Description
Stock prices and corporate financial variables have certain fundamental characteristics that can be used to derive estimates of the future. These estimates, in turn, can be applied to evaluate investment decisions and to help set corporate financial policy. The fundamental characteristics of stock prices and financial variables therefore constitute the basis for determining what kinds of statements can and cannot be made about the future.
The most fundamental feature of stock prices, corporate sales, and earnings is that these variables bear a very close resemblance to a random walk-typified by a drunk, wander-ing over a plain. It follows then, that first differences in the natural logarithms of these variables approximate a random series. While a random walk would seem to defy making any estimates about the future, it nevertheless has two major characteristics that are extremely important and useful:
1. A random variable (like first differences in the logs of stock prices) conforms to an approximately normal distribution. As the most common distribution in the world, the normal distribution is well-known and has been studied extensively. We can use that knowledge about the normal distribution to estimate the probability of future occurrences. The application of the normal distribution gives us an approximate and very powerful tool for making estimates about the probabilities of future changes in stock prices and in other financial variables.
2. The dispersion of a random variable, measured by the standard deviation, rises with the square root of the holding period, or time.
This square-root-of-time rule is true of differences in the logs of stock prices, earnings, and other financial variables. The rule applies both to the dispersion of a single series, such as the price of Microsoft and to the cross-section dispersion, or the dispersion across stocks. Cross-section dispersion is like the dispersion of particles of smoke emerging from a chimney. The particles gradually spread out in the sky.
ISBN: 9837201495
