Investments - Ch 10,11,12
Efficient Market
- Any information that could be used to predict stock performance should already be reflected in stock prices - New information must be unpredictable, if it could be predicted then the prediction would be part of today's information
APT Basics
- Assumes a well-diversified portfolio, but residual risk is still a factor - Does not assume investors are mean variance optimizers - Uses an observable market index - Reveals arbitrage opportunities (a small number of sophisticated investors intervene and correct any type of mispricing) - Individual investors do not really matter much => they are price takers
Technical analysis
- Attempts to exploit recurring and predictable patterns in stock prices to generate superior investment performance - As traders become overconfident, they may trade more inducing an association between trading volume and market returns - Uses volume data as well as price history to direct trading strategy
Prospect Theory
- Behavioral (as opposed to rational) model of investor utility - investor utility depends on changes in wealth rather than levels of wealth - Higher wealth provides higher satisfaction or utility, but at a diminishing rate (the curve flattens as the individual becomes wealthier) - Investors will reject risky propsects that don't offer a risk premium - Utility depends not on the level of wealth, but on changes in wealth from current levels
Bubbles and market efficiency
- Bubble: Prices appear to depart from any semblance of intrinsic value - Arise when a rapid run up in prices creates a widespread expectation that they will continue to rise - During periods of stability and rising prices, investors extrapolate that stability into the future and become more willing to take on risk - Risk premiums shrink leading to further increases in asset prices, and expectations become even more optimistic in a self-fulfilling cycle
Bubbles and behavioral economics
- Bubbles are a lot easier to identify as such once they are over - While they are going on, irrational exuberance is less obvious, and many financial commentators during the dot com bubble justified the boom as consistent with glowing forecasts for the new economy
Cumulative Abnormal Returns Efficient Market
- CAR should not go up/down after the event because if it is efficient it should fully reflect this information at time 0 and then should go back to the new equilibrium price - During event we have a jump - in line with EMH - After the event CAR is flat, meaning the market is efficient because it fully incorporates the info quickly and then we have a new equilibrium price
Well diversified portfolios
- Cause the firm specific component to go away => firm specific risk can actually be diversified away - Portfolio spread out over many securities in such a way that the weight in any security is close to zero, resulting in negligible diversifiable risk - Variance of firm specific component will go towards 0 as n increases
Framing
- Decisions are affected by how choices are described - Whether uncertainty is posed as potential gains from a low baseline level or as losses from a high baseline level - Express strategy in terms of gains more likely you will accept, express strategy in terms of losses more likely you will decline - Way you frame it will affect your tolerance of risk
Lucky event issues
- Don't hear about the big losers, only about the big winners - Someone might be big winner due to luck not skill - The winners turn up in the WSJ as the latest stock market gurus, then they can make a fortune publishing market newsletters
Emerging Markets and Small stocks
- Emerging markets that are less intensively analyzed that US markets or in which accounting disclosure requirements are less rigorous may be less efficient than US markets - Small stocks that receive relatively little coverage by Wall Street analysts may be less efficiently priced than large ones - Competition among these many well-backed, highly paid, aggressive analysts ensures that, as a general rule, stock prices ought to reflect available information regarding their proper levels
Magnitude Issue
- Event if I find an arbitrage opportunity in the market, as an individual investor I am going to receive a very small payoff simply because the capital that I allocate is very small as opposed to an institutional investor - To realize significant profits you need to place a very large order, something only a very large trader can do
January Effect
- Every jan the returns of stocks are much higher than other months - People sell stocks in Jan
HML
- Every month you buy high book to market stocks and every month you sell low book to market stocks - Extremely profitable strategy - High book to market ratio firms are relatively underpriced
Utility Function Under Prospect Theory
- Focuses on changes in wealth - when you take more losses you want to take more risks to be better off later - when you realize gains you have concave strategy -> loss aversion
Lucky Event Issue
- For every big winner, there may be many big losers, but we never hear of these managers - The winners turn up in the WSJ as the latest stock market gurus; then they can make a fortune publishing market newsletters
Mental Accounting
- Form of framing - Individuals mentally segregate assets into independent accounts rather than viewing them as part of a unified portfolio - Two accounts, one used to invest and one for education, take more from your account than the one for education - More risk with what you gained over past year because you did not have it a year ago
Momentum effect
- Good or bad recent performance continues over short to intermediate time horizons - While the performance of individual stocks is highly unpredictable, portfolios of the best performing stocks in recent past appear to outperform other stocks with enough reliability to offer profit opportunities
Tax considerations in security choice
