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.