The Volatility of the Stock Market

A Random Walk?

In his famous book, "A Random Walk Down Wall Street," Burton Malkiel explains the Random Walk Theory, "In essence, the random walk theory wspouses the belief that future stock prices cannot be predicted. It says that a blindfolded moonkey throwing darts at the newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts." (Malkiel, 1973) He describes the investing in the Stock Market as being "a gamble whose success depends on an ability to predict the future." The intrigue, therefore, is just that. There is a great deal of uncertainty involved however the payoff is can be very great. Malkiel divides the approaches to "predicting the future" into two categories: "The firm-foundation Theory" and the "castle in the sky theory," and these theories appear to be mutually exclusive.

The Firm Foundation Theory

This theory argues that each common stock (representative of a certificate of part ownership of a corporation) has a firm anchor of something called intrinsic value, which can be determined by careful analysis of the firm's current position and future prospects. (Malkiel, 1973) Market prices flling below this firm foundation of intrisic value means a buying opportunity, because, according to the theory, price fluctuation is eventually corrected. Conversely, with prices rising above this value comes a selling opportunity. This technique, develooped in large part by John B. Williams, appears quite simple. Williams presented a formula for determining the intrinsic value which was based on dividend income. Hw utilised the idea of "discounting" which, as Malkiel describes it, basically involves looking at income backwards.

Discounting looks at the desired future return on an investment and determines the present value corresponding to that return. This present value thus depends on the interest rate. If future returns (dividends) are viewed in real terms, we take the real interest rate and perform the following calculations:

Jean-Paul wants a $27,500 payment at the end of one year. The real interest, r, is 10% How much does Jean-Paul have to invest now in order to get the return that he wants?

Let Jean-Paul's investment amount (present value) = x Therefore Jean-Paul's return amount at the end of one year is the principal plus interest gained That is,

Return payment = x(1+r)

              = x(1 + 0.1)
              = x(1.1)

So we have,

x(1.1) = 27,500

Therefore,

x = 27,500/(1.1)

 = 25,000

So Jean-Paul needs to invest $25,000 today if he wants to have $27,500 at the end of one year. That is, The present value of $27,500 is $25,000.