CAPITAL MARKETS RESEARCHAnish Aggarwal, Calvin Chen, Kurt Heino, Mason Peebles, Maya Polson, Christine Sturrock

Rational Investing

Rational Investors Three factors make an investor rational:

Asset integration

Risk aversion

Rational expectation

Rational Personalities Logical

Skeptical

Curious

“Success in investing doesn’t correlate with I.Q… Once you

have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing”

- Warren Buffet

6 Steps for Rational Investing1. Question your decisions2. Set your investment goals3. Know your risk profile4. Keep informed 5. Diversify your portfolio6. Seek advice

A classic look at market efficiency

The Efficient Market Hypothesis

Efficient Market Hypothesis (EMH)

3 kinds of EMH Weak, Semi-Strong, and Strong Efficiency

It is impossible to beat the average market return adjusted for risk

Assumes all public information is reflected in share price immediately after release

Evidence for Market Efficiency

Performance of Investment Analysts and Mutual Funds “Investment Dartboard” that compares how

well stocks picked by investment advisers did relative to stocks picked by throwing darts

the dartboard beat them as often as they beat the dartboard

Evidence for Market Efficiency Random Walk

Future changes in stock prices should be unpredictable 2 tests:

examine stock market records to see if changes in stock prices are systematically related to past changes and hence could have been predicted on that basis

examines the data to see if publicly available information other than past stock prices could have been used to predict changes

Technical Analysis Study past stock price data and search for patterns such as trends and regular

cycles. Buy and sell stocks are then established on the basis of the patterns that

emerge

Early results from both types of tests generally confirmed the efficient market view that stock prices are not predictable and follow a random walk.

Misconception about EMH EMH claims that investors cannot

outperform the market. Yet we can see that some of the successful analysts (such as Warren Buffett) are able to do exactly that. Therefore, EMH must be incorrect.

Misconception about EMH EMH claims that financial analysis is

pointless and investors who attempt to research security prices are wasting their time. However, financial analysts are still used which means that their services are valuable. Therefore, EMH must be incorrect.

Misconception about EMH EMH claims that new information is

always fully reflected in market prices. Yet one can observe prices fluctuating (sometimes very dramatically) every day, hour, and minute. Therefore, EMH must be incorrect

Misconception about EMH EMH presumes that all investors have to

be informed, skilled, and able to constantly analyze the flow of new information. Still, the majority of common investors are not trained financial experts. Therefore, EMH must be incorrect.

Discussion Efficient Market Hypothesis…

Claims that financial analysts are useless and investors who attempt to research security prices are wasting their time.

Claims that an investor cannot outperform the market, yet we see that some of the successful analysts are able to exactly do that, therefore EMH must be incorrect.

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

50.00% Magellan Fund Performance vs. S&P 500

Total ReturnS&P 500 Return

Was Peter Lynch simply lucky?

Discussion EMH claims…

That new information is always reflected in market price.

That all investors must be skilled and informed and be able to analyze new information.

What can be said of these assertions?

Symptoms of Inefficient Markets Over/Under-reaction to news Post earnings announcement drift Irrational social and psychological

reactions (Behavioural Finance) Value strategies Small firm effect

In Inefficient Markets… Fund managers may underperform

market average, despite investing fees Insider trading is profitable Market crashes are evident

Against Market Efficiency Markets are full of Irrational

Investors Attach emotions to stocks

Ex. Hope, Fear, Doubt, etc... There are social and crowd

influences Data can be gathered in a biased

way

Against Market Efficiency Investors can attach undue

importance to extraordinary events, distorting reality

They may have bad opinions and incorrect interpretationshttp://www.youtube.com/watch?v=4of1

jfKASlUWhat do you think the effect of this will

be on the stock price?

Against Market Efficiency Investors with any of the above

qualities can send prices far above or below reasonable values However in aggregate, it is possible such

behaviour cancels itself out

Against Market Efficiency Why does this matter?

