1 alpha, the capital markets, and the efficient markets hypothesis ( chapter 6) adapted from...
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Alpha, the Capital Markets, and Alpha, the Capital Markets, and the Efficient Markets Hypothesisthe Efficient Markets Hypothesis
((Chapter 6)Chapter 6)
Adapted from Portfolio Construction, Management, & Protection, 4e, Robert A. StrongCopyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.
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No matter how many winners you’ve got, if you No matter how many winners you’ve got, if you either leverage too much or do anything that either leverage too much or do anything that
gives you the chance of having a zero in gives you the chance of having a zero in there, it’ll all turn into pumpkins and mice.there, it’ll all turn into pumpkins and mice.
Warren BuffettWarren Buffett
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OutlineOutline
IntroductionIntroduction
Alpha and Portfolio ManagementAlpha and Portfolio Management
Role of the Capital MarketsRole of the Capital Markets
Efficient Market HypothesisEfficient Market Hypothesis
AnomaliesAnomalies
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What is “alpha”?What is “alpha”? Alpha = the amount by which the market is beaten, after Alpha = the amount by which the market is beaten, after
adjusting for riskadjusting for risk What is alpha for the market as a whole?What is alpha for the market as a whole? Alpha for market as a whole is zeroAlpha for market as a whole is zero
– So, on average, portfolios are ON the SMLSo, on average, portfolios are ON the SML
Provides conceptual value of CAPMProvides conceptual value of CAPM– Regardless of whether market is efficient, it is still a zero-sum Regardless of whether market is efficient, it is still a zero-sum
gamegame
Burden of active managerBurden of active manager– In order to win (i.e., beat the market), someone else has to loseIn order to win (i.e., beat the market), someone else has to lose
Key question = what is special about you (and about Key question = what is special about you (and about your knowledge) that will allow you to be the one that your knowledge) that will allow you to be the one that wins?wins?
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Generating alphaGenerating alpha
Are there ways to consistently generate Are there ways to consistently generate alpha?alpha?
See portfolio manager performance See portfolio manager performance example:example:
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Portfolio Manager’s Performance:Portfolio Manager’s Performance:Past Three YearsPast Three Years
Previous Three Years: S&P 500 Fund
Manager
Compound Annual Return -4.98% -22.01%
Total Return -14.20% -52.56%
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Portfolio Manager’s Performance:Portfolio Manager’s Performance:Past Four YearsPast Four Years
Previous Four Years: S&P 500 Fund
Manager
Compound Annual Return 0.50% -14.19%
Total Return 2.02% -45.77%
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Portfolio Manager’s Performance:Portfolio Manager’s Performance:Past Five YearsPast Five Years
Previous Five Years: S&P 500 Fund
Manager
Compound Annual Return 3.17% -0.54%
Total Return 16.91% -2.67%
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Portfolio Manager’s Performance:Portfolio Manager’s Performance:Past Six YearsPast Six Years
Previous Six Years: S&P 500 Fund
Manager
No. of Down Years 2 of 6 4 of 6
Compound Annual Return 3.29% -1.66%
Total Return 21.47% -9.58%
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Generating alphaGenerating alpha
Would you have invested with this manager?Would you have invested with this manager?
Who is this manager with this horrible record?Who is this manager with this horrible record?
Warren Buffett, of course!!!Warren Buffett, of course!!!
Portfolio = investment in Berkshire-Hathaway, over Portfolio = investment in Berkshire-Hathaway, over the period of 1970 – 1975the period of 1970 – 1975
Note: while stock price lagged market Note: while stock price lagged market substantially, book value per share grew faster substantially, book value per share grew faster than market each year except 1975; this is a than market each year except 1975; this is a metric with which Buffett is more concernedmetric with which Buffett is more concerned
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Generating alphaGenerating alpha
As we have seen previously in discussing the EMH, value As we have seen previously in discussing the EMH, value stocks tend to outperform growth stocksstocks tend to outperform growth stocks
Concomitantly, Warren Buffett has the best investment Concomitantly, Warren Buffett has the best investment record in history, becoming the 2record in history, becoming the 2ndnd richest man in the world richest man in the world in the processin the process
However, as we have just now seen, although value wins However, as we have just now seen, although value wins on average, over the long run, it does on average, over the long run, it does notnot win perfectly win perfectly consistently!consistently!
