Midterm Summaries - Summary Investment Anly/Portfolio Mgt PDF

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Midterm summaries for investments...

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Efficient Market Hypothesis: Price P = expected value of all future cash flows from that security. P is outcome of supply/demand. 3 situations where market is efficient: Rational investors; Investor misperceptions cancel each other out (some think value is higher than fundamental, some lower); & Unconstrained arbitrageurs enforce market efficiency. Neither of 2 assumptions behind market efficiency is correct; Investor biases are systematic (and predicting how investors will behave in different situations is possible.) Limits to arbitrage prevent arbitrageurs from taking advantage of biases and restoring efficiency. (Costs/risks): fundamental risk, higher volatility risk/noise-trader risk, synchronization risk (not unlimited time) & implementation costs and institutional/regulatory barriers / transaction costs. Contrary to efficient markets hypothesis, anomalies can be observed in returns to firms after corporate events: mergers, share repurchases, stock splits, i.e. returns after these events are predictable. Share repurchases are followed by significantly positive long-term excess returns, while stock-financed mergers are followed by negative excess returns. Weak form of market efficiency: market prices reflect only past market data; semi-strong form: past data + public info, strong form: this + private information. Weak-Form Violations: Calendar Patterns: technical trading shouldn’t be able to earn money in a weak-form efficient market; once you include transaction costs, the potential profit is negligible. But, January effect, Weekend, Holiday effect, etc. January effect: Taxes - sell stocks in December to avoid tax losses, and buy them stocks in January, which drives up the prices. Why no more? Tax sheltered retirement. / Price Patterns: Momentum. Semi-Strong Violations: Firm Characteristics: Size (small-firm effect), B/M, Growth. Fama and French (1992) find evidence for Size and B/M effects: firms with low market caps and high B/M equity earn much higher returns than predicted by CAPM. Investor Reactions: PEAD, (post-earnings announcement drift) IPOs, Acquisitions, Share repurchases, Unrelated news. In standard finance, an investor is “rational” if he forms rational expectations and maximizes expected utility given those expectations. But behavioral investors don’t know the fundamental value of the security E[P*]. They may form 1. irrational expectations of future cash flows, leading to incorrect estimates of fundamental value. And may have 2. odd preferences; i.e. may rely on heuristics. Odean: Trading by individuals is highly correlated and persistent. Generalized Behavioral Asset Pricing Model: GBM: market composed of rational traders(neoclassical) & irrational ones w/ heuristics and biases. In GMB, fundamental value = the stock’s previous fundamental value + a random variable, some kind of new information (it’s random because we don’t know if it’s good news or bad news) includes a variable that is behavioral mispricing; irrational investors aren’t driven out because rational investors aren’t considering this behavioral mispricing aspect, so they can’t take advantage of it. 3 Variables: 1. Errors in Processing Info: Underreaction: Anchoring to existing price & Confirmation Effect (only accept info that confirms what we already know) / Overreaction: Availability bias, i.e. the media — an event, might cause you to overreact & Overconfidence: You may be relying too much on your own signals. (Insufficient response to new positive information or overreaction to bad news results in asset underpricing (ε F1 < 0). And overreaction to positive signals or underreaction to bad news causes asset overpricing.) 2. Representativeness: Short series effect: investor draws premature conclusions based on limited observations, makes ill-founded rules/Excessive extrapolation of trends. Gambler’s fallacy (coin flip) unjustified belief that even in small samples the number of outcomes should be in line with the probability distribution. 3. Errors from Biases in Investor Preferences: Prospect Theory (Underreaction to good news and temporary underpricing - Not the view of investors above reference point. / Underreaction to bad news and temporary overpricing - Not the view of investors below reference point/. When evaluating investment alternatives, traders often focus not on the aggregate final values but primarily on changes in the value of their investment from a reference point i.e. asset purchase price. Mispricing Returns broken into two components: Return in an efficient market, and Behavioral mispricing component. GBM can help explain: 1. Continuations and reversals 2. Excessive volatility 3. Categorical issues like firm size and B/M effects. Model of Investor Sentiment: Vishny: attitudes of investors correspond to two behavioral patterns: investors are convinced that the profitability of each corporation fluctuates around a specific mean value; i.e. if it had a recent high profitability, weaker results should be expected in the next period. 2nd pattern assumes the opposite: there is a continuing trend with regard to the profitability of corporations, an example of representativeness/(from class: prior stock returns lower risk aversion) Models of Shifting Risk Attitude: Barberis/Huang. 