FIN630 Short Notes Lectures 23-45 by Humaira

FIN630 Investment Analysis and Portfolio

Short Notes for Lecture 23-45

INVESTMENT ANALYSIS & PORTFOLIO MANAGEMENT (Dr. Shahid A. Zia)

Random Walks Idea

Does not state that security prices move randomly. Rather it maintains that the news arrives randomly. And in accordance with the EMH security prices rapidly adjust to this random arrival of news.

Consequences of Efficient Market

Quick price adjustment in response to the arrival of random information makes the reward for analysis low. Prices reflect all available information. Price changes are independent of one another and move in a random fashion.

• New information is independent of past.

Evidence on Market Efficiency

Keys:

• Consistency of returns in excess of risk.
• Length of time over which returns are earned.

Economically efficient markets:

• Assets are priced so that investors cannot exploit any discrepancies and earn unusual returns. Transaction costs matter.

Implications of Efficient Market Hypothesis

What should investors do if markets are efficient?

Technical analysis

• Not valuable if the weak form holds.

Fundamental analysis of intrinsic value.

• Not valuable if semi-strong form holds.
• Experience average results.

For professional money managers

• Less time spent on individual securities. Passive investing favored. Otherwise must believe in superior insight.
• Tasks if markets informationally efficient Maintain correct diversification. Achieve and maintain desired portfolio risk. Manage tax burden. Control transaction costs.

Exceptions that appear to be contrary to market efficiency. Earnings announcements affect stock prices.

• Adjustment occurs before announcement but significant amount afterwards.
• Contrary to efficient market because the lag should not exist.
• The lag would than be a way of selling what you should bought earlier.
• Extra returns than general public.

Low P/E ratio stocks tend to outperform high P/E ratio stocks.

• Low P/E stocks generally have higher risk-adjusted returns.
• But P/E ratio is public information.

Should portfolio be based on P/E ratios?

• Could result in an undiversified portfolio.

Size effect:

• Tendency for small firms to have higher risk-adjusted returns than large firms.

January effect:

• Tendency for small firm stock returns to be higher in January.
• Of 30% size premium, half of the effect occurs in January

Value Line Ranking System:

• Advisory service that ranks 1000 stocks from best (1) to worst (5) Probable price performance in next 12 months.
• 13 years study (1980-1993), Group 1 stocks had annualized return of 19%. Best investment letter performance overall.
• Transaction costs may offset returns.

Profitability ratios Liquidity ratios Business Sales ratios

Conclusions About Market Efficiency

Support for market efficiency is persuasive.

• Much research using different methods.
• Also many anomalies that cannot be explained satisfactorily.

Markets very efficient but not totally.

• To outperform the market, fundamental analysis beyond the norm must be done. If markets operationally efficient, some investors with the skill to detect a divergence between price and semi-strong value earn profits.

Controversy about the degree of market efficiency still remains. Excludes the majority of investors. Anomalies offer opportunities.

Empirical Research Theoretical Research Behavioral Finance

Behavioral Finance

Seeks to integrate psychology into the investment process. A variety of established behavior patterns may influence security prices. If market is going bullish we will find that people are gathering behind the same sentiments and thinking that the market is bullish whether it is or it isn’t become secondary. Our behavior is also a function of how a problem is framed and the reference point we use in evaluating a situation. We may have definite preference for one alternative over another that, according to classical finance, is economically equivalent. People get carried away with sentiments.

Established Behaviors

Loss Aversion Fear of Regret Myopic Loss Aversion Herding Anchoring Illusion of Control Prospect Theory Mental Accounting Asset Segregation Hindsight Bias Overconfidence Framing Illusion of Truth Biased Expectations Reference Dependence We also may misinterpret statistics, especially by misjudging the likelihood of events. Certain random numbers seem ―less random‖ than others, and this belief influences certain investment decisions we might make.

Mistaken Statistics

The Special Nature of Round Numbers Extrapolation Percentages vs. Numbers Apparent Order Regression to the Mean Sample Size

Risk Aversion

People tend to react differently when confronted with losses rather gains. There is a tendency to become less risk averse or even risk seeking when an adverse event occurs. Investors may choose to gamble on an even bigger loss in the hope that the loss will disappear.

Equity Market Indicators

Provide a composite report of market behavior on a given day. Dow Jones Industrial Average (DJIA).

• Composed of 30 ―blue-chip‖ stocks.
• Price-weighted index: Essentially adds the prices of 30 stocks, divides by 30. Adjusted for stock splits, stock dividends.
• Oldest, most well-known measure.

Standard & Poor’s Composite Index:

• Composed of 500 ―large‖ firm stocks.
• Expressed as index number relative to a base index value of 10 (1941-43).
• Value-weighted index: Prices and shares outstanding considered. Indicates how much the average equity value of the 500 firms in the index has increased relative to the base period.

NYSE and NASDAQ Composite Indices.

• Value-weighted indices of broad markets.

Nikkei 225 Average.

• Price-weighted index of 225 actively-traded stocks on the Tokyo Stock Exchange.

Index

Indexes are useful in assessing the performance of an investment. Choose which index:

• It is important to ensure that the chosen index is an accurate proxy for what investors want to measure.
• A stock index should not be used with a bond portfolio.
• An index of large-capitalization stocks be used to judge a small-cap stock portfolio.

An investor can choose from any of the hundreds of indexes.

• Dow Jones Industrial Average (DJIA)
• S&P 500
• S&P 500

Index Construction

Price Weighting Equal Weighting Capitalization Weighting Volume based indices will tell you about companies that is best traded companies in the index. Price Weighting:

• assigns heavy weight to high-priced stocks.
• make use of a divisor to adjust for stock splits. The stocks in a way in which you would understand that if you have Rs. 100 stock or Rs. 500 stock and Rs. 10 stock or Rs. 20 stock you would than give them, you would than perhaps add them up and divide by the number of stocks you want to based your indicator. Capitalization Weighting:
• considers the size of the company.
• needs no adjustment for stock splits.
• must be adjusted for changes in.