- High bracket investors find it advantageous to buy tax exempt municipal bonds despite their relatively low pretax yields, whereas those same bonds are unattractive to low tax bracket or tax exempt investors - High bracket investors might want to tilt their portfolios in the direction of capital gains as opposed to interest income because capital gains are taxed less heavily and because the option to defer the realization of capital gains income is more valuable the higher the current tax bracket
Predictors of broad market returns
- If market is efficient it should not be able to predict stock market returns - Dividend yield very good predictor of stock returns, stock returns are high when dividend yield is high - Earnings to price ratio is also a strong predictor of stock returns - Bond yield is strong predictor
Active vs Passive portfolio management
- If the market is efficient then there is no mispricing on the market, so active management is fruitless
Resource allocation
- If we are in an inefficient market, have overvalued and undervalued securities in the market, we usually have systematic misallocation of resources - Overvalued securities that have less growth opportunities because they are overvalued can raise capital quickly => cost of capital is lower - Undervalued securities have more growth opportunities but they might invest in less projects because the cost of capital for them is much higher
P/E effect
- If you short stocks based on the Price to Earnings ratio, we find that low P/E stocks have exhibited higher average risk-adjusted returns than high P/E stocks - Risk adjustment important: could be case where once you control for risk, alpha goes away - If two firms have the same expected earnings, the riskier stock will sell at a lower price and lower P/E ratio => low P/E stock will also have higher expected returns
CAPM vs APT
- In capm we do not allow for mispricing, so alphas should be zero. - If there is mispricing, all of us act the same way because we are price makers - increase weight for positive alpha securities and decrease weight for negative alpha securities => this will correct the mispricing - In APT we are price takers. - Individual investors do not matter much => they cannot move prices. - If there is mispricing, we have a small number of sophisticated investors that we call arbitragers who are going to intervene on market and place a very large order and correct this mispricing
Limited Attention
- Individuals have limited time and attention and as a result may rely on rules of thumb or intuitive decision making procedures known as heuristics - If investors pay attention to "headline" earnings announcements, but comparitvely neglect the less apparent extent to which accruals management has been used to manipulate reported earnings - High P/E firms tend to be poor investments
Small firm effect
- Investments in stocks of small firms appear to have earned abnormal returns => tend to be riskier - Small minus big is the size factor where every month you buy small stocks and every month you sell large stocks => very profitable - Small firms more mispriced than big firms
Affect
- Investors don't look at performance of firm - Look at other characteristics (eg good work environment) - Affect associated with consumer perception of company that are associated with stuff other than performance of the firm
Overconfidence
- Investors overestimate their abilities and the precision of their forecasts - Why active strategies dominates - People are overconfident => they think they can beat the market
Interpreting the anomalies - risk premiums or inefficiencies
- Investors view the aditonal returns as a compensation for taking on more risk - Securities might be mispriced maybe for behavioral reasons - Analysts extrapolate past performance too far into the future and therefore overprice firms with recent good performance and underprice firms with recent poor performance - Analysts seem overly pessimistic about firms with low growth prospects and overly optimistic about firms with high growth prospects
Behavioral Biases
- Largely affect how investors frame questions of risk versus return and therefore make risk return trade offs
Information Leakage
- Leakage occurs when information regarding a relevant event is released to a small group of investors before official publlic release - Stock price might start to increase days or weeks before the official announcement date - Any abnormal return on the announcement date is then a poor indicator of the total impact of the information release
competition as the source of efficiency
- Many large players that correct mispricing quickly, helping market be more efficient in competitive markets - Investors will have an incentive to spend time and resources to analyze and uncover new information only if such activity is likely to generate higher investment returns
Implementation costs
- Many strategies are driven by the short leg of the trade - See there is mispricing but cannot exploit it - exploiting overpricing can be particularly difficult - short selling a security entails costs
CAPM basics
- Model is based on an inherently unobservable market portfolio Rests on mean-variance efficiency. The actions of many small investors restore CAPM equilibrium => no mispricing, investors will act exact same way and move prices (price makers)
Behavioral Finance
- Model of financial markets that emphasizes implications of psychological factors affecting investor behavior - We are not always rational - Investor decisions are subject to different biases - Leads to mispricing because not fully taking advantage of information - Can lead to post earnings announcement drift - We have limited info to news so we might end up with incorrect probability distribution of returns - Our decisions might be subject to different behavioral biases
Multifactor Model
