CFP Class 2 - Module 3 - Modern Portfolio Theory and Behavioral Finance

Strong Form of the Efficient Market Hypothesis

A perfect market. All information is simultaneously available to all investors at no cost. Not even inside information would provide superior results. There is no way to outperform the market consistently.

Capital Asset Pricing Model - Risk Free Asset

A debt security that ideally will have no interest rate risk, inflation risk, liquidity risk or default risk. Typically Treasury bills. This asset has an expected return below the minimum variance standard deviation portfolio on the efficient frontier.

Modern Portfolio Theory Terminology: Security market line (SML)

A graph showing the relationship between systematic risk measured by beta and the required return for an investment for any given level of risk. The CAPM determines the SML.

Capital market line (CML)

A graph showing the relationship between total risk or standard deviation and return for a portfolio with risky securities combined with a risk-free asset. As riskier securities are added, standard deviation goes up, required return also goes up to compensate for additional risk.

Loss Aversion

A loss has about 2.5 times the impact of a gain of the same magnitude. Related to fear of regret. Explains why many investors will not sell anything at a loss. Having valuation targets for entry and exit points for a given security takes emotion out of the process.

SML Undervalued

A stock above the SML is undervalued because its expected return is higher than the required return plotted on the SML. An investor should want to purchase Stock B.

SML Overvalued

A stock below the SML is overvalued because its expected return is lower than the required return plotted on the SML. Might choose to short Stock C or simply choose not to invest in it.

Arbitrage Pricing Theory (APT) vs. Efficient Market Hypothesis (EMH)

APT analysts who anticipate information about a company, the economy, or the direction of interest rates may be able to achieve superior risk adjusted investment results. The EMH, however, says no analyst can consistently use APT principles to achieve superior results.

APT vs CAPM - Variables affecting stock prices

APT: Multivariate model that recognizes that variables other than market return and beta can affect stock prices. CAPM: Assumes that only a market return and a beta with respect to that market are necessary to explain all stock returns.

APT vs CAPM - Relationship between risk and return &Factors that affect returns

APT: Relationship between a stock's return and its risk not a straight line. Factors that can affect returns sector influences and systematic influences. CAPM: Assumes a straight line relationship between risk and return. Only factor explaining returns stock's beta.

Low P/E Effect.

According to this anomaly, investing in stocks with low price-to earnings ratios is the best way to make money in the market. Studies have shown that generally low P/E stocks do outperform high P/E stocks over time.

Core/Satellite Asset Allocation - Satellite

Add return, diversification, and/or reduce risk. Might include actively managed small-cap funds, real estate investment trusts, commodity funds, sector funds, junk bond funds containing low-grade bonds for higher yield etc. that hopefully outperform the overall market.

Arbitrage Pricing Theory (APT) Factors 1 of 2 - Sector Influences

Affect a company's industry. For example, factors that affect a bank are different from the factors that affect an airline.

Arbitrage Pricing Theory (APT) Factors 2 of 2 - Systematic Influences

Affect businesses generally. For example, all businesses are affected by changes in interest rates and by changes in overall economic activity.

Life Cycle Analysis - Three of Four Phases - Spending

After retirement, expenses funded by withdrawals from investment portfolios/retirement plans. Investment time horizons can still be long, with joint life expectancies of 20 years or more. Equities at a lower percentage since can't make up for large investment losses.

Markets in Equilibrium

All assets should plot along the SML. Expected return for any asset should be equal to its required return. The return should be consistent with the asset's systematic risk and the prevailing SML.

Capital Market Line (CML) Market Portfolio and Beta

All portfolios (including the market portfolio) on the CML have a correlation coefficient of +1.0 with one another and are fully diversified. When a correlation coefficient of +1.0 is plugged into the formula, beta becomes the standard deviation of the portfolio divided by the standard deviation of the market.

Size Effect

Also referred to as the "small-firm effect." Studies have shown that over time, small firms do outperform large firms. Bear in mind, though, that the variability of returns or standard deviation of small firms can be nearly twice that of large firms.

Arbitrage Pricing Theory (APT) Factors

An unspecified number of general factors are used. How a company reacts to these general factors varies. The sensitivity of a security to the general factors is estimated, and a risk premium assigned to each of the factors. The security's required return is then computed.

Arbitrage

Arbitrage buying an asset in a market where it is priced low and simultaneously selling it in another market where it is priced higher. As the overpriced and underpriced assets move closer to equilibrium in all markets, an investor profits as the spread decreases.

Sequential Risk

As a retiree makes withdrawals, the order or the sequence of annual investment returns is a primary concern particularly in the period just prior to or after retirement. 2008 a blow to the plans of many who were planning to retire around that time.

Capital Market Line Formula

Not needed for exam. Uses standard deviation not beta. The macro version of the CAPM. As you add riskier assets to the portfolio—both risk and return increase.

Semi-Strong Form Efficiency Tests: Predicting Cross-Sectional Returns

Assuming efficient markets, all securities should have equal risk-adjusted returns, as all should plot on the security market line (SML). Studies in this category attempt to determine if it is possible to predict future returns, given publicly available information. Anomalies evident.

