Fin 4201/8001 1

Conclusion

“I’d be a bum on the street with a tin cup if

the markets were always efficient.”

Warren Buffett.

Fin 4201/8001 2

Three stories, three lessons

Stock Market behavior Herd mentality People will follow, anywhere.

Fin 4201/8001 3

Mr. Market Allegory used by Ben Graham to teach students about stock market behavior

To understand the irrationality of stock prices, imagine that you and

Mr. Market are partners in a private business. Each day without fail,

Mr. Market quotes a price at which he is willing to either buy your

interest or sell you his.

Fin 4201/8001 4

The business that you both own is fortunate to have stable economic

characteristics, but Mr. Market’s quotes are anything but. For you see, Mr.

Market is emotionally unstable. Some days, Mr. Market is cheerful and can

only see brighter days ahead. On these days, he quotes a very high price for

shares in your business. At other times, Mr. Market is discouraged and,

seeing nothing but trouble ahead, quotes a very low price for you shares in

the business.

Fin 4201/8001 5

Mr. Market has another endearing characteristic, said Graham. He does not

mind being snubbed. If Mr. Market’s quotes are ignored, he will be back

again tomorrow with a new quote. Graham warned his students that it is

Mr. Market’s pocketbook, not his wisdom, that is useful. If Mr. Market’s

shows up in a foolish mood, you are free to ignore him or take advantage of

him, but it will be disastrous if you fall under his influence.

Fin 4201/8001 6

LemmingsCase of herd mentality among institutional investors

Lemmings are small rodents indigenous to the tundra

region and are noted for their mass exodus to the sea.

Every three or four years they do a suicidal exodus:

following each other into sea until they drown and die.

Fin 4201/8001 7

Buffett equates the mob like behavior of institutional

investors in stock market to the suicidal behavior of

Lemmings, and holds it responsible for the wide swings in

share price.

Fin 4201/8001 8

Fin 4201/8001 9

Modern Finance and Buffett

“Traditional wisdom

can be long on tradition

and short on wisdom.”

Fin 4201/8001 10

The crashes

The stock market crash of 1929 and the Great

Depression that followed it.

Bear market and the recession of 1973-74.

Stock Market crash of 1987.

Fin 4201/8001 11

Bear Market of 1973-74

Slow, tortuous process of unrelenting losses that

lasted, uninterrupted, for two years.

Broader market declined by over 60 percent.

Interest rates and inflation soared to double digits.

Fin 4201/8001 12

Fixed income securities depreciated because of low

coupons.

Oil prices skyrocketed.

Mortgage rates were unaffordable

Fin 4201/8001 13

Why am I telling this story?

Because, this leads the investment professionals to question their approach.

This period led to two streams:• Buffett stream

• Modern finance

Fin 4201/8001 14

Modern finance stream

Frustrated by the failures, investment

professionals looked at the academic world

which offered an edifice that changed the

entire industry.

Fin 4201/8001 15

Three concepts and three men

Diversification Risk Efficient Market Theory

Harry Markowitz William Sharpe Eugene Fama

Fin 4201/8001 16

Harry Markowitz and Diversification

“Portfolio Selection” in Journal of Finance, 1952.

This 14 page article is credited with launching

modern finance.

Simple notion – return and risk are related.

Fin 4201/8001 17

Risk = variance / standard deviation

(deviation from the expectation/average)

Concept of efficient frontier – portfolios

giving highest return for a given level of risk.

Fin 4201/8001 18

Portfolio risk – more than the weighted average of

individual security risk. What more? Covariance between

securities or how they move together.

If they move in opposite direction – overall risk of the

portfolio reduces.

Birth of the theory of Diversification.

Fin 4201/8001 19

William Sharpe and Risk

“A Simplified Model of Portfolio Analysis” in

Journal of Finance, 1963.

Birth of CAPM – Capital Asset Pricing Model.

Simplified Markowitz’s idea of efficient frontier.

Fin 4201/8001 20

No need to calculate unlimited covariance between individual

securities.

Each security is related to a common portfolio, the market

portfolio.

It is the relationship of the stock with the market portfolio that

determines its effect on the portfolio variance.

Fin 4201/8001 21

This he called what is known as ‘beta’ or the measure of a stock with the market portfolio

• BETA = COV(STOCK, MKT) / VAR (MKT)

If stock has low beta, its inclusion will reduce the overall risk of the portfolio.