1. investors care about fluctuations value of their wealth and not about total level of consumption. 2. more sensitive to reductions in their wealth than to increases (Kahneman/prospect theory.) 3. are less risk averse after prior gains and more risk averse after prior losses. Probability Misperception Model: Investors assign probabilities to price growth. Dacey and Zielonka: suggest a model in which some investors make two types of errors in their pursuit of subjective utility maximization. 1. errors may relate to incorrect initial estimation of the probability of events. 2. Errors may result from assigning incorrect weight to the estimated probability level as provided by the weighing function in Kahneman/Tversky’s prospect theory. Hong and Stein: 2 types of traders: fundamentalists (don’t care about unrelated news, only care about fundamentals) and momentum traders (only DHS Model: investors can be: informed or underinformed. actions of underinformed traders have no significant impact on the market. Informed traders may influence the market through their overconfidence (overestimate their analytical abilities and understate their potential errors.) If fundamental reasons explain IPO waves, they should correspond with periods of high economic growth for the entire economy or for a specific industry. Alternative hypothesis: most firms go public when firms in their industry are overvalued. Ritter calls this the “window of opportunity” hypothesis, and relies on 2 assumptions: 1. market prices occasionally diverge from fundamental values. 2. managers know when the market is too optimistic about their firm’s value and can take advantage of the mispricing of their firm by selling overvalued stocks to investors. Theories about windows of opportunity are consistent with the three components of the IPO puzzle: (underpricing: high first-day returns, hot-issue markets, and IPO long-run underperformance) b/c: When (at least some) investors are ready to overpay for some or all listed firms, first-day returns of IPOs become high. This triggers massive arrival of IPO candidates, i.e. a hot-issue market. As sentiment investors realize their error, stock prices of recent IPOs drop to their fundamental values, leading to underperformance. Examples: IPOs occurring during the Internet bubble performed poorly in the long run. Finance Decisions: pecking order decisions: internal financing, debt, and equity. Internal financing = preferred (you don’t owe anyone for this, as with debt and equity) / With debt, the interest is tax-deductible. Even optimistic managers still exhibit this pecking order, and Optimistic managers do unsuccessful M&A. Overconfident managers invest more, use more debt, & do share repurchases. Optimistic managers have a different probability — they overweight the good outcome and underweight the bad one. Managers make suboptimal decisions for their own benefit. It can be a good thing that biased managers use too much debt. it offsets the agency cost of managers using too little debt. Debt overhang/underinvestment problem: a manager with a small bias can be more aggressive and invest earlier than a rational one, and this can be a good thing boards are more likely to fire rational managers for their underinvestment, as opposed to overconfident managers who exhibit over-investment. Dividends - inefficient way to distribute cash relative to share repurchases, b/c dividends are subject to double taxation. Bird-in-hand: investors don’t understand that dividends are the same as capital gains in terms of value. They need to realize wealth (via dividends) in order to consume. self-control: investors feel guilty when they need to sell investments to finance consumption. Mental accounting, investors use a prospect theory utility function, which evaluates payoffs independently of total wealth – they like dividends’ routine small positive returns. Signaling theory: a company initiates a dividend to signal that they have become successful/established. But if you cut off your dividend, the market takes that as a signal as well. Agency theory: dividends may help keep managers in line. Institutional investors: dividends can attract certain investors such as institutional ones. Clientele theories. Who prefers dividends? retirees, institutions: Firm life cycle theory: younger companies no dividend vs. mature. Catering theory: in certain times, people prefer dividends — when the economy is not doing well. 3 main issues: Underpricing (the issuers are leaving $ on the table), Hot issue markets, and Underperformance. Underpricing: Rational Explanation: Information Asymmetry b/t issuers & investors. Issuers’ Objective Function: Prospect Theory, these investors are leaving money on the table, but they’re going to make a huge post-IPO gain i.e. prospect theory/framing, rather than looking at just the initial losses they’re taking. Underwriters voluntarily underprice IPOs, b/c it makes them easier to sell. Issuers underprice to get more analyst coverage. Optimistic investors: retail investors drive this. Hot Issue Markets (clusters of when IPOs are hot) firms like to IPO when everything is overvalued and they can get great valuations: managers take advantage of overvaluations, owners go public to optimally time growth, and underwriters are bundling IPOs. Long-run Underperformance. stocks get too hyped during IPOs, and eventually drop back down close to