- Model of security returns positioning that returns respond to several systematic risk factors as well as firm specific influences - Captures more information regarding systematic component - Gives us a simple way to measure investor exposure to various macroeconomic risk and construct portfolios to hedge those risk
Single Factor Model
- Model of security returns that decompose the sources of return variability into one systematic economy wide factor and firm specific factors - Because it is just single factor, you might leave other sources of risk outside your model - Decompose risk of security into two parts: systematic component and macro factor that captures economy wide events
Regret avoidance
- Notion from behavioral finance that individuals who make decisions that turn out badly have more regret when that decision was more unconventional - Invest in blue chip stock and goes bad blame bad luck - Invest in penny stock and goes bad blame yourself
Conservatism
- Notion that investor are too slow to update their beliefs in response to new evidence - Positive earnings surprise today (difference between actual earnings and expected) so we wait awhile and trade the info in a couple days - Security will be mispriced for a couple days - Initially underreact to news about a firm, so that prices will fully reflect new information only gradually
Sign of Efficient Market
- On the announcement day the CAR increases substantially, indicating a large and positive abnormal return on the announcement date - Immediately after the announcement date the CAR no longer increases or decreases significiantly - If insider trading rules were perfectly obeyed and perfectly enforced, stock prices should show no abnormal returns on days before the public release of relevant news because no special firm specific information would be available to the market before public announcement
Dot come bubble
- One case where the market is inefficient is the case where we have bubbles - Ex: dot com bubbles - Very hard to get a fundamental value of a tech company - High P/E ratio means company is a growth firm or that the firm is overvalued - In dot com bubble companies believed to have strong future growth opportunities but actually they were just overvalued
Weak form tests
- Patterns in stock returns
Serial Correlation
- Positive serial correlation means that positive returns tend to follow positive returns (a momentum type of property) - Negative serial correlation means that positive returns tend to be followed by negative returns ( a reversal or "correction" property)
Conventional finance
- Prices are correct and equal to intrinsic value - Resources are allocated efficiently - Consistent with EMH
Efficient Market Hypothesis
- Prices of securities fully reflect available information - Investors buying securities in an efficient market should expect to obtain an equilibrium rate of return - Current prices should fully reflect all the available info that comes from past prices, public info, and private info so there should be no further drift in prices after the announcement date - if the market is efficnet, there is no mispricing on the market because all the new available information is incorporate rapidly into prices
Interpreting the anomalies - anomalies over time
- Profitability for all anomalies went down over time because the market is more efficient - Easier for us to exploit mispricing
Event Study
- Research methodology designed to measure the impact of an event of interest on stock returns - Way to look at a response of prices of a particular event - assess the impact of a particular event on a firm's stock price
Technical Analysis
- Research to identify mispriced securities that focuses on recurrent and predictable stock price patterns and on proxies for buy or sell pressure in the market - if the price responds slowly enough, the analyst will be able to identify a trend that can be exploited during the adjustment period - The key to successful technical analysis is a sluggish response of stock prices to fundamental supply-and-demand factors - EMH implies technical analysis is fruitless - Once a useful technical rule is discovered, it ought to be invalidated when many traders attempt to exploit it
Interpreting the anomalies - anomalies or data mining
- Researchers spend a lot of time to come up with a new strategy which may be significant in the period they are looking at, but if you extend the period the strategy might not be significant anymore - Values stocks (defined by low P/E ratio, high book to marekt ratio, or depressed prices relative to historic levels) seem to have provided higher average returns than "glamour" or growth stocks
Abnormal Return
- Return on a stock beyond what would be predicted by market movements alone
Fundamental Risk
- Risk that even if an asset is mispriced, there is still no arbitrage opportunity because the mispricing can widen before prices eventually converges to intrinsic value - market can remain irrational longer than you remain solvent - mispricing can become more pronounced before it goes back to its fundamental value - mispricing can be persistent
Factor Beta
- Sensitivity of security returns to the realization of a systematic factor - Also called factor loading and factor sensitivity - Better estimate returns but also alphas of specific stocks - Whatever component has the highest absolute value of Beta that one is more sensitive - Can provide framework for a hedging strategy: investor concerned with exposure to macro factor might offset that risk by initiating a positon with equal but opposite exposure
Post earnings announcement post drift
- Should be flat after the announcement - Post earnings announcement drift where goes up for good announcement and down for bad - There is lagging adjustment of price to the new information allows us to make abnormal profits
Risk arbitrage
- Speculation on perceived security mispricing, often in connection with M&A targets - usually merger target firm is mispriced - risky