Instead, the markets tend to cycle, with different styles of Instead, the markets tend to cycle, with different styles of investment performing well at different timesinvestment performing well at different times
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Book to Market as a Predictor of Return:Book to Market as a Predictor of Return:Value (positive Value (positive ) tends to outperform Growth (negative ) tends to outperform Growth (negative ))
ValueValue
GrowthGrowth
0%0%
5%5%
10%10%
15%15%
20%20%
2525%%
Annualiz
ed R
ate
of
Retu
rnA
nnualiz
ed R
ate
of
Retu
rn
1010998877665544332211
High Book/Market Low Book/MarketHigh Book/Market Low Book/Market
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Rolling Annualized Average 5-year Difference Rolling Annualized Average 5-year Difference Between the Returns to Value and Growth Composites:Between the Returns to Value and Growth Composites:
The Market cycles between Value and Growth,The Market cycles between Value and Growth,But Value Wins on AverageBut Value Wins on Average
-20%-20%
-10%-10%
0%0%
10%10%
20%20%
30%30%
40%40%
50%50%
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iffere
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iffere
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Empirical Regularities:Empirical Regularities:Sources of alphaSources of alpha
Three categories that tend to outperform over the long run:Three categories that tend to outperform over the long run:
– ValueValue stocks vs. Growth stocks stocks vs. Growth stocks
– SizeSize: Small caps tend to outperform large caps: Small caps tend to outperform large caps
– MomentumMomentum: stocks with momentum (earnings or price) tend to beat stocks : stocks with momentum (earnings or price) tend to beat stocks without momentumwithout momentum
However, the payoffs to all of these tend to cycle!However, the payoffs to all of these tend to cycle!
– A typical portfolio manager, being judged on a quarter-by-quarter basis, A typical portfolio manager, being judged on a quarter-by-quarter basis, would have been fired long before if he had the same record as Buffett for would have been fired long before if he had the same record as Buffett for 1970 – 1975!1970 – 1975!
– (In fact, he fired himself during this period!)(In fact, he fired himself during this period!)
None of these beats the market perfectly consistentlyNone of these beats the market perfectly consistently
– A typical portfolio manager would need to try to cycle along with the market, A typical portfolio manager would need to try to cycle along with the market, in order to keep from ever lagging too far behind itin order to keep from ever lagging too far behind it
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Empirical Regularities:Empirical Regularities:Sources of alphaSources of alpha
Beating the market consistently would require some sort of Beating the market consistently would require some sort of rotation strategy in order to profit from the type of securities rotation strategy in order to profit from the type of securities that are performing well in the given type of marketthat are performing well in the given type of market
But - combination of “fat tails” and “volatility clustering” But - combination of “fat tails” and “volatility clustering” (discussed previously) can cause problems!(discussed previously) can cause problems!
– Best performance for a given style is likely to follow closely on the Best performance for a given style is likely to follow closely on the heels of its worst performance, and much of the movement for the heels of its worst performance, and much of the movement for the style is likely to come in a relatively short burst (thus, if you miss it, style is likely to come in a relatively short burst (thus, if you miss it, it’s gone)it’s gone)
– E.g.: 40% of the stock market gains for the entire decade of the E.g.: 40% of the stock market gains for the entire decade of the 1980’s occurred during a mere 10 trading days !1980’s occurred during a mere 10 trading days !
– So efforts to cycle with the market and keep from falling too far So efforts to cycle with the market and keep from falling too far behind it also make it much more difficult to beat the market!behind it also make it much more difficult to beat the market!