their fundamental value. Managerial biases improve shareholder welfare: a biased manager makes less suboptimal decisions compared to unbiased. In manager-shareholder conflicts, rational managers underuse debt to maintain the discretion to divert funds, while biased managers choose higher debt levels, and unknowingly restrict themselves from diverting funds and increasing shareholder welfare. (Bankruptcy Costs and Tax Benefits: Biased managers use too much debt. Manager-Shareholder Conflicts. Agency costs resulting from too little debt & small biases (using too much debt) may help alleviate these. Bondholder-Shareholder Conflicts. Debt overhang/underinvestment problem. optimistic and/or overconfident managers invest earlier compared to rational managers and fixes the underinvestment problem; shareholder welfare increases.) M&A. Bidders profit in a stock offer by using overvalued equity to acquire less overvalued target assets. Bidders in stock mergers should be overvalued and show signs of overvaluation. Target managers with short horizons can profit by selling the shares they obtain in the exchange. And, target managers profit by cashing out of their illiquid stock and option holdings, and may receive side payments from the bidder. Bidders profit in a cash offer by acquiring undervalued target assets; targets in cash acquisitions should be undervalued. As bidders in stock offers tend to be overvalued, bidders are expected to have low long-run returns. But, the bidder still gains from the merger if the bid premium is less than the valuation advantage over the target. Because target firms in cash offers tend to be undervalued, if the offer premium is lower than the intrinsic value of the target, target management’s resistance to takeover bids is in the best interest of target shareholders. Overvaluation encourages firms to acquire other less overvalued firms. So, acquisitions (especially for stock) are more likely when market or sector valuations are high and when the dispersion of valuations is high across firms. When market or sector valuations are low, waves of cash takeovers of undervalued assets are possible. Managerial Overconfidence: More acquisitions, Overly optimistic about synergies, underestimate costs. Prospect Theory: Reference points as bids. Envy: Merger waves Rational Expectations Investor: Assumes everyone is purely self-interested, Investigates everyone, then evaluate the investment. Trusting Investor: Knowingly making oneself vulnerable. Knowing someone could exploit that vulnerability. Believing that person, despite self-interest, will not take advantage. Trust behavior is the rule for Strangers & Nonhuman (computers). But - people trust some people but not others. Trust is learned. Rational expectations investor is forward-looking, while Trusting investors look to the past. Lessons for securities markets: Bubbles, (not paying attention to economic fundamentals at all; instead, they are paying attention to history.), Sophisticated investors fall for fraud (might assume a similar regulatory structure is in place for their hedge funds, as w/ mutual funds.) Investor trust in decline. Individual Investor trading: Rational Explanations: Rebalance portfolios, Liquidate, Smooth consumption. / Behavioral Explanations: Overconfidence, Availability and Representativeness. MPT, Harry Markowitz, Efficient Frontier (portfolio with optimal return to risk levels.) 1. All investors select same well-diversified risky portfolio and choose optimal portfolio between risky portfolio and risk-free asset. 2.Investor should always hold some investment in optimal risky portfolio as long as it has a positive expected risk premium. Deviations from MPT: Underdiversified portfolios: Biases: Costs and Constraints. Limited stock market participation: Fixed cost of participation/Preference-based explanation. Empirical evidence: Limited stock participation: Among all wealth groups. Fixed costs would not explain wealthy households. Underdiversification: Direct equity holdings, only 1 to 4 companies. MeanVariance Metric: Loss from investing in inefficient portfolio. The % loss from under-diversification varies with wealth; more for lower wealth. Older Investors, better choices? More Experience: Diversification, Less frequent trading, &Tax-loss Selling. / Cognitive Aging. 3 Aspects of Individual Trading: Disposition Effect (Prospect Theory), Local Bias, & Learning over Time. Implications: Asset Prices, Welfare Evaluation, Cost of Time. Cognitive Abilities/3 Puzzles: Portfolio Concentration, (retail investors only invest in a few), Propensity to Trade (shows overconfidence bias) and Local Bias. Differences in cognitive abilities alter portfolio performance when investors depart from normative prescription. Explain under-diversification: Biases would have to persistent and not eliminated over time with learning. And they fail to account for why educated and wealthy investors have under-diversified segments of their portfolios. Rank-dependent expected utility (RDEU): ranks/weightings — with tails — we can weigh our losses more, or our gains —allows you to assign different weights, as w/ prospect theory. Sometimes people assign weights to certain probabilities that don’t match their actual probability. Cumulative Prospect Theory: weighting is applied to the cumulative probability distribution function. implies under-diversification, and might help explain non-participation....