Overconfidence or Optimism Bias

Illusions of control that can lead to biased judgments, investing too much in investments about which they know too little, taking undue risks, and failure to realize they are at an informational disadvantage to institutional investors.

Tactical Asset Allocation

Attempt to "beat the market." Periodic revision of the asset mix, moving funds from one category that appears to be overvalued to one that appears undervalued. Periodic revision of the asset mix, such as changing the stock allocation of the portfolio & market timing.

Behavioral Finance Includes Study of: (Continued)

Availability Bias, Status Quo Bias, Illusion of Control Bias, Endowment Bias

Two Primary Types of Representativeness

Base-rate neglect and sample size neglect. Applying an asset allocation strategy and sticking with it will help to counteract the effects of representativeness bias.

Stock Market Anomalies

Behavior that contradicts the efficient market hypothesis. Anomalies show possible to "beat the market." These anomalies have been identified and studied but can change and evolve over time. Investors have to be careful about treating these as trading rules.

Factors that support a specific form of the EMH or an anomaly to the EMH: an investor focuses on companies not followed by many analysts

Believes companies that are not covered much by analysts may be undervalued and thus may be good sources of investment opportunities. This investor believes in the neglected-firm anomaly.

Negative Beta and Expected Return

Beta for asset Z is negative (-.05). This is due to a negative correlation between the market portfolio and asset Z. An investor would be willing to pay for these negative beta assets in order to increase their portfolio's diversification, as measured by the correlation coefficient.

Capital Market Line Theoretical, Impossible in Real Investing

But allows people to see the risk and the potential return of various asset classes do increase along a relatively straight line. The significance of the capital market line is that it leads to the derivation of the security market line, which investors can and do use in practice.

Modern Portfolio Theory Terminology: Arbitrage

Buying a security in an underpriced market (e.g., the New York Stock Exchange) and simultaneously selling the same security in an overpriced market (e.g., the Chicago exchange) to profit from the difference in price between the two markets.

Can the Markowitz model by itself be used to select an optimal portfolio for an investor?

By itself, the model does not identify the optimal portfolio, only the efficient frontier of portfolios. The optimal portfolio occurs at the point of tangency of the indifference curve and the efficient frontier. Must combine efficient frontier and investor's willingness to bear risk.

Capital Market Line and the Risk Free Asset

CML extends from the risk-free asset (Rf), and it is tangent to the efficient frontier. Since portfolios combining the risk free asset and the Market efficient portfolio dominate, investors purchase only the risk-free asset and Portfolio M which consists of a proportional share of all risky assets that exist.

Capital Market Line vs. Security Market Line

CML: Macro. Risk/return relationship for portfolio that contains all risky assets that exist, with cash equivalents being used to lower the risk of the market portfolio. Standard deviation used as a measure of risk. SML: Micro. Risk/return for individual/portfolio of securities. Beta used.

Weak Form of the Efficient Market Hypothesis: Only form where fundamental analysis has a role

Can't achieve above-average returns consistently using trading rules based upon historical information so technical analysis of no value. However, fundamental analysis can help investors spot information errors and potentially find undervalued and overvalued securities.

Arbitrage Pricing Theory (APT) Four Unanticipated Factors Having Greatest Impact on Stock Returns

Changes in inflation, interest rates, industrial production/gross domestic product & risk premiums.

Dynamic Asset Allocation or "Dynamic Hedging Strategy"

Changes the asset mix as the market changes. The risky assets are sold to buy riskless assets as the portfolio loses value, and riskless assets are liquidated in favor of risky assets as their values rise. Takes constant analysis. Primary users institutional investors.

Core/Satellite Asset Allocation

Combination of strategic and tactical asset allocation. Portfolio divided into core holding of stocks and bonds, often in low-cost, broad-based index mutual funds or exchange-traded funds (a basket of stocks or bonds that follow an index and trade like stock), and a satellite portion.

MPT 7 Model Assumptions: There are no transaction costs.

Commissions, fees, and taxes are nonexistent. Moreover, every investment is perfectly divisible. Investors are able to trade securities on a fractional basis.

Semi-Strong Form Efficiency Tests: Predicting Cross-Sectional Returns - Neglected Firm Effect

Companies followed by few analysts outperformed companies followed by many analysts

Capital Asset Pricing Model (CAPM) Formula

Compute the required return by adding a "risk premium" to the risk-free rate using the capital asset pricing model, or CAPM formula. ri = rf + (rm - rf)Bi

Factors that support a specific form of the EMH or an anomaly to the EMH: an investor concentrates on small-cap stocks for investment

Considering their risk, small-cap stocks perform better than can be expected. They have been identified as EMH anomalies.

For each of the following types of asset allocation decisions made, which kind of asset allocation strategy is being employed? Decision to allocate 75% to stock and bond index funds and 25% to investments adding diversification and/or reducing risk.

Core/satellite asset allocation

Seven Risk Tolerance Measurement Factors - Simulations such as Monte Carlo

Demonstrate the probabilities of achieving various levels of outcomes. Show investors how their present risk tolerance level may be too low or too high relative to their goals and can adjust accordingly.