Fin 4201/8001 22

Sharpe divided the total risk (variance) into systematic

and unsystematic risk.

Systematic risk = beta (how stock moves with the market)

This cannot be diversified.

Fin 4201/8001 23

Unsystematic or idiosyncratic risk: unique to

a stock. This can and should be diversified.

Thus, there is no reward for bearing this risk.

Fin 4201/8001 24

Eugene Fama and EMT

Inspired by French mathematician Benoit Mandelbrot.

Mandelbrot’s idea: stock prices fluctuated so irregularly, they

would never oblige any fundamental or statistical research;

furthermore, the pattern of irregular price movements was

bound to intensify, causing unexpectedly large and intense

shifts.

Fin 4201/8001 25

“The Behavior of stock prices” in Journal of

Business, 1963.

Efficient Market: new information is incorporated

into prices quickly. Simple terms, price = value.

Thus, there is no place for predictions, patterns or

systems that can outperform the market.

Fin 4201/8001 26

Buffett on

Risk Diversification Efficient Markets

Fin 4201/8001 27

Risk

Recall modern portfolio theory:

• risk = volatility.

According to Buffett a fall in prices is a time

to buy, and a fall actually reduces the risk.

Fin 4201/8001 28

Buffett definition: possibility of harm or

injury.

A factor of the “intrinsic value risk” of the

business, not the price behavior of the stock.

Fin 4201/8001 29

The real risk is whether after-tax returns from an

investment will give him (an investor) at least as

much purchasing power as he had to begin with,

plus a modest rate of interest on that initial stake.

Fin 4201/8001 30

Investment vs. Speculation

“An investment operation is one which, upon

thorough analysis, promises safety of principal

and a satisfactory return. Operations not meeting

these requirements are speculative.”

Fin 4201/8001 31

Risk and time horizon

Short term:• investment = speculation = high risk.

Extend the time horizon out to several years and risk reduces meaningfully.

Fin 4201/8001 32

Conclusion

“For owners of a business – and that’s the

way we think of shareholders – the

academics’ definition is far off the mark, so

much so that it produces absurdities”.

Fin 4201/8001 33

On Diversification

Primary benefit of diversification is to mitigate the effect of price

volatility of the individual stock.

But, if you are unconcerned with price volatility, as Buffett is, then

portfolio diversification means something different.

Fin 4201/8001 34

On the contrary…

Concentration reduces risk. How?

• It increases the intensity with which investor thinks about

investment, and

• It raises the comfort level he must feel with its economic

characteristics before buying into it.

Fin 4201/8001 35

Conclusion

Diversification is a remedy for ignorance.

• If you don’t know much about the stock market, buy a lot of

stocks.

• But, if you can do thorough analysis then concentrate on

few stocks. The more knowledge you have about your

company, the less risk you are likely taking.

Fin 4201/8001 36

On Efficient Market Theory

The big question

How can you explain the performance of

Warren Buffett and other students of Ben

Graham, who all followed a similar strategy?

Fin 4201/8001 37

Behavioral Finance, arguements against EMTBarberis and Thaler, 2001

Investors are not always rational: Research in psychology shows biases and beliefs.

• Overconfidence

• Representativeness

• Optimism and Wishful Thinking

• More…

Fin 4201/8001 38

Example: RepresentativenessKahneman and Tversky, 1974

Linda is 31 years old, single, outspoken, and very bright.

She majored in philosophy. As a student, she was deeply

concerned with issues of discrimination and social justice,

and also participated in anti-nuclear demonstrations.

Fin 4201/8001 39

Which statement is more likely?

Linda is a professor.

Linda is a professor and is active in the feminist movement.

Linda works in the banking industry.

Fin 4201/8001 40

Limits to arbitrage

Limits to arbitrage: Prices can be wrong without creating profitable opportunities.

•Prices are right = No free lunch

•No free lunch ≠ Prices are right

Fin 4201/8001 41

“Observing correctly that the market was frequently

efficient, they went to conclude that the market was

always efficient. The difference between these

propositions is night and day.”

Fin 4201/8001 42

Belief in EMT is good for Buffett

“In any sort of a contest – financial, mental, or

physical – it’s an enormous advantage to have

opponents who have been taught it’s useless to even

try.”

“From a selfish standpoint, we should probably

endow chairs to ensure the perpetual teaching of

EMT.”

Fin 4201/8001 43

Conclusion

“I’d be a bum on the street with a tin cup if

the markets were always efficient.”

Warren Buffett.