The Volatility of the Stock Market

A Random Walk?

A Random Walk theory holds that future stock prices cannot be predicted. In his famous book, "A Random Walk Down Wall Street," Burton Malkiel describes investing in the Stock Market as being "a gamble whose success depends on an ability to predict the future." He divides the approaches to attempting to do so into two categories: an approach using the "firm-foundation theory" and one using the "castle-in-the-air theory," two theories which appear to be mutually exclusive.

An Introduction to 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 intrinsic value, which can be determined by careful analysis of the firm's current position and future prospects. When market prices fall below this firm foundation of intrinsic value a buying opportunity arises," (Malkiel 1973, 19-20) because, according to the theory, price fluctuation is eventually corrected. Similarly, when the price of a stock rises considerably above its intrinsic value, sale of the stock is recommended. This technique, developed 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. He utilized the idea of "discounting" which, as Malkiel describes it, basically involves looking at income backwards. (Malkiel 1973, 20)

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.

Williams said that the intrinsic value of a stock was equal to the present (or discounted) value of all its future dividends. However, this way of valuating stock prices encounters problems of its own: one must attempt to forecast the extent and duration of future growth which, in Malkiel's opinion, is a tricky and treacherous business.

An Introduction to the Castle-in-the-Air Theory

This theory concentrates on "psychic values" (Malkiel 1973, 22) as opposed to intrinsic values. Lord Keynes, a famous economist and, according to Malkiel, "an outstandingly successful investor," developed this theory, arguing that intrinsic values were too difficult to calculate. Keynes was more interested in how investors are likely to behave in the future and how, in times of optimism, they tend to "build their hopes into castles in the air" (Malkiel 1973, 22). Keynes focus was therefore more on investor psychology rather than on financial evaluation.

Keynes described "playing" the stock market as "being analogous to entering a newspaper beauty-judging contest in which you have to select the six prettiest faces out of 100 photographs. The prize goes to the person whose selections most nearly conform to those of the group as a whole. The smart player recognizes that his personal criteria of beauty are irrelevant in determining the contest winner. A better strategy is to select those faces the other players are likely to fancy. This logic tends to snowball. After all, the other contestants are no fools and they are likely to play the game with at least as keen a perception. Thus the optimal strategy is not to pick those faces the player thinks are prettiest, or even those he may believe the other players are likely to fancy, but rather to predict what the average opinion is likely to think the average opinion will be or to proceed even further with this sequence." (Malkiel 1973, 23)

As difficult as this may seem, Keynes believed that this kind of analysis is much more beneficial in predicting what will happen to stock prices. He argued that the average man is no expert and also, is subject to psychological influences that affect his behavior in the stock market. An example of one of Keynes' ideas about human behavior is found in what Malkiel calls the "greater-fool theory" in which, "It's perfectly alright to pay three times what a stock is worth as long as later on you can find some innocent to pay five times what it's worth."

Since Keynes' time, there have been many other developments in such Behavioral Finance that are discussed later.