Use in Portfolio Construction: Optimal Portfolio

Determine the specific combination of assets that will have the greatest probability of maximizing an investor's expected return at the investor's given level of risk.

Important Points with Portfolio Construction:

Diversification avoiding overlap, Correlation studies suggest 4 to 7 different asset classes sufficient but remember correlation can change, Efficient Portfolios or mean-variance optimization meaning lowest risk for a given return, Life Cycle Analysis, Risk tolerance.

Efficient Market Hypothesis Skeptics:

Don't believe entire stock market is efficient, but rather different parts of the market have varying degrees of efficiency. Many believe large-cap stocks more efficient than small-caps, so buy a large cap index fund but buy an actively managed fund for the small-cap allocation.

Life Cycle Analysis - One of Four Phases - Accumulation

Early career phase. Income tends to be low but growing, assets small debt high. Home biggest asset, growing balances in 401(k). Liquidity and insurance for cash needs important. Higher risk growth investments to match long investment time horizons but may be risk averse.

Seven Risk Tolerance Measurement Factors - Psychographics

Emotions in addition to risk and loss aversion. Questionnaires often include categories like methodical, cautious, individualistic, and spontaneous. "Methodical" or "cautious" more risk averse, "individualists" or "spontaneous" less risk averse.

Name the behavioral bias being exhibited: a client does not have a realistic expectation of what the value is of an investment they want to sell

Endowment bias

Semi-Strong Form Efficiency Tests

Evidence is mixed. Event studies tends to validate the semi-strong hypothesis, while return prediction studies and predicting cross-sectional returns both provide evidence that security markets are not semi-strong efficient.

Assumptions Forming Basis for the Efficient Market Hypothesis (EMH)

Expected return for each security reflects its risk. Current price may not be correct, but it is unbiased. Sometimes it will be too high, at other times too low. However, one should not be able to predict the direction of the error if the capital market is informationally efficient.

Capital Market Theory

Extends the Markowitz portfolio theory by developing a mathematical model for pricing risky assets. This model, the capital asset pricing model (CAPM), provides a required rate of return for any risky asset and has two forms, macro and micro.

Efficient Market Hypothesis (EMH): Random Walk Hypothesis

Future stock prices random. Doesn't mean security prices themselves are randomly determined, rather all the information up to this point has been priced into the security. Future price movements based on future information. Random as we don't know the future.

Mental Accounting Example

Gift from a grandparent might seem more valuable than the same dollar amount earned from a job so invested more conservatively than money earned because losing "Grandma's" money would be more traumatic than losing one's own money.

Availability Bias

Giving more importance to data or information that is easy to obtain. For example, in an annual report, it is easy to find the earnings per share for a company, but reading the financial footnotes takes more effort to interpret.

Seven Risk Tolerance Measurement Factors - Proximity and Priority of Goals

Goals with time horizons of five years or less funded with low-risk investments; exceeding five years can be funded with higher-risk investments, such as stocks. In most cases, if funds are going to be needed within the next five years should not be in the stock market.

Modern Portfolio Theory Terminology: Efficient frontier

Graph that represents various combinations of securities plotted so that a maximum expected return is shown for each incremental risk level. In other words, for any given level of risk there is an optimal return.

Indifference Curve

Graphical expression of utility function of expected return and risk. At a certain point an investor is "indifferent" to the amount of risk they are taking to achieve that return. Investor willing to take on risk as measured by standard deviation in order to achieve a certain return.

Arbitrage Pricing Theory and Unexpected Changes in the Factors

Have the greatest impact. Expected changes will have already been incorporated into a security's price. An analyst's ability to anticipate the unexpected changes will have the greatest impact on a security's required return.

Seven Risk Tolerance Measurement Factors - Liquidity Available

High liquidity and job stability can afford to take higher risks Individuals now change jobs more often during their working lives than did previous generations. This may mean that individuals need more liquidity now than was necessary in the past.

Efficient Frontier Provides:

Highest return at any given level of risk; or lowest risk at any given level of return. All of the portfolios that lie within the parabola, or not on the frontier, are inefficient. Choose portfolios along efficient frontier most aligned with risk preference.

Explain how portfolio risk is used to develop the efficient frontier in the Markowitz model

Horizontal axis measures the risk vertical axis the portfolio's expected return. Various combinations of securities plotted and a curve emerges defining efficient set or frontier of portfolios offering highest return for any given level of risk.

Life Cycle Analysis - Two of Four Phases - Consolidation

Mid-to-late career income exceeds expenses peak productivity. Large home equities, retirement funds, large net worth or catch-up time if not true. Investment time horizons still long.

Markets in Disequilibrium

If expected return greater than the required return, the asset would be considered undervalued and would plot above the SML. Likewise, if the expected return was less than the required return, the asset would be considered overvalued and would plot below the SML.

Efficient Market Hypothesis (EMH) & Random Walk Hypothesis vs. Technical Analysis

If markets truly efficient, technical analysis has no use, as attempts to predict future price movements based on past price movements. Technical analysts don't believe future prices are random, can be predicted. Contradicts efficient market and random walk.