Two Factor Model
- Suppose the two most important macroeconomic sources of risk are uncertainty surrounding the state of the business cycle, news of which we will again measure by unanticipated growth in GDP, and changes in interest rates - Both os these macro factors have zero expectation: they represent changes in these variables that have not already been anticipated
Representativeness bias
- Tendency to believe that a small sample is reliably representative of a broad population and therefore to infer patterns too quickly - Analyze small set of stocks and draw conclusions from these stocks leading us to make mistakes - Infer a pattern too quickly based on a small sample and extrapolate apparent trends too far into the future
Returns over long horizons
- Tests of long-horizon returns have found suggestions of pronounced negative long term serial correlation in the performance of the aggregate market - Over long horizons, extreme performance in particular securities tends to reverse itself: the stocks that have performed best in the recent past seem to underperform the rest of the market in following periods, while the worst past performers tend to offer above average future performance
Portfolios with different betas
- Their risk premiums must be proportional to beta - If a market index portfolio is well diversified its return will perfectly reflect the value of the macro factor - The risk premium measure the distance between the risk free rate and expected return on the portfolio - to preclude arbitrage opportunities, the expected return on all well diversified portfolios must lie on the straight line from the risk free asset
Are Markets Efficient
- There are enough anomalies in the empirical evidence to justify the search for underpriced securities that clearly goes on - The market is competitive enough that only differentially superior information or insight will earn money
Forecasting errors
- Too much weight is placed on recent experiences - Instead of processing info we keep in mind what we recently did and use this to make decisions
Cumulative abnormal return
- Total abnormal return for the period surrounding an announcement or the release of information - Used to try to see if there is information leakage before the announcement - Captures the total firm specific stock movement for the entire period that the market might be responding to new information
Model risk
- Use your own model and miss some factors - Use right model or else will make incorrect investment decisions
Returns over short horizons
- Very profitable using momentum strategy - Every month you allocate stocks into portfolio based on the cumulative return of each stock over the previous year and then sort stocks into portfolio based on cumulative - Stocks with highest returns are winners and lowest returns are losers - Return of momentum strategy can be viewed as compensation for taking on more risk - Past winners continue to appreciate in the future and past losers continue to perform poorly in the future - Very profitable strategy not just in stocks but across all other classes - Clear violation of weak form of market efficiency
Selection Bias Issue
- We hear more about unsuccessful strategies than successful strategies - We don't see the full story and most often hear about unsuccessful strategies which implies the market efficient but might not be true - Only unsuccessful investment schemes are made public, and good schemes remain private - We cannot fairly evaluate the true ability of portfolio managers to generate winning stock market strategies
Factor portfolio
- Well diversified portfolio constructed to have a beta of 1.0 on one factor and a beta of 0 on any other factor - factors are not correlated with each other - Independent sources of systematic risk
When does arbitrage opportunity arise
- When an investor can earn riskless profits without making a net investment
Four factor alpha
- Whenever we want to assess the performance of a mutual fund manager, we focus on the well-known four factor alpha - Alpha of an asset pricing model based on events that are augmented
Arbitrage
- Zero risk, zero net investment strategy that still generates profits - exploit stock mispricing in such a way that you will earn risk free profits - long short strategy (long=buying, short=selling, buy securities where security is cheap and sell where expensive) - Investors like to have infinite position in these types of strategies
SML
- all portfolios that satisfy no arbitrage opportunity should lie on the SML - If we have a portfolio with the same B but not on the SML this is an arbitrage opportunity
Semi Strong Form of EMH
- asserts that stock prices already reflect all publicly available info - current prices should fully reflect all information that comes from past prices and all publicly available info - should already be reflected in prices so you cannot use technical analysis to predict future prices
Weak form
- asserts that stock prices reflect all information contained in the history of past prices, trading volume, or short interest - current prices should fully reflect all of the info that comes from past prices - should not be able to find a recurrent pattern in the data of prices - if the market is efficient you should not be able to utilize info that comes from past prices to predict future prices and you should not be able to find any predictable patterns - If past prices every conveyed reliable signals about future performance, all investors already would have learned to exploit them
Strong form of EMH
- asserts that stock prices reflect all relevant info, including inside info and info only available to insiders - should fully reflect all the info that comes from past prices, publicly available info, and private info - very hard to access
Fundamental analysis
