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Fin 4201/8001

Fin 4201/8001. Topic 2a: EMH, Risk, & Diversification. Conclusion. “Traditional wisdom can be long on tradition and short on wisdom” “I’d be a bum on the street with a tin cup if the markets were always efficient.”. Three Stories, Three Lessons. Stock Market behavior Herd mentality

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Fin 4201/8001

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  1. Fin 4201/8001 Topic 2a: EMH, Risk, & Diversification

  2. Conclusion • “Traditional wisdom can be long on tradition and short on wisdom” • “I’d be a bum on the street with a tin cup if the markets were always efficient.”

  3. Three Stories, Three Lessons • Stock Market behavior • Herd mentality • People will follow, anywhere

  4. Mr. Market • You and Mr. Market are partners in a reasonably stable business. Each day Mr. Market quotes a price at which he is willing to either buy you out or sell you his share. • Mr. Market isn’t always rational. He can be optimistic on business prospects and quote a high price. Other days he needs his meds and quotes a low price. • Mr. Market also has a bad memory. He doesn’t remember if you rejected him yesterday. • Just DON’T fall victim to his moods.

  5. Lemmings • Tundra based rodents known for herding behavior. Every three or four years they follow each other into the sea until they drown. • Buffett equates the mob like behavior of institutional investors in the market to the suicidal behaviors of lemmings and holds it responsible for the wide swings in share price.

  6. Put together = third story • Oil prospector was met at pearly gates by St. Peter…. • Herding of similar “investors” • Fell victim to his own misinformation • How does this fit with Buffett? A little more background.

  7. Crashes • The stock market crash of 1929 and the Great Depression that followed it. • Stock Market crash of 1987. • Asian meltdown of late 1990s & Tech bubble of 2001 • Bear market and the recession of 1973-74. • Frustrated, investors turned to academics for answers • Buffet held fast vs. modern finance

  8. Three men and three concepts • Modern Finance • Harry Markowitz – Portfolio Selection 1952 • William Sharpe – Portfolio Analysis 1963 • Eugene Fama – Behavior of Prices 1963 • Diversification • Risk • Efficient Market Hypothesis

  9. Markowitz and Diversification • Risk = volatility • Risk and return related • If covariance negative – portfolio risk reduced • Diversification → less risk

  10. Sharpe and Beta • Don’t need infinite covariance terms – just one per firm relative to some benchmark • Low beta (systematic risk) reduces risk • Unsystematic risk CAN and SHOULD be diversified away

  11. Fama and Efficient Markets • Stock prices reflect information quickly • Therefore the price = the value of the firm • Predictions, patterns, or systems CANNOT beat the market so why try? • So all of this is always true? Ask Warren.

  12. Buffett on Modern FinanceRisk, Diversification, and Efficient Markets • Risk = possibility of harm or injury, not volatility • Decline in prices is time to buy. Price decline REDUCES risk. • Take long-term view. Longer horizon REDUCES risk • Lack of patience. Look at some charts. • “intrinsic value risk” that the business is worth less, not price behavior of the stock • Will after tax return yield equal purchasing power and modest return? ≈ thorough analysis, safety of principal, and satisfactory return

  13. Buffett on Modern FinanceRisk, Diversification, and Efficient Markets • Diversification for Buffett is a “remedy for ignorance and may increase risk • Diversification reduces volatility, but also returns • Concentration • Increases investor focus and raises comfort level with economics of firm • Greater firm knowledge = less risk

  14. Buffett on Modern FinanceRisk, Diversification, and Efficient Markets • “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.” • Arbitrage implies prices are right • Prices are right = No Free Lunch • No Free Lunch ≠ Prices are right

  15. More observations on market efficiency • “Traditional finance is more concerned with checking that two 8 oz. bottles of ketchup are close to the price of one 16 oz. than in understanding the price of ketchup.” Lawrence Summers • “The market can stay irrational longer than you can stay solvent.” Keynes • Here is where behavioral finance fits in

  16. Quick peek at behavioralism • overconfidence • Reference points • Representativeness = Law of small numbers • Conservatism = old dog, new tricks • Confirmation bias = seek support

  17. Conclusion • “I’d be a bum on the street with a tin cup if the markets were always efficient.” • Sample exam questions • Next time topic 2a

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