How Diversification Reduces Risk Risk of Portfolio (Standard Deviation of Return) Total risk – Unsystematic Risk – Systematic Risk. Number of Securities in Portfolio. Both financial theorists and practitioners agree that investors should be compensated for taking one more risk by a higher expected return. Stock prices must therefore adjust to offer higher returns where […]
Modeling Risk: The Capital Asset Pricing Model (CAPM) Portfolio theory has important implications for how stocks are actually valued. If investors seek to reduce risk in anything like the manner Harry Markowitz described, the stock market will tend to reflect these risk-reducing activities. This brings us to what is called the “capital-asset pricing model”, a […]
Reducing Risk: Modern Portfolio Theory (MPT) Portfolio theory begins with the premise that all investors are like my wife – they are risk-averse. They want high returns and guaranteed outcomes. The theory tells investors how to combine stocks in their portfolios to give them the least risk possible, consistent with the return they seek. It […]
Documenting Risk: A Long-Run Study One of the best-documented propositions in the field of finance is that, on average, investors have received higher rates of return for bearing greater risk. The most thorough study has been done by Roger Ibbotson and Rex Sinquefield. Their data cover the period 1926 through 1988. Appearances notwithstanding, the table […]
Defining Risk: The Dispersion of Returns Risk is a most slippery and elusive concept. It’s hard for investors – let alone economists – to agree on a precise definition. The American Heritage Dictionary defines risk as the possibility of suffering harm or loss. If I buy one-year Treasury bills to yield 8 percent and hold […]
Modern Portfolio and Capital-Asset Pricing Theory … Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribber of a few years back. (J.M. Keynes, General Theory of […]
Stock-index Arbitrage Another form of program trading is called “stock-index arbitrage.” A position in a portfolio stocks is combined with an index futures contract with the objective of producing a perfectly hedged position and an abnormally large risk-free return. Arbitrage opportunities arise whenever the value of an index future and the value of the underlying […]
A Digression on Program Trading and Derivative Instruments Whenever the stock market moves sharply one can be sure that financial commentators and even many market professionals will attribute the change to computer “program trading” or to related activities in the futures and options markets. These markets, where one can purchase an option not only on […]
The Market Crash in October 1987 Can an event such as the October 1987 market crash be explained by rational considerations, or does such a rapid and significant change in market valuations prove the dominance of psychological rather than logical factors in understanding the stock market? Behaviorists would say that a one-third drop in market […]
Anomalies in the Markets While it is clear that evidence in favor of the efficiency of markets remains extremely strong, two other studies published in the late 1980s are disturbing because they cast doubt on some of the key assumptions of the efficient-market hypothesis.
Strong Form of the Efficient-Market Hypothesis The strongest form of the efficient-market hypothesis is unlikely to hold. We know that stock splits, dividend increases, and merger announcements can have substantial effects on share prices. Consequently, insiders trading on such information can clearly profit before the announcement is made. While such trading is illegal, the fact […]
Semi-strong Efficiency and Some More Anomalies Academic and financial analysis in the semi-strong school of market efficiency believe that all public information about a company is always reflected in the stock’s price. Thus, they are skeptical about the ability of “fundamental” security analysts to pore over data concerning a company’s earnings and dividends in an […]
Evidence Inconsistent with the Weak Form of the Efficient-Market Hypothesis Recall that the weak form of the efficient-market hypothesis (the random-walk notion) says simply that the technical analysis of past price patterns to predict the future is useless because any information from such as analysis will already have been incorporated in current market prices. If […]
Beyond the Random Walk It is difference of opinion that makes horse races (Mark Twain, Pudd’nhead Wilson). Even a dart-throwing chimpanzee can select a portfolio that performs as well as one carefully selected by the experts. This, in essence, is the practical application of the theory of efficient markets. The theory holds that the market […]
The Middle of the Road: A Personal Viewpoint Let’s first briefly recap the diametrically opposed viewpoints about the functioning of the stock market. The view of most investment managers is that professionals certainly outperform all amateur and casual investors in managing money. Much of the academic community, on the other hand, believes that professionally managed […]
The Semi-strong and Strong Forms of the Random-Walk Theory The academic community had rendered its judgment. Fundamental analysis is not better than technical analysis in enabling investors to capture above average returns. Nevertheless, given its propensity for splitting hairs, the academic community soon fell to quarreling over the precise definition of fundamental information. Some said […]
The Verdict on Market Timing Many professional investors move money from cash to equities or to long-term bonds based on their forecasts of fundamental economic conditions. Indeed, several institutional investors now sell their services as “asset allocators” or “market timers.” The words of John Bogle, chairman of the Vanguard Group of Investment Companies, are closest […]
Can Any Fundamental System Pick Winners? Research has also been done on whether above-average returns can be earned by employing trading systems based on press announcements of new fundamental information. The answer seems to be a clear no.
Do Security Analysts Pick Winners? The Performance of the Mutual Funds I can almost hear the chorus in the background as I write these words. It goes something like this: The real test of the analyst lies in the performance of the stocks he recommends. Maybe Sloppy Louie, the copper analyst, did mess up his […]
Why the Crystal Ball Is Clouded It is always somewhat disturbing to learn that a group of highly trained and well-payed professionals may not be terrible skillful at their calling. Unfortunately, this is hardly unusual. Similar types of findings could be made for most groups of professionals.
The Loss of the Best Analysts to the Sales Desk or to Portfolio Management My fourth argument against the profession of analyst is a paradoxical one: Many of the best security analysts are not paid to analyze securities. They are either very high-powered institutional salesmen or efficient new-business getters, successful in bringing new underwriting business […]