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Capital Market TheoryCapital Market Theory
Capital market theory springs from the Capital market theory springs from the notion that:notion that:
– People like returnPeople like return
– People do not like riskPeople do not like risk
– Dispersion around expected return is a Dispersion around expected return is a reasonable measure of riskreasonable measure of risk
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Role of the Capital MarketsRole of the Capital Markets
DefinitionDefinition
Economic FunctionEconomic Function
Continuous Pricing FunctionContinuous Pricing Function
Fair Price FunctionFair Price Function
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DefinitionDefinition
Capital markets trade securities with lives of Capital markets trade securities with lives of more than one yearmore than one year
Examples of capital marketsExamples of capital markets
– New York Stock Exchange (NYSE)New York Stock Exchange (NYSE)
– American Stock Exchange (AMEX)American Stock Exchange (AMEX)
– Chicago Board of TradeChicago Board of Trade
– Chicago Board Options Exchange (CBOE)Chicago Board Options Exchange (CBOE)
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Economic FunctionEconomic Function
The The economic functioneconomic function of capital markets of capital markets facilitates the transfer of money from savers facilitates the transfer of money from savers to borrowersto borrowers
– e.g., mortgages, Treasury bonds, corporate e.g., mortgages, Treasury bonds, corporate stocks and bondsstocks and bonds
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Continuous Pricing FunctionContinuous Pricing Function
The The continuous pricing functioncontinuous pricing function of capital of capital markets means prices are available moment markets means prices are available moment by momentby moment– Continuous prices are an advantage to Continuous prices are an advantage to
investorsinvestors
– Investors are less confident in their ability to get Investors are less confident in their ability to get a quick quotation for securities that do not trade a quick quotation for securities that do not trade oftenoften
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Fair Price FunctionFair Price Function
The The fair price functionfair price function of capital markets of capital markets means that an investor can trust the means that an investor can trust the financial systemfinancial system– The function removes the fear of buying or The function removes the fear of buying or
selling at an unreasonable priceselling at an unreasonable price
– The more participants and the more formal the The more participants and the more formal the marketplace, the greater the likelihood that the marketplace, the greater the likelihood that the buyer is getting a fair pricebuyer is getting a fair price
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Efficient Market HypothesisEfficient Market Hypothesis
DefinitionDefinition Types of EfficiencyTypes of Efficiency Forms of EfficiencyForms of Efficiency
– Weak FormWeak Form– Semi-Strong FormSemi-Strong Form– Strong FormStrong Form
Semi-Efficient Market HypothesisSemi-Efficient Market Hypothesis Security Prices and Random WalksSecurity Prices and Random Walks
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DefinitionDefinition
The The efficient market hypothesis (EMH)efficient market hypothesis (EMH) is the is the theory supporting the notion that market prices are theory supporting the notion that market prices are in fact fairin fact fair– Under the EMH, security prices fully and fairly (i.e., Under the EMH, security prices fully and fairly (i.e.,
without bias) reflect all available information about the without bias) reflect all available information about the securitysecurity
– Since the 1960’s, the EMH has been perhaps the most Since the 1960’s, the EMH has been perhaps the most important paradigm in financeimportant paradigm in finance
– Whether markets are efficient has been extensively Whether markets are efficient has been extensively researched and remains controversialresearched and remains controversial
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Types of EfficiencyTypes of Efficiency
Operational efficiencyOperational efficiency measures how well measures how well things function in terms of speed of things function in terms of speed of execution and accuracyexecution and accuracy– It is a function of the number of orders that are It is a function of the number of orders that are
lost or filled incorrectlylost or filled incorrectly– It is a function of the elapsed time between the It is a function of the elapsed time between the
receipt of an order and its executionreceipt of an order and its execution
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Types of Efficiency (cont’d)Types of Efficiency (cont’d)
Informational efficiencyInformational efficiency is a measure of is a measure of how quickly and accurately the market how quickly and accurately the market reacts to new informationreacts to new information– This is the type of efficiency with which the EMH This is the type of efficiency with which the EMH
is concernedis concerned– The market is informationally very efficientThe market is informationally very efficient
Security prices adjust rapidly and fairly accurately to Security prices adjust rapidly and fairly accurately to new informationnew information
However, as we’ve already seen, the market is still However, as we’ve already seen, the market is still not completely efficientnot completely efficient
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Forms of Market EfficiencyForms of Market Efficiency
Eugene Fama’s original formulation of the Efficient Eugene Fama’s original formulation of the Efficient Market Hypothesis established three forms of market Market Hypothesis established three forms of market efficiency, based on the level of information reflected in efficiency, based on the level of information reflected in security prices:security prices:
1.1. Weak formWeak form = prices reflect all past market level (price = prices reflect all past market level (price and volume) informationand volume) information
2.2. Semi-strong formSemi-strong form = prices = prices alsoalso reflect all publicly reflect all publicly available fundamental company and economic available fundamental company and economic informationinformation
3.3. Strong formStrong form = prices = prices alsoalso reflect all privately held reflect all privately held information that would affect the value of the company information that would affect the value of the company and its securitiesand its securities
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Weak FormWeak Form
DefinitionDefinition
ChartingCharting
Runs TestRuns Test
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DefinitionDefinition
The The weak formweak form of the EMH states that it is of the EMH states that it is impossible to predict future stock prices by impossible to predict future stock prices by analyzing prices from the pastanalyzing prices from the past
– The current price is a fair one that considers The current price is a fair one that considers any information contained in the past price dataany information contained in the past price data
– Charting techniques are of no use in predicting Charting techniques are of no use in predicting stock pricesstock prices
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Definition (cont’d)Definition (cont’d)
ExampleExample
Which stock is a better buy?Which stock is a better buy?
