Dr. Burton Malkiel's Random Walk Riposte to Fundamental Analysis

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We have now spent the last dozen or so blogs exploring fundamental analysis with Philip Carret, Benjamin Graham, Al Frank, Warren Buffett, Philip Fisher and David Dreman.  You may remember the excerpt from Al Frank's 1995 book, Al Frank's New Prudent Speculator in which he comments on the various forms of investing:

Given the multitude of information, possibilities, published "successful" methods, and strategies for speculating with stocks, how is one to choose?  The problem is especially vexing as apparently successful strategists dismiss their competitors' methods as seriously flawed or completely missing the point.

I pointed out in an earlier blog that proponents of the efficient market hypothesis, also called the random walk theory, reject, more or less, the fundamental and technical forms of analysis.  I say "more or less" because there are three subsets of random walk theory, the "weak", "semi- strong" and "strong" forms.  The essence of the theory is that the price of a stock, at any given moment, represents its true value, which varies in a random fashion as the stock is constantly repriced by the market.

One of the most famous of these random walkers is Professor Burton G. Malkiel, the Chemical Bank Chairman's professor of economics at Princeton University.  His famous book, A Random Walk Down Wall Street, is the classic text on the efficient market hypothesis, first published in 1973.  It is now in its 10th edition.  We will explore the book in depth in a later blog, but I wanted to share with you Professor Malkiel's analysis of fundamental investing.  He called it the "firm-foundation theory" of investing and described it as follows:

The firm-foundation theory argues that each investment instrument, be it a common stock or a piece of real estate, has a firm anchor of something called intrinsic value, which can be determined by careful analysis of present conditions and future prospects.  When market prices fall below (rise above) this firm foundation of intrinsic value, a buying (selling) opportunity arises, because this fluctuation will eventually be corrected - or so the theory goes.  Investing then becomes a dull but straightforward matter of comparing something's actual price with its firm foundation of value. (author's emphasis in bold)

Given all we have read about the fundamental form of investing, this is a very succinct and accurate summary of fundamental analysis.  Professor Malkiel goes on to point out what he feels are its weaknesses as follows: 

Despite its plausibility and scientific appearance, there are three potential flaws in this type of analysis.  First, the information and analysis may be incorrect.  Second, the security analyst's estimate of value may be faulty.  Third, the market may not correct its "mistake" and the stock price might not converge to its value estimate.

Professor Malkiel's observations should be kept in mind by any investor drawn to fundamental analysis.  In essence, he is reminding investors that nothing is perfect in this world, including Wall Street.  There is no one fool proof method for an investor to always use in managing his or her portfolio through constantly changing markets.  As Al Frank advised, the individual investor can only find the investment strategy that he or she feels most comfortable with and stick to it through up and down markets, enjoying the market rises and enduring the market declines.

You may have noticed that I have now added links in the blog to help you move around the site more conveniently.  Credit for this must go to my IT department, my daughter Susan.  If the links work, she gets the credit.  If they fail to connect you, it's my fault.  Comments are always welcome.

The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.
 
The material from A Random Walk Down Wall Street by Burton G. Malkiel, copyright 1999, 1996, 1990, 1985, 1981, 1975, 1973 by W.W. Norton & Company, Inc is used with permission of W.W. Norton & Company, Inc.