The New Yorker Magazine this week features a review of two investment classics, Benjamin Graham’s The Intelligent Investor and Burton Malkiel’s A Random Walk Down Wall Street. Benjamin Graham, one of the teachers of billionaire investor Warren Buffert, comes down on the side of financial entrepreneurship. Based on simple mathematical models using the future profits of a business, he provided analytical methods for estimating the “intrinsic value” of its securities - the price that an informed investor would pay to purchase the asset. The intelligent investor will apply Graham’s methods to company financials, looking for bargains: companies selling for less than their intrinsic value.
According to the Austrian school, profit opportunities always exist somewhere, no less in the financial markets, because in a constantly changing world prices can never all converge to their equilibrium values. However, modern finance would dispute this. According to the Efficient Market Hypothesis, securities prices always and at all times are trading at a value that incorporates the best judgement of the most informed investors, taking into account all relevant information. This view is expounded by academic finance professor Burton Malkiel in his book. All that effort that Warren Buffet spent investing in companies was a waste of time, according to Malkiel, because individual investors cannot profit from the purchase and sale of securites. Better to just buy a passively managed mututal fund that tracks the S&P 500 and benefit from the gradual appreciation of stocks over time. Never mind that Malkiel himself owns actively managed mutual funds.
The New Yorker article concludes with a discussion of the emerging field of behavioral finance, that is attempting to study and quantify some of the more stable patterns that have occurred in securities prices, and Malkiel’s response.