Representativeness: Base-Rate Neglect

Investors attempting to determine the potential success of a new investment by comparing it to an already understood category or previously held investment. Essentially, the investor relies on stereotypes.

Four Asset Allocation Strategies

In practice, there are four basic forms of asset allocation: strategic, tactical, core/satellite, and dynamic. Only the first three strategies are typically employed by individual investors.

Capital Market Line vs. Straight Market Line

In reality, most assets (both individual securities and portfolios) within the real life market portfolio (often the S&P 500 index) contain some unsystematic risk and are not perfectly positively correlated with the real-life market portfolio so use security market line (SML), CAPM micro version.

Market Risk Premium

In the Capital Asset Pricing Model = market return minus return of the risk free asset (rm - rf)

Arbitrage Pricing Theory (APT)

In the capital asset pricing model, a single factor, a security's beta with respect to the market portfolio, is used to value assets. The APT is a multi-factor alternative to the CAPM. Under the APT, the market portfolio no longer plays a pivotal role in pricing assets.

Historical Security Market Information

Includes historical sequences of prices, rates of return, trading volume, odd-lot transactions, block trades, and exchange specialists' transactions. This type of info used by technical analysts to try to predict the market as don't believe it is already factored into the price.

Indifference Curve

Indicates an investor's willingness to bear risk. The investor has the same level of satisfaction from any of the combinations of risk and return shown by all the alternatives on the curve.

MPT 7 Model Assumptions: Free Access to Info

Investors have free access to all information relevant to investment decision making. Thus, there is no privileged access to inside information.

Four primary factors Affect a Stock's Return under Arbitrage Pricing Theory:

Inflation, Industrial production or changes in gross domestic product, Risk premiums, and Yield curves or interest rates. Not a comprehensive list. APT highly dependent on person performing the analysis and the factors they are using. CAPM more commonly used.

Efficient Capital Market

Informationally efficient. That is, security prices adjust rapidly to the arrival of new information, and current security prices reflect all information about the security. Assumes investors behave rationally, and use information in a rational way.

Overcoming Overconfidence

Investing zero sum game. For every seller there is a buyer. If one made the correct decision the other did not. Stay objective. Post-investment analysis separates successful investment decisions from the poor ones, patterns to establish rules or reminders to avoid unprofitable trades.

Representativeness: Sample-Size Neglect

Investor failing to accurately consider the sample size of the data used to make a judgment. The investor makes an assumption that a small sample size is representative of the larger body of data.

Mental Accounting House Money Effect Distracts from Considering Portfolio as a Whole

Investor more conservative when reinvesting $1,000 initial "real" investment and tend to take greater risks with $3,000 profit. Similar to a gambler thinking of the $3,000 as the "house's money" and if it is lost, well, it was not really the gambler's money to begin with.

MPT 7 Model Assumptions: Investors Risk Averse

Investors are risk averse. Investors prefer higher returns to lower returns, given the same level of risk. Likewise, investors prefer less risk to more risk, given the same level of expected return.

Modern Portfolio Theory Summary

Investors are trying to obtain the optimal amount of return they can for the level of risk that they are taking.

Disequilibrium Correction

Investors purchase undervalued assets and sell (or short) overvalued ones. Creates excess demand for undervalued assets driving prices higher and excess supply of overvalued assets forcing prices down until all profit opportunities gone and prices at equilibrium on SML.

Overlap

Investors who own too many large-cap funds may find that the top 10 holdings of each fund have many of the same stocks. This is known as an overlap effect.

Framing

It matters how a concept is presented to an individual. People pick different answers because of how the questions are asked or framed. Many guilty of just focusing on gains and losses, buying things on "sale". Should look at big picture and affect on wealth/meeting goals.

Semi-Strong Form Efficiency Tests: Return Prediction Studies Four Most Significant Anomalies 1 to 2

January anomaly: buy stocks, especially small stocks, in December and sell in January. Dividend-yield anomaly: stocks with high dividend rates outperform those with low dividend rates.

Eight Common Stock Market Anomalies

January effect, Dividend-yield anomaly, Weekend effect, Low P/E Size or small firm effect, BV/MV effect, Neglected-firm effect, Value Line effect: Stocks rated 1 in Value Line outperform stocks rated 5

Representativeness

Judgments based on stereotypes. Method brain uses to classify things rapidly and create shortcuts. Overly negative about investments that have done poorly in the past and overly positive about investments that have done well. Focus on past performance.

Five More Truly Efficient Market Assumptions

Large number of competing participants. Information readily available. Transaction costs small or zero. Security cannot be overvalued or undervalued. Investor cannot outperform or underperform the market. Will earn a return commensurate with risk.

Minimum Variance Frontier

Large parabola. Traces the outside of all the portfolio combinations that an investor could possibly choose from. Theoretically, this includes every publicly traded asset, as well as every non-publicly traded asset globally.

Mean-Variance Optimization

Look at the return or the mean and the standard deviation or the variance of each asset, as well as the correlation of each asset with every other asset. The goal is to put together "optimal" portfolios.