- assessment of firm value that focuses on such determinants as earnings and dividends prospects, expectations for future interest rates, and risk evaluation - attempt of different analysts to try to identify the fundamental value, increasing the value of the firm - use different valuation models to come up with the fundamental value of the firm and then compare this with the market value of the firm to see whether the securities are overvalued, undervalued, or fairly priced
Information processing
- depends on having limited access to the news, don't process information correctly - errors in information processing can lead investors to misestimate the true probabilities of possible events or associated rates of return
Random walk
- describes the notion that stock price changes are random and unpredictable - If prices are determined rationally, then only new info will cause them to change - A random walk would be the natural result of prices that always reflect all current knowledge
Neglected firm and liquidity effects
- investments in stocks of less well known firms have generated abnormal returns - analysts don't pay too much attention to these types of stocks -> they care more about large stocks (amazon, tesla) - tend to be more mispriced, might trade less of these securities so don't correct mispricing
Small minus big
- return on a portfolio of small stocks in excess of the return on a portfolio of large stocks - all of these stocks are long short portfolios - buy small stocks and sell big stocks - has very important information for intersection of stock returns - buy small stocks every month and sell big stocks every month
High Minus Low
- returns on a portfolio of stocks with high book to market ratio in excess of the return on a portfolio of stocks with low book to market ratio - buy stocks with high book to market every month and sell stocks with low book to market every month - an asset pricing model
Law of One price
- rule stipulating that equivalent securities or bundles of securities must sell at equal prices to preclude arbitrage opportunities - whenever we see a deviation from one price, arbitragers will intervene very quickly and correct the mispricing very quickly - they will bid up the price where it is low and force it down where it is high until the arbitrage opportunity is eliminated
F
- unobserved factor that captures different economic events and captures systematic component of the securities - the deviation of the common factor from its expected value
Reasons behind irrationalities of investors
1. Investors do not always process information correctly and therefore infer incorrect probability distribution about future rates of return 2. Even given a probability distribution of returns, they often make inconsistent or systematically suboptimal decisions
Conventional Utility Function
As wealth increases, utility increases at a diminishing rate
Arbitrage Pricing Theory
Asset pricing theory that is derived from a factor model, using diversification and arbitrage arguments - describes the relationship between expected return and factor exposure that follows from risk free arbitrage opportunities - In well functioning markets, arbitrage opportunities doe not persist and will go away very quickly - Speed with which you can transact is extremally important
Rational risk based pricing
Can be used to calculate the alpha of a security
EMH $20 Analogy
Don't bother picking up $20 off the ground because if the bill were real someone would have picked it up The market is efficient, so there is no arbitrage opportunities for us to explore because if it were very competitive someone would have already done it
Which security do you go long and which short
Go long on the security with high returns Short the security with low returns
Growth and Profitability as predictors of stock returns
Growth: more rapidly growing firms tend to have lower future returns Profitability: gross profitability seems to predict higher stock returns
Strong form tests
Inside information Insiders trade on information to make a profit - We do not expect markets to be strong form efficient; we regulate and limit trades based on inside information - Stock prices tend to rise after insiders intensively bought shares and fall after insiders intensively sold shares - If markets are efficient, fully and immediately processing that information, an investor should not be able to profit from following those trades
Reversal effect
Losers rebound and winners fade back, suggests that the stock market overreacts to relevant news After the overreaction is recognized, extreme investment performance is reversed
Semi strong tests
Market anomalies
Magnitude issue
Only managers of large portfolios can earn enough trading profits to make the exploitation of minor mispricing worth the effort
Anomalies
Patterns of returns that seem to contradict the EMH Strategies we cannot explain
Arbitrage opportunity
Portfolios that have exact same sensitivity with market factor (Beta) should offer the exact same returns. If not we have an arbitrage opportunity
Earnings Surprise
The difference between the announcement of actual earnings to the value previously expected by marekt participants
Multifactor model interpretation
The expected return on a security is the sum of... - the risk free rate (captures time value of money => compensation to waiting) - the sensitivity to GDP times the GDP risk premium - the sensitivity to interest rate risk times the interest rate risk premium
e
The firm specific component that you can minimize by holding well-diversified portfolio
Winners Minus Losers
The return on a portfolio that buys recent well performing stocks and sells poorly performing ones
CAR Ineffieicent
There will be a post announcement drift and the price will continue to go up/down
Resistance level
price level above which it is supposedly difficult for a tock or stock index to rise
Support level
price level below which it is supposedly difficult for a stock or stock index to fall
