Random Walk Summaries - Chapter 1 Firm Foundations and...

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Chapter 1 – Firm Foundations and Castles in the Air What is a Random Walk? - One in which future steps cannot be predicted on the basis of past actions. Distinguishing investing from speculating - The definition of the time period for the investment return and the predictability of the returns that often distinguish an investment from a speculation. - This book is not for speculators, it is for investors. Two approaches to asset valuation: Firm Foundation Theory and Castle in the Air Theory. The Firm Foundation Theory - each investment instrument has a firm anchor (called an intrinsic value) - 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. - S. Eliot Guild and John B. Williams are credited with originating this theory - The theory stresses that a stock’s value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends - Warren Buffet followed this approach The Castle-in-the-Air Theory - concentrates on psychic values - John Maynard Keynes is credited with discovering this theory. - He says that the successful investor tries to beat the odds by estimating what investment situations are most susceptible to public castle-building and then buying before the crowd. - It applies psychological principles rather than financial evaluation to the study of the market. - The theory essentially says that you can buy something for three-times what it is worth as long as you think that you can sell it to someone else for five-times what it is worth. Chapter 2 – The Madness of Crowds The Tulip Bulb Craze - A get-rich-quick binge of the early 17 th century. - History: o A botany professor from Vienna brought to Leydan (Holland) a collection of tulips (which were unusual at the time) that had originated in Turkey.
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o The Dutch were fascinated with the flowers, but were angry about the price. o A thief broke into the professor’s house and stole the bulbs, which were subsequently sold at a lower price but at greater profit. o These became expensive, highly coveted items in Dutch gardens. o Many flowers succumbed to a virus called mosaic which gave them a contrasting color. These diseased tulips were called bizarres and sold for a premium. o Tulip prices rose dramatically, and the higher the price, it was thought, the better the investment. o Everyone imagined that this craze would last forever. - The instruments that enabled tulip speculators to get the most action for there money was called call options . o The call option gave the holder the right to buy tulips at a fixed price during a specific period. - Eventually prices got so high that some people decided they would be prudent and sell their bulbs. Soon others followed suit. And eventually bulb deflation grew at an increasingly rapid pace.
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  • Fall '07
  • CURTIS,R.
  • stock markets

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