Stock A
Stock B
Current Stock Price
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Definition (cont’d)Definition (cont’d)
Example (cont’d)Example (cont’d)
Solution:Solution: According to the weak form of the EMH, neither According to the weak form of the EMH, neither stock is a better buy, since the current price already stock is a better buy, since the current price already reflects all past information. reflects all past information.
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ChartingCharting
People who study charts are People who study charts are technical technical analystsanalysts or or chartistschartists
– Chartists look for patterns in a sequence of Chartists look for patterns in a sequence of stock pricesstock prices
– Many chartists have a behavioral elementMany chartists have a behavioral element
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Runs TestRuns Test
A A runs testruns test is a nonparametric statistical is a nonparametric statistical technique to test the likelihood that a series of technique to test the likelihood that a series of price movements occurred by chanceprice movements occurred by chance
– A A runrun is an uninterrupted sequence of the same is an uninterrupted sequence of the same observationobservation
– A runs test calculates the number of ways an observed A runs test calculates the number of ways an observed number of runs could occur given the relative number of number of runs could occur given the relative number of different observations and the probability of this numberdifferent observations and the probability of this number
– These tests have provided evidence in favor of weak These tests have provided evidence in favor of weak form efficiencyform efficiency
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Conducting A Runs TestConducting A Runs Test
1 2
1 2
1 2 1 2 1 22
1 2 1 2
1 2
where number of runs
21
2 (2 )
( 1)
, number of observations in each category
standard normal variable
R xZ
R
n nx
n n
n n n n n n
n n n n
n n
Z
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Semi-Strong FormSemi-Strong Form
The The semi-strong formsemi-strong form of the EMH states that of the EMH states that security prices fully reflect all publicly security prices fully reflect all publicly available informationavailable information– e.g., past stock prices, economic reports, e.g., past stock prices, economic reports,
brokerage firm recommendations, investment brokerage firm recommendations, investment advisory letters, etc.advisory letters, etc.
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Semi-Strong Form (cont’d)Semi-Strong Form (cont’d)
Academic research supports the semi-Academic research supports the semi-strong form of the EMH by investigating strong form of the EMH by investigating various corporate announcements, such as:various corporate announcements, such as:– Stock splitsStock splits– Cash dividendsCash dividends– Stock dividendsStock dividends– Examined through “event studies”Examined through “event studies”
This means investors are seldom going to This means investors are seldom going to beat the market by analyzing public newsbeat the market by analyzing public news
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Market seems to do a relatively good job at adjusting a Market seems to do a relatively good job at adjusting a stock’s valuation for certain types of new informationstock’s valuation for certain types of new information
• Determining how much the new info. will change the stock’s value Determining how much the new info. will change the stock’s value and then adjusting the price by an equivalent amountand then adjusting the price by an equivalent amount
This is what event studies examineThis is what event studies examine
• But it does seem to have problems developing an overall But it does seem to have problems developing an overall valuation for a stock in the first place valuation for a stock in the first place
• E.g., What is the correct value for IBM as a whole is a very difficult E.g., What is the correct value for IBM as a whole is a very difficult question to answer, but how much IBM’s value should change if it question to answer, but how much IBM’s value should change if it is awarded a specific new contract is much easier to determineis awarded a specific new contract is much easier to determine
Semi-Strong Form (cont’d)Semi-Strong Form (cont’d)
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Semi-Strong Form (cont’d)Semi-Strong Form (cont’d)
Burton Malkiel points out that two-thirds of Burton Malkiel points out that two-thirds of professionally managed portfolios are consistently professionally managed portfolios are consistently beaten by a low-cost index fundbeaten by a low-cost index fund