If some investors are irrational, it means the EMH is inapplicable and the average market return can be beat

Efficient Market Hypothesis

Do you think efficient markets exist?

A modern look at market efficiency

Behavioural Finance

A Brief Introduction Social, cognitive, and

emotional factors are all encompassed in behavioural finance Integration of psychology

with economic theory Derives its roots from

Adam Smith’s The Theory of Moral Sentiments Individual behaviour

differs from group behaviour

Self-interest

Recent Developments Functional Magnetic

Resonance Imaging (fMRI) enabled researchers to detect brain activity while reaching financial decisions Helps researchers

determine plausible explanations of behaviour

Three Pillars of the Theory Heuristics

Mental guidelines, common sense, “rule of thumb”

Framing Patterns of interpretation, mental filters

Inefficiencies Over/under-pricing, illogical decisions

Heuristics Loss Aversion

Avoiding losses is preferable to acquiring gains

Losing $XX.XX causes more dissatisfaction than a gain of $XX.XX causes satisfaction

Gambler’s Fallacy The belief that

independent deviations from expected results make future results of adverse outcomes more likely

Ex: After flipping a coin 5 times and getting heads every time, is getting tails next time more likely than not?

Heuristics Cont. Self-Serving Bias

“All my successes are attributable to me and my failures are attributable to exogenous factors.”

Also includes the tendency to interpret ambiguous information in a beneficial manner

Status Quo Bias The tendency to

prefer the current state of affairs unless there is a compelling reason to do otherwise

Related to Loss Aversion

Framing Cognitive Framing

Use of stereotypes and mental filters to decide course of action

Perceptions of phenomena and the interpretations of information

Mental Accounting The mental

evaluation of economic transactions Acquisition Value:

the perceived value of the transacted good

Transaction Value: the perceived value of the bargain

Inefficiencies Disposition Effect

The tendency to sell securities whose value has increased and retain assets whose value have decreased

The will to recognize gains is greater than the will to recognize losses

Endowment Effect Owned assets are

perceived as more valuable than non-owned assets

Willingness to pay (WTP) vs. Willingness to accept compensation (WTA) WTP ≠ WTA

Quantitative Behavioural Finance

Employs statistical analysis in conjunction with psychological factors

Derived from observations and survey responses

Criticism of the Theory Cognitive theories and biases relate to

decision making Decision making ≠ Mass economic

behaviour Investors are rational

Able to learn from mistakes due to cognitive biases

Bias affecting the data gathered in surveys

References Bank, E. (2010, December 24). Investment Risk and Return: Efficient Markets,

Rational Investor. Retrieved January 17, 2012, from Hedge Fund Writer: http://www.hedgefundwriter.com/2010/12/24/investment-risk-and-return-efficient-markets-rational-investors/

Brown, M. (2011, July 12). Six Steps to Rational Investing. Retrieved January 20, 2012, from Morning Star: http://www.morningstar.co.nz/NZLearn.mvc/article/six-steps-to-rational-investing/3733/2

Deaves, R. (2006). What Kind of Investor are you? Toronto: Insomniac Press. "Evidence on the Efficient Market Hypothesis." Pearson. Web. 2012.

<http://wps.aw.com/wps/media/objects/7529/7710171/appendixes/ch07apx.pdf>. Clarke, Jonathan, Tomas Jandik, and Gershon Mandelker. "The Efficient Markets

Hypothesis." The Efficient Markets Hypothesis. Web. 21 Jan. 2012. <http://www.e-m-h.org/ClJM.pdf>.

Ashraf, N., Camerer, C., & Loewenstein, G. (2005). Adam Smith, Behavioral Economist. Journal of Economic Perspective - Volume 19, Number 3 , 131-145.

Behavioral Economics. (2012, January 13). Retrieved January 17, 2012, from Wikipedia: http://en.wikipedia.org/wiki/Behavioral_economics

Ritter, J. (2003). Behavioral Finance. Pacific-Basin Finance Journal Vol. 11, No. 4 , 429-437.