Behavioral Finance Includes Study of:

Loss Aversion, Fear of Regret, Overconfidence (or Optimism Bias) Representativeness, Framing, Rationalization or Confirmation Bias, Cognitive Dissonance Bias, Hindsight Bias, Self-Attribution Bias, Anchoring, Recency, Mental Accounting, Money Illusion,

Seven Risk Tolerance Measurement Factors - Loss Aversion Continued

May also choose to hold on to loss making investments. The pain one feels from a loss is greater than the joy one feels from a gain; which may help to explain why individuals hold on to losing investments—they do not want to feel the pain.

Core/Satellite Asset Allocation - Core

May represent 60% to 80% of the total portfolio. This portion may be further divided into, say, 60% stocks and 40% bonds, and maintained at those proportions through periodic rebalancing.

Semi-Strong Form Efficiency Tests: Event Studies

Measure how returns react to significant economic news. If markets efficient, expect most of the reaction or abnormal returns to occur around the time of the event. Returns should adjust quickly to the new information, and one should not be able to profit by acting after the event.

Second Form of CAPM: Security Market Line (SML)

Micro version looks at risk and return as applied to a specific asset. The risk used to calculate the SML is beta. SML is the one widely used by analysts since it is applicable with both individual stocks and funds. If exam refers to CAPM and does not specify, assume SML.

Name the behavioral bias being exhibited: a client wants a 5% return and does not take into account what the inflation rate may be

Money illusion

Weak Form Efficiency Tests: Trading Rules Generally Prove Weak Form Holds Up

Most research has shown the weak form holds up. That is, investors using technical trading rules based solely on past market information do not consistently obtain above-average returns but those using fundamental analysis may.

Most Investors Over-Diversified

Not all that many individual securities are required to eliminate unsystematic risk. Some suggest 10 to 15 large cap U.S. stocks in different industries are sufficient others say 20 to 40 required. Over 75% own more than 10 mutual funds in their portfolios.

Weak Form Tests: Random Information

New information is assumed to come to market in a random nature, security prices should follow a random sequence. If prices did not follow a random sequence, investors would derive trading rules to profit from the non-randomness of the price movements.

Efficient Frontier - No Portfolio Superior

No single portfolio on the efficient frontier is superior to any other single portfolio on the frontier. Each portfolio has a different risk level and a return consistent with that risk level.

Efficient and Attainable or Feasible but Inefficient or Inferior Portfolios:

Offer an inferior return for a given amount of risk. Inefficient because the investor can get a higher return without increasing risk or get the indicated return at a lower risk level. Efficient portfolios have highest return for a given level of risk or lowest risk for a given level of return.

Strategic Asset Allocation - Rebalancing

Once the asset mix is determined and the weights such as 60% stocks, 30% bonds, and 10% cash equivalents are assigned, balance within the portfolio should remain the same/within assigned range through rebalancing, effectively buying low and selling high.

Adherents to Efficient Market Hypothesis Buy:

Only index funds, because it is impossible to beat the market if you believe that stocks cannot be undervalued.

Dividend-Yield Anomaly

Over time, stocks paying higher dividend rates tend to outperform stocks paying lower dividend rates.

Semi-Strong Form Efficiency Tests: Predicting Cross-Sectional Returns - Most Common Anomalies

P/E ratio anomaly: low P/E stocks experience superior future returns compared to the returns of high P/E stocks. Size effect: small companies outperform large ones. BV/MV anomaly: companies with high book value to market value ratios outperform those with low ratios.

Status Quo Bias

People faced with a selection of choices tend to choose whatever option ratifies, confirms, or continues the existing situation. Inertia. We've always done it this way. Can be very strong.

Which one of the two companies would be most affected by unanticipated changes in the factors indicated: Electric utility or food retailer when interest rates unexpectedly increase

People must purchase food regardless of interest rate levels. Electric utilities are very highly leveraged, and increased interest rates have a direct impact on their net profit. The value of the utilities' securities would decrease.

Mean-variance Optimization

Requires looking at the return and standard deviation of each asset, as well as the correlation of each asset with every other asset. Portfolio reallocations should be designed to move the portfolio closer to the efficient frontier curve. Many use software to help.

Use in Portfolio Construction: Efficient Frontier

Plot th.e various combinations of security portfolios that represent the optimal combination of assets for any specific level of risk that an investor is willing to bear.

Markowitz Portfolio Theory (MPT)

Portfolio model showing how to derive the expected return and risk for a portfolio and how to achieve effective diversification. Standard deviation is the measure for portfolio risk. Achieve the best return for any given level of risk.

Money Illusion

Preferring high nominal rates or prices even if real inflation-adjusted rates or prices actually higher. Choice of 7% gain when inflation is 8% or 4% gain when inflation is 2%, most choose 7% gain. In real terms, however, the investor would be better off in the 2% inflation scenario.

Random Walk Hypothesis

Price movements unpredictable/unrelated to a price change yesterday or any other day. Doesn't mean security prices randomly determined. Trading rules cannot lead to superior security selection. Although price changes random, prices do tend to rise over long periods.

Efficient Market

Prices fully reflect all known information quickly and accurately, new information generated randomly, security's equilibrium price true valuation; thus can't consistently beat the market i.e., earn excess returns over time. Analysis to discover mispricing useless.

