According to the book, A Random Walk Down Wall Street, by Burton Malkiel, there are two philosophies when it comes to ways to view the stock market and individual stock value. These are labeled "The Firm-Foundation Theory" and "The Castle-In-the-Air Theory." Let's look at them individually.
The firm foundation theory believes that a share in a company (a stock) has an inherent value. More importantly, you can discover that inherent value by inputting some numbers from the company's financial statements and calculating it. This is called fundamental analysis and includes the techniques of looking at the future cashflows of the company, calculating the present value of those cash flows and then dividing by the number of shares. The value you get, should be what the stock should be worth.
This is useful, because you if the stock price is actually higher, than you can guess it will fall back to its "inherent" value; conversely if it is lower, than you should buy, because the stock will rise to its inherent value. This sounds pretty good, but according to Malkiel, if we examine it closely, we start to see that it might not work.
First of all, you have to make hundreds of assumptions in order to calculate the future cashflows of the company. You have to make economic assumptions, such as where will interest rates be in the future? How about other economic variables like fuel prices, inflation, etc? Do these things affect the company you are looking at?
Another factor that is disheartening is normally, the final value you arrive at is never right. If you realize that, you will be farther than most. Now, what you have to do is determine if the market price is really the inherent value or if your assumptions are correct. Sensitivity analysis helps with this a little, but even then does this help you pick winning stocks? Malkiel says, "no."
The second theory is the "Castle-in-the-air" theory. The basis of this theory is that stock prices are not based on a rational number such as inherent value, but more on what people believe the stock should be worth. The theory speculates that investors' emotions and other personal issues can strongly affect their buying and selling decisions, and this is what really has an effect on the market price. If you can figure out their psychology, then you can beat the market. An implied belief also means that every time a stock is sold, it is being sold to a "sucker." The seller is just trying to sell the stock to someone who is willing to buy it at a higher price, not because of inherent value, but because the that buyer thinks the stock will go higher, while the seller does not.
Technical analysis uses this philosophy. These are people that study charts to find patterns in a stocks movement in the past, in order to predict the future. Rather than assume that stocks have inherent value and that their cashflows predict the value, they believe that indicators such as volume traded and the direction of the price charted can predict the future price. These people have patterns that they rely on and look for when analyzing a company. Malkiel shows that with different studies conducted, this doesn't hold much water.
So what does Malkiel think? He believes that the stock market is a "random walk" and that there is no way to predict individual prices into the future. He thinks that you can hold a broad portfolio (such as an index fund) and do better than people trying to beat the market. Why? Because the market in general, is moving up and providing a return. Each of the individual stocks are in the market and "you will not be compensated for risk you take that you can diversify away." That's true in the long run and most of us invest in stocks to plan for retirement.
This is a great book, not specifically for these opinions but because even though Malkiel believes that an index fund is the way to go, he still surveys every other product out there from futures to REITs to fine art investment and gives his opinion on it in simple to understand prose. If you're interested in stocks, you should check it out.
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