CAPITAL MARKETS RESEARCH Anish Aggarwal, Calvin Chen, Kurt Heino, Mason Peebles, Maya Polson, Christine Sturrock Rational Investing Rational Investors Three factors make an investor rational: Asset Risk integration 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 Investing 1. 2. 3. 4. 5. 6. Question your decisions Set your investment goals Know your risk profile Keep informed Diversify your portfolio Seek advice The Efficient Market Hypothesis A classic look at market efficiency 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: Technical Analysis 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 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. Magellan Fund Performance vs. S&P 500 50.00% 40.00% 30.00% 20.00% Total Return S&P 500 Return 10.00% 0.00% 1990 1991 1992 1993 1994 1995 -10.00% 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 Ex. emotions to stocks 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 interpretations http://www.youtube.com/watch?v=4of1jfKASlU What 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? Behavioural Finance A modern look at market efficiency 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 nonowned 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 Investors are rational Able making ≠ Mass economic behaviour 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-marketsrational-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-rationalinvesting/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-mh.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.