Weekend Effect

Research has found that stocks tend to peak in value on Friday, and generally decline in value on Monday. Buy late Monday, and sell on late Friday. The problem with this anomaly is that over time the price movements may not be enough to cover transaction costs.

Capital asset pricing model (CAPM)

The investment model that establishes the link between an investment's risk, as measured by its beta, and its required return. The formula for the CAPM is: ri = rf + (rm - rf)Bi

Seven Risk Tolerance Measurement Factors - Loss Aversion

Psychological concept in which a gamble is preferred over a certain negative outcome with the same expected value. If confident of losing money on a certain stock may be willing to make a high-risk investment in another stock in an attempt to overcome the expected loss.

Seven Risk Tolerance Measurement Factors - Risk Aversion

Psychological concept where a sure, certain positive outcome is preferred over a gamble with the same expected value; it holds for gains with large probabilities. 6% per year in a bond preferred over higher risk, potentially higher return of an equity investment.

Utility Function

Reflects a given investor's trade-off between risk and return.

Fear of Regret

Regret is more than experiencing the pain of a loss. The pain of feeling responsible for the loss. Educate clients to accept that losses happen for everyone at some point while maintaining the appropriate level of overall risk in the portfolio based upon the client's goals.

Normalcy Bias

Related to anchoring. Refusal to plan for, or react to, a major event that has never happened before. Investors may put blinders on and not want to acknowledge, much less react to, events that could be real game changers. Objectively question security's value

Life Cycle Analysis - Four of Four Phases - Gifting

Relatively high net worth/inability to outspend retirement assets, begin gifting programs to relatives/charities. Growth assets generally gifted to those with longer time horizons, with donor retaining income-producing assets. Estate planning important.

Name the behavioral bias being exhibited:. a client makes investment decisions based upon stereotypes

Representativeness

Weak Form Tests: Trading Rules

Researchers also have considered trading rules that use data other than security prices. Trading rules using odd-lot volume, advance/decline ratios, short sales, and other market-generated information have generated mixed results.

Weak Form Tests: Random Information Weak Form Holds Up

Researchers have found that no one can tell what the return of a security will be tomorrow based on the return today. Weak form holds up.

Rationalization or Confirmation Bias

Search for and rely on information that supports their decisions. Give too much importance to information that confirms one's impressions or preferences. Seek out both opposing and corroborating info.

Strategic Asset Allocation

Seeks asset mix that will provide optimal balance between expected risk and return for a long investment horizon: mean-variance optimization. Creates efficient portfolios from different asset classes. Closely related to modern portfolio theory.

Two Types of Cognitive Dissonance in Decision Making

Selective perception when only register information that affirms an already chosen decision. Related to rationalization or confirmation bias. Selective decision making when commitment to an original decision high. Rationalizes actions to adhere to original decision.

Name the behavioral bias being exhibited: a client blames others for his losses while taking personal credit for any gains

Self-attribution bias

Anamolies

Superior returns.

Strong Form Efficiency Tests

Show Strong Form does not hold.

January Effect Anomaly Timing

Small stocks outperform the market in January, especially during the first five days. More and more investors have become familiar with it and have tried to benefit from it. As a result of this the January effect has begun to occur sooner, now in December or even earlier.

Efficient or Mean Variance Frontier

Some portfolios are better than others. Those portfolios lie on the efficient frontier section of the boundary in the parabola. Per modern portfolio theory, a risk-averse investor would limit their portfolio choices to the upper boundary of the investment opportunity set.

Neglected Firm Effect

Some studies show stocks followed by few or no analysts tend to outperform stocks followed by many analysts. Some believe the neglected firm effect is just an extension of the small firm effect, since many "neglected" firms also tend to be small.

The Book Value (BV) to Market Value (MV) Effect

Some studies show stocks with high book values, relative to their market value, tend to outperform stocks with lower book value, relative to their market value. The higher the book value relative to market value, the more likely the stock may be undervalued.

Name the behavioral bias being exhibited: a client believes that the U.S. stock market will always bounce back quickly as it has done in the past

Status quo bias

For each of the following types of asset allocation decisions made, which kind of asset allocation strategy is being employed? Decision to maintain an allocation of 60% stocks and 40% fixed income.

Strategic asset allocation

Market Anomaly

Strategy or situation that cannot be explained away and that would not be expected to occur if the efficient market hypothesis were completely true.

January Effect Anomaly

Strives to take advantage of lower prices in December in part due to tax selling, and then sell at higher prices at the beginning of the year. Studies done in countries that don't have our tax laws also found abnormal returns in January, so tax selling may not be the reason or the entire reason.

Semi-Strong Form Efficiency Tests: Event Studies Results

Studies found price adjustments did occur quickly with stock splits, initial public offerings, listing on an exchange, and responses to unexpected world events and surprise economic announcements. Event studies generally confirm the validity of the semi-strong form.

Fundamental Analysis

Studies of the EMH generally do not support the strong form only the weak and semi-strong forms. Fundamental analysis considered valuable under the EMH weak form. Analysts may be able to uncover mispriced securities that others have overlooked.

