Tuesday, December 1, 2009

Understanding Wall Street

The book Understanding Wall Street by Jeffrey Little and Lucien Rhodes is in its fifth edition and has a history going back 30 years and over a million books sold. The main strengths of this book are the wide range of investing concepts explained with clear language. The main weaknesses, although relatively minor, are the authors’ curious biases and the fact that the book hasn’t quite been updated for the internet age.

The main topics covered are

– the nature and history of different types of investments including stocks, bonds, commodities, and derivatives
– accounting basics and the various fundamental analysis ratios such as price/earnings, dividend yield, and several others
– technical analysis
– the history of Wall Street and some of its colourful personalities
– price bubbles through history

Newspaper and the Internet

Curiously, a separate section is devoted to the internet, rather than just mentioning its use as necessary in the other sections. Some of the discussion of investment information is still discussed in terms of newspaper listings. Although the book’s contents are definitely still relevant in the modern world, the incomplete update for this edition undermines the reader’s confidence. Hopefully the sixth edition will turn newspaper listings into a footnote and focus on how people really get investment data.

The Iraq War

The most amusing part of the book was a brief and pointless foray into politics: “The recent wars in Iraq and elsewhere in that region are additional examples of U.S. altruism.” There is plenty to debate about the Iraq war, but few would call it U.S. altruism.

Traditional vs. Discount Brokers

“A good stockbroker ... can be worth his or her weight in gold.” The authors endorse the traditional stockbroker saying that most investors “need the extra assistance ... that a so-called full service brokerage firm can provide.” Discount brokers “are worth considering if the investor expects to be independent and active.”

Inactive index investing through a discount broker may not be for everyone, but it has many advantages that deserve to be included in a book like this one. The brief discussion of ETFs that focuses mainly on leveraged ETFs and narrow ETFs is further evidence that the passive indexing approach was not seriously considered for discussion in this book.

Technical Analysis

The authors devote considerable space to various types of technical analysis. For the uninitiated, technical analysis is where investors study charts of stock prices and share volume to try to guess whether a stock is headed up or down.

The authors are quite positive about the usefulness of these techniques. I’m sceptical. Most of the methods seem subjective and there are so many different methods. For a given stock at a given time, there will be some methods that give the correct answer and others that give the wrong answer. The problem is that a different subset of techniques gives the right answer each time.

The authors allow that “chart patterns are never 100% reliable.” I’d say that they are about 50% reliable, or about as good as tossing a coin.

Stock Options

“The most reliable and effective technical indicators are found among stock option statistics. Options players ... are wrong more often that they are right.” I don’t know if this is true, but it won’t make options traders happy.

“Writing covered calls and writing naked puts (but strictly against shares that the investor intends to purchase anyway) are the two best and most consistently profitable applications of stock options.” If this is true, then options must be consistently overpriced so that the option writer is favoured over the option buyer.

In a section that does an otherwise good job of explaining the costs associated with option trading, the authors miss bid-ask spreads as a significant cost. The bid-ask spreads on options tend to be larger than those of stocks.


Overall, this book is a useful primer and reference for a broad range of investing concepts. Its shortcomings are minor.

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