The Contrarian View

There are a substantial number of investors and academics that do not think the careful analysis of companies will tell us anything about the price of a stock.  In Burton Malkiel’s modern investment classic A Random Walk Down Wall Street, the author describes two fundamental paradigms of stock pricing.  The fundamental analysis described in this section is known as the Firm Foundation Theory, and the competing paradigm is the Castles in the Air Theory.  The basic premise of the book is that the stock market is mostly efficient and most investors are wasting their time trying to find inefficiencies to exploit.  The counterargument to fundamental analysis, then, is that every other investor had access to the same information that you did, and had the opportunity to value stocks based on that information as you have.  We will explore the psychological and often irritation implications of this theory in the next section.

Malkiel has at least a modicum of respect for fundamental analysis because it is based on a foundation of empirical logic (what social scientist could hate that?) and is open to accepting wide varieties of data from different sources.  However, he finds fundamental analysis to be deeply dysfunctional as a predictor of stock prices.  The fault of fundamental analysis is that it doesn’t take into account the effects of unpredictable events and irrational behaviors.  Random events (e.g., 9/11), unreliable financial data from companies (e.g., Enron), human psychology (emotional attachments, irrational fears, irrational exuberance, and so forth), the loss of good analysts to better positions, and other things conspire to move prices in ways that are not predicted by fundamental analysis.

Simply put, Malkiel concludes that professional analysts may possess a slight edge on retail investors simply because they tend to have more readily available news and other cues.  The advantage, Malkiel argues, is minimal.  If the advantage does exist at all, high fees will quickly eat it away, so there is no advantage to putting your money into a managed fund.

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