Conclusion

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Conclusion

• Id be a bum on the street with a tin cup if
  the markets were always efficient.
  
• Warren Buffett.

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Three stories, three lessons

• Stock Market behavior
• Herd mentality
• People will follow, anywhere.

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Mr. Market Allegory used by Ben Graham to teach
students about stock market behavior

• To understand the irrationality of stock prices,
  imagine that you and Mr. Market are partners in a
  private business. Each day without fail, Mr.
  Market quotes a price at which he is willing to
  either buy your interest or sell you his.

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• The business that you both own is fortunate to
  have stable economic characteristics, but Mr.
  Markets quotes are anything but. For you see,
  Mr. Market is emotionally unstable. Some days,
  Mr. Market is cheerful and can only see brighter
  days ahead. On these days, he quotes a very high
  price for shares in your business. At other
  times, Mr. Market is discouraged and, seeing
  nothing but trouble ahead, quotes a very low
  price for you shares in the business.

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• Mr. Market has another endearing characteristic,
  said Graham. He does not mind being snubbed. If
  Mr. Markets quotes are ignored, he will be back
  again tomorrow with a new quote. Graham warned
  his students that it is Mr. Markets pocketbook,
  not his wisdom, that is useful. If Mr. Markets
  shows up in a foolish mood, you are free to
  ignore him or take advantage of him, but it will
  be disastrous if you fall under his influence.

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LemmingsCase of herd mentality among
institutional investors

• Lemmings are small rodents indigenous to the
  tundra region and are noted for their mass exodus
  to the sea. Every three or four years they do a
  suicidal exodus following each other into sea
  until they drown and die.

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• Buffett equates the mob like behavior of
  institutional investors in stock market to the
  suicidal behavior of Lemmings, and holds it
  responsible for the wide swings in share price.

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Modern Finance and Buffett

• Traditional wisdom
• can be long on tradition
• and short on wisdom.

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The crashes

• The stock market crash of 1929 and the Great
  Depression that followed it.
  
• Bear market and the recession of 1973-74.
• Stock Market crash of 1987.

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Bear Market of 1973-74

• Slow, tortuous process of unrelenting losses that
  lasted, uninterrupted, for two years.
  
• Broader market declined by over 60 percent.
• Interest rates and inflation soared to double
  digits.
  

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• Fixed income securities depreciated because of
  low coupons.
  
• Oil prices skyrocketed.
• Mortgage rates were unaffordable

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• Why am I telling this story?
• Because, this leads the investment professionals
  to question their approach.
  
• This period led to two streams
• Buffett stream
• Modern finance

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Modern finance stream

• Frustrated by the failures, investment
  professionals looked at the academic world which
  offered an edifice that changed the entire
  industry.

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Three concepts and three men

• Diversification
• Risk
• Efficient Market Theory
• Harry Markowitz
• William Sharpe
• Eugene Fama

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Harry Markowitz and Diversification

• Portfolio Selection in Journal of Finance,
  1952.
  
• This 14 page article is credited with launching
  modern finance.
  
• Simple notion return and risk are related.

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• Risk variance / standard deviation (deviation
  from the expectation/average)
  
• Concept of efficient frontier portfolios giving
  highest return for a given level of risk.
  

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• Portfolio risk more than the weighted average
  of individual security risk. What more?
  Covariance between securities or how they move
  together.
• If they move in opposite direction overall risk
  of the portfolio reduces.
  
• Birth of the theory of Diversification.

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William Sharpe and Risk

• A Simplified Model of Portfolio Analysis in
  Journal of Finance, 1963.
  
• Birth of CAPM Capital Asset Pricing Model.
• Simplified Markowitzs idea of efficient frontier.

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• No need to calculate unlimited covariance between
  individual securities.
  
• Each security is related to a common portfolio,
  the market portfolio.
  
• It is the relationship of the stock with the
  market portfolio that determines its effect on
  the portfolio variance.

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• This he called what is known as beta or the
  measure of a stock with the market portfolio
  
• BETA COV(STOCK, MKT) / VAR (MKT)
• If stock has low beta, its inclusion will reduce
  the overall risk of the portfolio.
  

