On the way home from Houston I finished the 8th edition of A Random Walk Down Wall Street. It covered the two major schools of camp on stock pricing in detail: firm foundations and castles in the air. Firm foundation believers seek to determine a stock’s proper value or “the worth of any share as the present value of all dollar benefits the investor expects to receive from it.” Most firm foundation followers assume that the market is 90% logical and 10% psychological. Castle in the Air believers are chartists and believe that past history grants clues to future behavior. Most castle in the air believers assume that the market is 90% psychological and 10% logical. They seek to anticipate the behavior of the other players in the game. Will there be a bigger fool to buy this stock later?

It appears from the evidence presented that the stock market is very efficient at pricing itself. The exact level at which the stock market is efficient appears to be debatable. However, the historical data currently suggests almost no pricing inefficiencies exist that are large enough to take advantage of and make money (after transaction costs and taxes are subtracted). Luck would explain the extraordinary performance of most at picking stocks. The nature of averages is a few investors will have extraordinary results, just as a few people will flip tails consistently when engaged in a coin flipping contest (with a fair coin).

Modern Portfolio Theory (MPT) assumes all investors are risk averse and want high returns with guaranteed outcomes. Harry Markowitz invented this theory in the 1950s and for his contribution received the Nobel Prize in Economics in 1990. Basically, this theory uses diversification among asset class to manage risk.

The Capital-Asset Pricing Model (CAPM) says that the total risk of each security is irrelevant as far as extra results go. The important component of risk is the systematic part, since given a sufficient pool of stocks the unsystematic risk (or specific risk) can be eliminated. (The specific risk of all the stocks in a given portfolio balance each other out and go to 0 with a sufficient pool, usually > 60 issues.) Consequently the CAPM asserts to get a higher average return you should increase beta (systematic risk) in your portfolio. However, study of the beta to return relationship of all stocks over the 1963-1990 period (of all New York, American, and NASDAQ exchange issues) didn’t support this theory.

Definitely read this book if you are interested in stock pricing theory!