Week 2: Efficient Market and Behavioural Finance Flashcards
Can you beat the market?
Hard to systematically beat the market, but possible to exploit inefficiencies
Jim Cramer example regarding beating the market.
He was beleived to be highly educated and experienced regarding stocks. He ensured viewers that everything was okay with Bear Staerns, a few days later it failed.
Lesson: intelligent, well educated, experienced experts fail to make good decisions on a regular basis
When people invest, they normally have problems regrading what to buy. How do they overcome this?
They usually try to diversify by buying some kind of fund. E.g. Mutual/ active fund. These portfolios are managed by professionals and typically have a small performance fee such as 0.9%.
What is a passive fund ?
Passive investing is a long-term strategy for building wealth by buying securities that mirror stock market indexes and holding them long term. It can lower risk, because you’re investing in a mix of asset classes and industries, not an individual stock.
How costly is a passive fund?
Typically ultra low cost. E.g. 0.01%.
Can fund managers beat the market?
Although fund managers have high levels of education and expertise, they are not guaranteed to beat the market.
Are those that beat the market this year, likely to beat it again next year?
No, funds that beat the market usually get lucky. So those that beat the market this year, usually don’t beat it next year
Why is it so hard to beat the market?
Fund managers are not stupid.
The power of stock market prices to quickly reflect available information. When new information becomes available it is quickly incorporated into market prices
That doesn’t leave much room for fund managers or individuals to profit from new information
The challenger disaster
In 1986, a space shuttle exploded. Within 2 hours, the market conducted who they though caused the disaster and their stock prices fell drastically. This was before a professional investigation confirmed it was that company at fault. This shows how knowledgable the stock market is and how they are usually quicker to respond that a proper investigation.
What are the 3 forms of market efficency?
1) Weak form market efficiency
2) Semi-strong market efficiency
3) Strong-market efficiency
What is weak form of market efficiency?
Prices reflect the information contained in the records of past prices. Impossible to make consistent superior profits by studying the past returns.
What is semi-strong market efficiency
Prices reflect not just past prices but all other public information
Eg. information posted on the internet and reported by the financial press.
Prices will immediately adjust to public information. E.g. Proposal to merge two companies.
What is strong-market efficiency?
Price reflects all the information that can be acquired on the company and the economy. Even insider information cannot enable an investor to beat the market. No superior investment manager should consistently beat the market.
Why does Technical Analysis fails?
If there is a profitable pattern, everyone would do it
If everyone follows the same strategy competition will eliminate any opportunity associated with the pattern
What are the properties of an efficient market?
1) Random and unpredictable
2) Prices should react quickly and correctly to news.
3) Investors cannot earn abnormal, risk adjusted returns (Or atleast it shouldn’t be easy).
Name 3 anomalies in the market:
1) The size effect
2) The January effect
3) Momentum effect
What is the size effect anomaly?
The smaller companies give us a higher return in comparison to big companies.
What is the January effect anomaly?
A market anomaly whereby stock prices regularly tend to rise in the first month of the year.
What is the momentum effect anomaly?
The momentum anomaly occurs when the prices of assets that have been rising tend to keep rising, and falling prices tend to continue falling.
What is behavioural Finance?
an area of study focused on how psychological influences can affect market outcomes.
what is individual bias? (Behavioural finance)
The brain does not process information like a computer, it processes in through shortcuts and filers to shorten analysis time. These filler and shortcuts could lead to predictable errors in investing.
What is herding behaviour? (Behavioural Finance)
The tendency for individuals to mimic the actions of a larger group.
Reason: societal pressure, common rational that a large group can’t be wrong.
Costs: Transaction costs; too late to enter the game and you’ll lose money.
What is Overconfidence ? (Behavioural Finance)
People overestimate precision of beliefs or forecasts, and overestimate abilities.
Overconfident investing: Overconfident investors trade more but with lower yield
What is the prospect theory?
It describes how individuals assess their loss and gain perspectives in an asymmetric manner
What does concave mean in regards to prospect theory?
Risk averse over gains
What does convex mean in regards to the prospect theory?
Risk seeking over losses
What are the 4 key effects derived from the prospect theory?
1) Risk aversion in gains, risk seeking in losses
2) Loss aversion
3) Endowment effect
4) Disposition effect
Explain Risk aversion/ seeking (1)
More people want a sure gains, not take a risk
But more people are risk seeking when its regrading making a loss.
Although both outcomes in both scenarios have same expected return.
Explain loss aversion (2)
You have an investment opportunity
50% chance of gaining $100 or 50% chance of losing $100.
Although the expected value is zero, most investors would reject this gamble due to loss aversion.
The pain of losing $100 looms larger than the pleasure of gainin
Explain the endowment effect (3)
Owner values something higher simply because the own it.
People expects more money while selling, but wants to pay less while buying the same amount of goods.
Explain the disposition effect (4):
refers to our tendency to prematurely sell assets that have made financial gains, while holding on to assets that are losing money. We are driven to sell our winning investments in order to ensure a profit, but are averse to selling losing investments in hopes of turning them into gains.
Why do firms pay dividends ( Prospect theory pov) ?
Results in a higher perceived utility due to the concavity of value in the domain of gains
(LOOK AT THE DIAGRAM ON THE PPT)