– Suggests that securities are accurately priced and that Suggests that securities are accurately priced and that in the long run returns will be consistent with the level of in the long run returns will be consistent with the level of systematic risk takensystematic risk taken
Supports semi-strong form of the EMHSupports semi-strong form of the EMH
– Also would suggest that portfolio managers do not Also would suggest that portfolio managers do not possess any private information that is not already possess any private information that is not already reflected in security pricesreflected in security prices
Supports the strong form of the EMHSupports the strong form of the EMH
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Strong FormStrong Form
The The strong formstrong form of the EMH states that of the EMH states that security prices fully reflect all relevant public security prices fully reflect all relevant public and private informationand private information
This would mean even corporate insiders This would mean even corporate insiders cannot make abnormal profits by using cannot make abnormal profits by using inside informationinside information about their company about their company
– Inside informationInside information is information not available is information not available to the general publicto the general public
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Semi-Efficient Semi-Efficient Market HypothesisMarket Hypothesis
The The semi-efficient market hypothesis (SEMH)semi-efficient market hypothesis (SEMH) states that the market prices some stocks more states that the market prices some stocks more efficiently than othersefficiently than others
– Less well-known companies are less efficiently pricedLess well-known companies are less efficiently priced
– The market may be tieredThe market may be tiered
– A security pecking order may existA security pecking order may exist
– Lynch prefers stocks that “the analysts don’t follow … Lynch prefers stocks that “the analysts don’t follow … and the institutions don’t own …”and the institutions don’t own …”
– See the Small Firm and Neglected Firm Effects See the Small Firm and Neglected Firm Effects discussed laterdiscussed later
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Security Prices and Security Prices and Random WalksRandom Walks
The unexpected portion of news follows a The unexpected portion of news follows a random walkrandom walk
– News arrives randomly and security prices News arrives randomly and security prices adjust to the arrival of the newsadjust to the arrival of the news
We cannot forecast specifics of the news very We cannot forecast specifics of the news very accuratelyaccurately
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AnomaliesAnomalies
DefinitionDefinition
Low PE EffectLow PE Effect
Low-Priced StocksLow-Priced Stocks
Small Firm and Neglected Firm EffectSmall Firm and Neglected Firm Effect
Market OverreactionMarket Overreaction
Value Line EnigmaValue Line Enigma
January EffectJanuary Effect
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Anomalies (cont’d)Anomalies (cont’d)
Day-of-the-Week EffectDay-of-the-Week Effect
Turn-of-the Calendar EffectTurn-of-the Calendar Effect
Persistence of Technical AnalysisPersistence of Technical Analysis
Behavioral FinanceBehavioral Finance
Joint Hypothesis ProblemJoint Hypothesis Problem
Chaos TheoryChaos Theory
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DefinitionDefinition
A financial A financial anomalyanomaly refers to unexplained refers to unexplained results that deviate from those expected results that deviate from those expected under finance theoryunder finance theory
– Especially those related to the efficient market Especially those related to the efficient market hypothesishypothesis
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Low PE EffectLow PE Effect
Stocks with low PE ratios provide higher returns Stocks with low PE ratios provide higher returns than stocks with higher PEsthan stocks with higher PEs
– And similarly for high P/B (hence lower Book/Market) And similarly for high P/B (hence lower Book/Market) stocksstocks
Supported by several academic studiesSupported by several academic studies
Conflicts directly with the CAPM, since study Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)returns were risk-adjusted (Basu)
Related to both semi-strong form and weak form Related to both semi-strong form and weak form efficiencyefficiency
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Low-Priced StocksLow-Priced Stocks
Stocks with a “low” stock price earn higher Stocks with a “low” stock price earn higher returns than stocks with a “high” stock pricereturns than stocks with a “high” stock price
There is an There is an optimum trading rangeoptimum trading range
