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

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