For each of the following types of asset allocation decisions made, which kind of asset allocation strategy is being employed? Decision to reallocate 40% of fixed income to intermediate-term bonds and 60% to short-term bonds.

Tactical Asset Allocation

Efficient Market Hypothesis Summary:

Technical analysis no use in any of the forms. Strong: nothing works to achieve superior returns, not inside or public info. Semi-strong: only inside info can produce superior returns, public info cannot. Weak: Fundamental analysis may provide superior returns or "anomalies".

Self-Attribution Bias

Tendency to ascribe successes to talent or foresight, while blaming failures on others or outside influences. The two primary types of bias are self-enhancing bias or irrational degree of credit for successes and self-protecting bias or irrational denial of responsibility for failure.

Anchoring

Tendency to hold to certain beliefs even when faced with new information that should alter those beliefs, thereby creating, in effect, tunnel vision. Underreact to new information.

Semi-Strong Form Efficiency Tests: Return Prediction Studies

Test whether there is any public information that will provide superior results for either a short-term or long-term time horizon. The studies assume that, in an efficient market, the best estimates of future rates of return are the long-run historical rates of return. Semi-Strong form failed.

First Form of CAPM: The Capital Market Line (CML)

The "macro" version looks at risk and return as applied to a portfolio of risky assets and the risk used to calculate the CML is standard deviation.

Beta of 1 and Expected Return

The expected return increases (decreases) as the level of systematic risk increases (decreases). The expected return of asset Y (beta 1.0) is the same as the expected return of the market portfolio. Required return simply sum of the risk-free rate and market risk premium since beta is 1.

Market Return by Definition is:

The return for all risky securities that exist in the world. In the real world, however, the market portfolio generally is an index, such as the S&P 500. If know the beta relative to the market index, can compute the required return for the security/portfolio.

Which one of the two companies would be most affected by unanticipated changes in the factors indicated: Casino Operator or Forest Products Company when inflation rises

The casino operator would experience little impact when inflation rises; people tend to gamble regardless of economic conditions. Forest companies have majority of net worth tied up in trees; rise in inflation tends to substantially increase the value of their inventories.

Foreign Investing and the Efficient Market Hypothesis

The factors that may make the markets for many listed stocks efficient in the United States may not exist in foreign markets or in the U.S. markets for real estate, art, etc. Info often limited and inaccurate, and dissemination narrow. The EMH does not apply to all assets in all markets.

Endowment Bias and Inherited Assets

The endowment bias tends to be strong with inherited assets. Adviser should explore reasons to continue holding the "endowed" assets. Adviser could ask client what they would have done if they had inherited a like amount of cash versus the assets that they did receive.

Straight Line Between Risk and Reward

The introduction of the risk-free asset results in a transformation of the efficient frontier from a curved line to a straight line. As a consequence, we can see that a straight line relationship exists between risk and reward.

When the Capital Market Line Turns Into the Security Market Line Continued

The former capital market line, valid only for fully diversified portfolios, now is transformed into the security market line. With SML does not matter whether the portfolio is fully diversified. It intersects the Y-axis at the risk-free rate and slopes upward to the right, just like the capital market line.

Seven Risk Tolerance Measurement Factors - Life Cycle Phase

The four phases are accumulation, consolidation, spending, and gifting.

Factors that Affect the SML - Inflation

The intercept and slope of the line change due to changes in the variables that affect the economy. Inflation expected to increase affects all assets, regardless of risk level. Would cause a parallel shift to the left in the SML (risk free assets making higher returns.)

MPT 7 Model Assumptions: Investors have homogeneous expectations regarding return and risk for all the investment opportunities available in the market.

The investment opportunity, set in the dimension of risk and return, is identical for all investors. Thus, any given investor's investment choice depends on their indifference curve, which reflects the risk/return trade-off of that investor.

Indifference Curve: Flat vs. Sloped

The more risk averse an investor is, the steeper the slope. Conversely, the less risk averse an investor is, the flatter the slope for that investor's indifference curve. Choose the portfolio along the efficient frontier that maximizes expected utility.

When selecting portfolio managers, investors should pay attention to:

The number of holdings typically held by a manager. Can eliminate most unsystematic risk by holding several mutual funds with concentrated portfolios or with one large balanced mutual fund. Don't need many funds to eliminate unsystematic risk from a portfolio.

MPT 7 Model Assumptions: Investors have a common one-period investment horizon.

The period can cover any length of time. Short as a day or as long as a year. An investor tries to make an optimal investment decision to maximize expected utility. While investors prefer more wealth to less wealth, the utility increases at a diminishing rate as wealth increases.

Modern Portfolio Theory Terminology: Optimal portfolio

The portfolio that maximizes an investor's expected return consistent with that investor's given level of risk.

Factors that Affect the SML - Investor's Degree of Risk Aversion

The price of risk or the market risk premium (rm - rf) would change, causing the slope of the SML to change. This change in the price of risk would only affect risky assets; there would be no impact on the risk-free rate of return. Slope goes up, less risk averse stays flatter.