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Small Firm and Neglected Firm Small Firm and Neglected Firm EffectsEffects
Small Firm EffectSmall Firm Effect
Neglected Firm EffectNeglected Firm Effect
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Small Firm EffectSmall Firm Effect
Investing in firms with low market Investing in firms with low market capitalization will provide superior risk-capitalization will provide superior risk-adjusted returnsadjusted returns
Supported by academic studiesSupported by academic studies
Implies that portfolio managers should give Implies that portfolio managers should give small firms particular attentionsmall firms particular attention
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Neglected Firm EffectNeglected Firm Effect
Security analysts do not pay as much Security analysts do not pay as much attention to firms that are unlikely portfolio attention to firms that are unlikely portfolio candidatescandidates
Implies that neglected firms may offer Implies that neglected firms may offer superior risk-adjusted returnssuperior risk-adjusted returns
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Market OverreactionMarket Overreaction
The tendency for the market to overreact to The tendency for the market to overreact to extreme newsextreme news
– Investors may be able to predict systematic Investors may be able to predict systematic price reversalsprice reversals
Results because people often rely too Results because people often rely too heavily on recent data at the expense of the heavily on recent data at the expense of the more extensive set of prior datamore extensive set of prior data
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The Value Line EnigmaThe Value Line Enigma
Value Line (VL) publishes financial information on Value Line (VL) publishes financial information on about 1,700 stocksabout 1,700 stocks
The report includes a timing rank from 1 down to 5The report includes a timing rank from 1 down to 5
Firms ranked 1 substantially outperform the marketFirms ranked 1 substantially outperform the market
Firms ranked 5 substantially underperform the Firms ranked 5 substantially underperform the marketmarket
Victor Niederhoffer refers to Value Line’s ratings as Victor Niederhoffer refers to Value Line’s ratings as “the periodic table of investing”“the periodic table of investing”
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The Value Line EnigmaThe Value Line Enigma
Changes in rankings result in a fast price Changes in rankings result in a fast price adjustmentadjustment
Some contend that the Value Line effect is merely Some contend that the Value Line effect is merely the unexpected earnings anomaly due to changes the unexpected earnings anomaly due to changes in rankings from unexpected earningsin rankings from unexpected earnings
Nonetheless, Value Line’s successful record is Nonetheless, Value Line’s successful record is evidence in support of the existence of superior evidence in support of the existence of superior analysts who apparently possess private analysts who apparently possess private informationinformation
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January EffectJanuary Effect
Stock returns are inexplicably high in Stock returns are inexplicably high in JanuaryJanuary
Small firms do better than large firms early Small firms do better than large firms early in the yearin the year
Especially pronounced for the first five Especially pronounced for the first five trading days in Januarytrading days in January
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January Effect (cont’d)January Effect (cont’d)
Possible explanations:Possible explanations:
– Tax-loss trading late in December (Branch)Tax-loss trading late in December (Branch)
– The risk of small stocks is higher early in the The risk of small stocks is higher early in the year (Rogalski and Tinic)year (Rogalski and Tinic)
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January Returns by Type of FirmJanuary Returns by Type of Firm
7.71%7.71%10.72%10.72%11.32%11.32%NeglectedNeglected
Non-S&P 500 Non-S&P 500 CompaniesCompanies
5.03%5.03%6.87%6.87%7.62%7.62%NeglectedNeglected
1.69%1.69%4.19%4.19%4.95%4.95%Moderately Moderately ResearchedResearched
-1.44%-1.44%1.63%1.63%2.48%2.48%Highly ResearchedHighly Researched
S&P 500 S&P 500 CompaniesCompanies
Average January Average January return after return after
adjusting for adjusting for systematic risksystematic risk
Average January return Average January return minus average monthly minus average monthly
return in rest of yearreturn in rest of year
Average Average January January returnreturn
Source: Avner Arbel, “Generic Stocks: The Key to Market Anomalies,” Journal of Portfolio Management, Summer 1985, 4–13.
