Passive Investor’s Bible

Most stock investors follow one of two approaches — technical analysis or fundamental analysis — or a mix of the two. In this well-researched book, A Random Walk Down Wall Street, Burton G Malkiel, professor of economics at Princeton University, points out the shortcomings of the two approaches and then argues in favour of passive investing.

Essence of the two approaches
Technical analysis is the making and interpretation of stock charts. Its practitioners study the movements of stock prices and volume of trading to get a clue about the future direction of stock prices. Fundamental analysts, on the other hand, focus on determining the intrinsic value of the stock. By estimating the rate at which a company’s earnings and dividends will grow, and using a suitable discount rate, they arrive at the stock’s intrinsic value. If this value is above the market price, they recommend a buy on the stock.

Pros and cons of charting
When charting might work. Chartists believe their approach works because history has a habit of repeating itself. Malkiel grants that charting might work in certain circumstances. First, it might work due to herd instinct. When investors see a favourite speculative stock rising, they jump on the bandwagon. The initial price rise fuels optimism and causes the stock to rise further.
Second, different categories of investors get information about a company at different points of time. Insiders are the first to know about a favourable development. They then tell their friends who act next. Thereafter, the professionals at big institutions learn about the development. Retail investors are the last to get the news. With each new investor class getting the news, there is a fresh bout of buying and this propels the stock higher. Chartists believe that even if they do not have insider information, just by observing a stock’s price movement they can know when smart money is moving into it and piggyback on it.
And when it might not. According to Malkiel, charting will fail to work, one, whenever a trend reverses itself. Second, he says, if a lot of people are taking advantage of a particular technique, then its value automatically depreciates.
Three, to pre-empt others, investors may begin to act early when they spot what they think is a trend. Others then try to anticipate the signal even earlier. But the earlier you try to anticipate a trend, the less certain it is that the trend will indeed pan out the way you think it will. And four, as the market becomes more efficient, the process of adjusting to new information happens so rapidly that technical analysis becomes a futile exercise.
According to Malkiel, several academic studies have shown that past movements in stock prices cannot be used to reliably predict future prices. He concedes that the market exhibits some momentum from time to time. But, he says, this does not occur dependably and persistently enough for investors to make money from a trend-following strategy (after paying transaction costs). Technical analysis, he asserts, does not do better than a buy-and-hold investment in a diversified portfolio of stocks.
Why are chartists still hired? If technical analysis does not work, then why are chartists still hired by brokerage houses? The reason, says Malkiel, is that almost every technical system involves constant buying and selling. Such systems generate trades, and trades imply more commissions for brokerages.

Fundamental analysis fares no better
The fundamental analyst first gathers information on a stock and then tries to estimate its future earnings stream. He then discounts those earnings to arrive at an intrinsic value. In the author’s opinion, the entire process is difficult and analysts could commit errors at any one of the various stages.
No better than astrologers. Forecasting future earnings is the security analyst’s raison d’etre (reason for existence). Malkiel found that fundamental analysts do not have a great track record in predicting future earnings.
The author requested and received from 19 companies past earnings predictions for specific companies for the one-year to five-year period. These estimates were then compared with actual results. The author found that five-year estimates of analysts were worse than predictions derived using naive forecasting models (say, predicting future earnings using the long run rate of growth in national income).
When the author confronted the analysts, the latter defended themselves by saying that five years is too far ahead to make reliable projections. “Judge us on our ability to predict one-year forward earnings,” they said. So the author did exactly that. And what did he find? These analysts’ track record in predicting one-year growth was even worse than their track record in predicting five-year growth.
The analysts then protested that it was unfair to judge their performance on cyclical companies. “Try us on utilities,” they asserted. So the authors did that and found that their forecasts for this most stable group of companies were also way off the mark.
The author concludes that if you base your investment decisions on the earnings forecasts of analysts, you are sure to come to grief. Financial forecasting, he concludes, appears to be a science that makes astrology look respectable in comparison!

What should you do?
If both technical analysis and fundamental analysis are flawed, then what should the investor do? The author suggests investing in index funds.
Merits of passive investing. Between 1974 and 2002, the S&P 500 index of the US outperformed more than three quarters of equity mutual funds in that country. Its annual return over this period surpassed the average return of equity mutual funds by 2 percentage points.
Malkiel offers several reasons why index funds do better over the long term. One, they have lower management expenses compared to active funds. Two, index funds buy and hold stocks. Due to their low churn they incur low trading costs. Moreover, index funds always remain invested. Fund managers, on the other hand, move into cash and in the process often miss out on a sudden upturn in the market.

Another advantage of index funds is their predictability. When you invest in one, you know that it will give you returns that are close to that of the index. On the other hand, when you invest in an actively managed fund, you can never be sure whether it will outperform its benchmark index or do worse than it. Further, the performance of actively-managed funds cannot be predicted on the basis of past performance. So choosing the few funds that will outperform the index over the next 25 years is nearly impossible.
One suggestion that Malkiel adds for passive investors is that they should invest in an index that includes both large- and small-cap stocks. This, he says, will enable investors to capture the dynamism inherent in small-cap stocks in their early growth stage, and hence earn a better return (than a large-cap index would produce).
This book is quite comprehensive: it also discusses the bubbles that have developed in stock markets from time to time. Investors are also likely to find the chapter on life-cycle investment strategy useful. If you take the pains to go through the 423 pages of this book, you are bound to emerge a wiser investor.