Capital Market Line Market Portfolio

The relevant portfolio against which all investment decisions are made. Fully diversified and contains no unsystematic risk. All assets located on the line are perfectly positively correlated (+1.0 correlation coefficient) with the market portfolio.

Use the Security Market Line to Determine:

The return that we "should" earn, if we know the risk level we are willing to endure. Provides the level of required return for an individual asset based on the asset's level of systematic risk. Using CAPM formula.

Investment Opportunity Set

The set of asset combinations inside the parabola. The set of all possible portfolios in the investment universe.

Factors that Affect the SML - Investor's Degree of Risk Aversion Continued

The slope of the SML becomes steeper when investors in general become more risk averse than before. Investors would require a higher return to bear the same risk level as before or that they would be willing to assume less risk for the same expected return.

Behavioral Finance

The study of investor behavior. Looks at the emotions, irrational decision-making, and biases that can come into play when individuals invest and handle money and can help clients avoid money traps.

Factors that support a specific form of the EMH or an anomaly to the EMH: an investor in Starbucks is concerned about the company's inventory costs, and he takes a trip to South America to investigate coffee production

This investor is obtaining information that is private and not generally available to all investors; therefore, he believes in the semi-strong form of the EMH.

MPT 7 Model Assumptions: Investors make investment decisions based on expected return and risk only

Their utility function or satisfaction level is set in the dimension of expected return and risk, with risk being measured by standard deviation.

MPT 7 Model Assumptions: The capital market is perfectly competitive.

Therefore, no one is able to manipulate the market.

Semi-Strong Form of the Efficient Market Hypothesis

Trading rules based upon information after it becomes publicly available should not result in consistently above-average returns so fundamental analysis useless, with the exception of inside, or private, information which may not be reflected in the security's value.

Mental Accounting

Treating one dollar different from another depending on where it comes from, where it is kept, and how it is spent. Focus should be on total portfolio returns, and not on which bucket or account has higher or lower returns.

Semi-Strong Form Efficiency Tests: Return Prediction Studies Four Most Significant Anomalies 3 to 4

Unanticipated earnings anomaly: Favorable earnings announcements: result in immediate price adjustments. Weekend-effect anomaly: buy on Mondays.

Unattainable or Nonfeasible Portfolios

Unattainable or nonfeasible portfolios do not exist i.e., there is no such combination of risk and return that is achievable for an extended period of time.

Semi-Strong Form of the Efficient Market Hypothesis - Inside Information

Use of this type of information may be illegal if it is considered inside information or private information known by officers, directors, or major stockholders. Consequently, the only way to "beat the market" under the semi-strong form is to trade in inside information.

Value Line Effect

Value Line Investment Survey gives a rating for timeliness, with "1" the highest rating, and "5" the lowest. Research has shown investing in stocks ranked "1" over time has provided superior results, but frequent trading will increase transaction costs and reduce returns.

Endowment Bias

Value an owned asset more than those that are not owned. One result is a tendency to demand a higher price to sell an owned asset, along with requiring a lower price to purchase an unowned asset. Ownership "endows" a given asset with added value.

Alternative Forms of the Efficient Market Hypothesis: Three Categories of Efficient Market Hpothesis (EMH)

Weak form, semi-strong form and the strong form. With all three current security prices reflect all historical security market information.

Factors that support a specific form of the EMH or an anomaly to the EMH: An investor studies corporate annual reports before making decisions about buying a stock

When an investor uses fundamental information to make decisions about companies, they believe in the weak form of the EMH. Return

Cognitive Dissonance

When newly acquired information conflicts with preexisting understandings, people often experience mental discomfort.. Significant rationalizations to maintain psychological stability not always in investor's best interest. Two Types.

When the Capital Market Line Turns Into the Security Market Line

With a portfolio with a limited number of not fully diversified assets the correlation coefficient of the portfolio with the market portfolio is not a perfect +1.0. Beta becomes not directly proportional to standard deviation. Correlation coefficient becomes an important element of the equation.

Capital Market Line Graph

With the macro version of the CAPM, as you add riskier assets to the portfolio both risk and return increase causing line to go up and out further when return on vertical access and risk on horizontal access.

Use in Portfolio Construction: Capital Asset Pricing Model & Capital Market Line

a. Determine the required return for a security when the risk-free rate, the market return, and the security's beta are known. b. Establish the relationship between risk and return for a fully diversified market portfolio.

Use in Portfolio Construction: Security Market Line & Arbitrage

a. Establish the relationship between risk and return for an individual security or for a portfolio of securities. b. Identify mispriced securities, especially when a single security is selling at different prices in different organized markets.

Assume that the risk-free rate is 5% and the expected return on the market portfolio is 13%. Comparing four assets with betas of: W .8, X 1.5, Y 1, Z -.05. Based on CAPM, the required return (or the expected return in equilibrium) for each asset is:

rw = 0.05 + (0.13 - 0.05) 0.80 = 0.114, or 11.4% rx = 0.05 + (0.13 - 0.05) 1.50 = 0.17, or 17.0% ry = 0.05 + (0.13 - 0.05) 1.00 = 0.13, or 13.0% rz = 0.05 + (0.13 - 0.05) (- 0.50) = 0.01, or 1.0%