information is minimal, one should be asking how large enough is this minimal advantage and does it justify paying fees or commissions to a professional advisor[Bur73]. One of the primary criteria that Malkiel suggests using in selecting a stock broker is whether the brokerage firm he or she works for has a large and well-respected research department. The purpose of an investment research department is in the gathering and dissemination of investment information, which ideally narrows the gap between random price movements in the market and an intelligent approach to selecting individual securities to invest in[Bur05]. If information moves quickly through the market, the value of a broker and the firm’s research department lies in getting to and utilizing information quicker than somebody without those services could. Principally, the issue of whether to choose to use a stock broker as an advisor in a world in which trades are executed electronically boils down to whether an individual investor can reduce or minimize risk to an acceptable level without having to pay extra for advice on which stocks to choose. Modern portfolio theory, which Malkiel introduces in Chapter 8, is the idea that investors should attempt to maximize portfolio expected return while minimizing risk for that level of expected return by choosing the correct proportion of (diversified) assets. Portfolio theory is presented as an alternative to fundamental and technical analysis, but Malkiel argues that no matter what, investors will be exposed to some risk. For example, during the financial crisis of 2007-08, it was not a matter of which stocks one chose, but rather all stocks, that dropped significantly in value in response to news of the collapse of financial institutions. In that case, just like in any efficient market scenario, entrusting one’s money with a stock broker provided no advantage over going it alone, despite stock brokers’ better proximity to equities markets. In an efficient market, it is not clear whether utilizing the services of stock brokers gives any advantage to individual investors looking to maximize the returns on their investments. In theory, all of us are equally best off if we choose stocks at random, rather than trying to choose “the right ones” or worse, trying to time the market. While alternatives like index funds and free websites exist to help individual investors make more intelligent decisions and to create better balanced portfolios in like of modern portfolio theory, there may be sufficient value in contracting help from someone who is more prepared and equipped to translate information into investment decisions than the average investor to at least cancel out the commissions and fees that are due to stock brokers. Ultimately, according to the author, investing in a target retirement fund that adjusts its risk profile based on investors’ expected retirement date may be the best solution for diversifying one’s portfolio between reasonable stock choices. Works Cited Bur03: , (Malkiel, The Efficient Market Hypothesis and Its Critics 1), Bur031: , (Malkiel, Passive Investment Strategies and Efficient Markets 3), Bur73: , (Malkiel, A Random Walk down Wall Street 166), Bur73: , (Malkiel, A Random Walk down Wall Street 129), Bur05: , (Malkiel, Reflections on the Efficient Market Hypothesis: 30 Years Later 5), Read More