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Day-of-the-Week EffectDay-of-the-Week Effect
Mondays are historically bad days for the Mondays are historically bad days for the stock marketstock market
Wednesday and Fridays are consistently Wednesday and Fridays are consistently goodgood
Tuesdays and Thursdays are a mixed bagTuesdays and Thursdays are a mixed bag
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Day-of-the-Week Day-of-the-Week Effect (cont’d)Effect (cont’d)
Should not occur in an efficient marketShould not occur in an efficient market
– Once a profitable trading opportunity is Once a profitable trading opportunity is identified, it should disappearidentified, it should disappear
The The day-of-the-week effectday-of-the-week effect continues to continues to persistpersist
However – there are confounding effects However – there are confounding effects between the levels and the volatilities of between the levels and the volatilities of returns across different daysreturns across different days
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Turn-of-the-Calendar EffectTurn-of-the-Calendar Effect
The bulk of the return comes from the last The bulk of the return comes from the last trading day of the month and the first few trading day of the month and the first few days of the following monthdays of the following month
For the rest of the month, the ups and For the rest of the month, the ups and downs approximately cancel outdowns approximately cancel out
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Persistence of Persistence of Technical AnalysisTechnical Analysis
Technical analysisTechnical analysis refers to any technique in refers to any technique in which past security prices or other publicly which past security prices or other publicly available information are employed to available information are employed to predict future pricespredict future prices
Studies show the markets are efficient in the Studies show the markets are efficient in the weak formweak form
Literature based on technical techniques Literature based on technical techniques continues to appear but should be uselesscontinues to appear but should be useless
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Behavioral FinanceBehavioral Finance
Concerned with the analysis of various Concerned with the analysis of various psychological traits of individuals and how these psychological traits of individuals and how these traits affect the manner in which they act as traits affect the manner in which they act as investors, analysts, and portfolio managersinvestors, analysts, and portfolio managers
Growth companies will usually not be growth Growth companies will usually not be growth stocks due to the stocks due to the overconfidenceoverconfidence of analysts of analysts regarding future growth rates and valuationsregarding future growth rates and valuations
Notion of “Notion of “herd mentalityherd mentality” of analysts in stock ” of analysts in stock recommendations or quarterly earnings estimates recommendations or quarterly earnings estimates is confirmedis confirmed
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Chaos TheoryChaos Theory
Chaos theoryChaos theory refers to instances in which refers to instances in which apparently random behavior is systematic or even apparently random behavior is systematic or even deterministicdeterministic– under Mauboussin’s theory of the market as a complex under Mauboussin’s theory of the market as a complex
adaptive system, then we would expect to see chaotic adaptive system, then we would expect to see chaotic dynamicsdynamics
EconophysicsEconophysics refers to the application of physics refers to the application of physics principles in the analysis of stock market behaviorprinciples in the analysis of stock market behavior– e.g., an investment strategy based on studies of e.g., an investment strategy based on studies of
turbulence in wind tunnelsturbulence in wind tunnels– Includes use of multifractal modelsIncludes use of multifractal models
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Are Markets Rational?Are Markets Rational?
This question always faces a This question always faces a joint hypothesis joint hypothesis problem:problem:– Tests of EMH are always Tests of EMH are always dualdual tests of tests of bothboth market market
efficiency and the specific asset-pricing model assumedefficiency and the specific asset-pricing model assumed– Market efficiency Market efficiency
Is the stock’s price equal to its true value?Is the stock’s price equal to its true value?
– Asset pricing model used (CAPM, APT, etc.)Asset pricing model used (CAPM, APT, etc.) What What isis the stock’s the stock’s truetrue value? value? Never known for sureNever known for sure ““The question of value presupposes an answer to the question, The question of value presupposes an answer to the question,
of value to whom, and for what?” – Ayn Randof value to whom, and for what?” – Ayn Rand E.g., the value of Apple stock would be different to Steve Jobs E.g., the value of Apple stock would be different to Steve Jobs
than to any other investorthan to any other investor
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Are Markets Rational?Are Markets Rational? Related issue – what is Related issue – what is informationinformation? ?
– ““Information is that which causes changes” – Claude Information is that which causes changes” – Claude Shannon (father of information theory)Shannon (father of information theory)
– So, if something causes the markets to move, then by So, if something causes the markets to move, then by definition, it must be information, and vice versadefinition, it must be information, and vice versa
– From this perspective, the market is neither efficient nor From this perspective, the market is neither efficient nor inefficient, it just inefficient, it just isis
So, are the markets efficient or rational?So, are the markets efficient or rational?– Ultimately, difficult to answer categoricallyUltimately, difficult to answer categorically– Key question is not whether or not the markets are efficient Key question is not whether or not the markets are efficient
– this is a side issue – but how investors should act, given – this is a side issue – but how investors should act, given how the markets workhow the markets work