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• Sharpe divided the total risk (variance) into
  systematic and unsystematic risk.
  
• Systematic risk beta (how stock moves with the
  market)
  
• This cannot be diversified.

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• Unsystematic or idiosyncratic risk unique to a
  stock. This can and should be diversified.
  Thus, there is no reward for bearing this risk.

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Eugene Fama and EMT

• Inspired by French mathematician Benoit
  Mandelbrot.
  
• Mandelbrots idea stock prices fluctuated so
  irregularly, they would never oblige any
  fundamental or statistical research furthermore,
  the pattern of irregular price movements was
  bound to intensify, causing unexpectedly large
  and intense shifts.

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• The Behavior of stock prices in Journal of
  Business, 1963.
  
• Efficient Market new information is incorporated
  into prices quickly. Simple terms, price
  value.
  
• Thus, there is no place for predictions, patterns
  or systems that can outperform the market.

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Buffett on

• Risk
• Diversification
• Efficient Markets

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Risk

• Recall modern portfolio theory
• risk volatility.
• According to Buffett a fall in prices is a time
  to buy, and a fall actually reduces the risk.

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• Buffett definition possibility of harm or
  injury.
  
• A factor of the intrinsic value risk of the
  business, not the price behavior of the stock.

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• The real risk is whether after-tax returns from
  an investment will give him (an investor) at
  least as much purchasing power as he had to begin
  with, plus a modest rate of interest on that
  initial stake.

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Investment vs. Speculation

• An investment operation is one which, upon
  thorough analysis, promises safety of principal
  and a satisfactory return. Operations not
  meeting these requirements are speculative.

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Risk and time horizon

• Short term
• investment speculation high risk.
• Extend the time horizon out to several years and
  risk reduces meaningfully.

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Conclusion

• For owners of a business and thats the way we
  think of shareholders the academics definition
  is far off the mark, so much so that it produces
  absurdities.

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On Diversification

• Primary benefit of diversification is to mitigate
  the effect of price volatility of the individual
  stock.
  
• But, if you are unconcerned with price
  volatility, as Buffett is, then portfolio
  diversification means something different.

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On the contrary

• Concentration reduces risk. How?
• It increases the intensity with which investor
  thinks about investment, and
  
• It raises the comfort level he must feel with its
  economic characteristics before buying into it.

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Conclusion

• Diversification is a remedy for ignorance.
• If you dont know much about the stock market,
  buy a lot of stocks.
  
• But, if you can do thorough analysis then
  concentrate on few stocks. The more knowledge
  you have about your company, the less risk you
  are likely taking.

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On Efficient Market Theory

• The big question
• How can you explain the performance of Warren
  Buffett and other students of Ben Graham, who all
  followed a similar strategy?

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Behavioral Finance, arguements against
EMTBarberis and Thaler, 2001

• Investors are not always rational Research in
  psychology shows biases and beliefs.
  
• Overconfidence
• Representativeness
• Optimism and Wishful Thinking
• More

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Example RepresentativenessKahneman and Tversky,
1974

• Linda is 31 years old, single, outspoken, and
  very bright. She majored in philosophy. As a
  student, she was deeply concerned with issues of
  discrimination and social justice, and also
  participated in anti-nuclear demonstrations.

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Which statement is more likely?

• Linda is a professor.
• Linda is a professor and is active in the
  feminist movement.
  
• Linda works in the banking industry.

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Limits to arbitrage

• Limits to arbitrage Prices can be wrong without
  creating profitable opportunities.
  
• Prices are right No free lunch
• No free lunch ? Prices are right

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• 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.

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Belief in EMT is good for Buffett

• In any sort of a contest financial, mental, or
  physical its an enormous advantage to have
  opponents who have been taught its useless to
  even try.
• From a selfish standpoint, we should probably
  endow chairs to ensure the perpetual teaching of
  EMT.

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Conclusion

• Id be a bum on the street with a tin cup if
  the markets were always efficient.
  
• Warren Buffett.