MARKET EFFICIENCY VERSUS BEHAVIORAL FINANCE

MARKET EFFICIENCY VERSUS BEHAVIORAL FINANCE
A discussion with Burton Malkiel. Princeton University and Sendhil Mullainthan, Harvard University

There two side in this debate.
Malkiel is a Efficient Market Hypothesis person, who publish book A random Walk Down Wall street.
Malkiel “There he maintained that stock price fallow a random walk and cannot systematically be predicted by stock markets professional –Underpinning- tenets of finance: market are efficient, meaning that they are rationally and accurate reflect all publicly available information.(note: Efficient Market Hypothesis EMH live for about 30 or 40 years with their all controversy)
Sendhil Mullainathans, behavioralist, “focused on when and how a human behavior differs from rational and not, profit seeking behavior typified by proponents of market efficiency” —believe—human have a limit to their cognitive abilities and their willpower, and may not always act rationally.
Malkiel: On average you can’t beat the market and so you’re better of with the index
Mullainathans: the era of MHT is over: see the market anomalies – tries to patch up the original model by attributing the anomalies to missing risk factor and adding those risk factor to the a model. (market is not a simple as returns and data)
Malkiel—recommended a index fund—principle “looking needle in a haystack is difficult, so its better if you just buy the hay stack”, because based on the data, if you buy a fund index is better than if you try to finds a good fund to be invest.
Are stock Price Predictable?
EMH : one cannot predict stock prices on their future trend.
Mullainathans –behavioralis- see there are some market inefficiencies, and we do some predictable.
Malkiel: still recommend a index—“ so I think there is a little predictability in term of when return are going to be high or low, but enough to do an investors any good, because nobody can predict when the market will turn”
Stangle: “Underpinning of the EMH is that price always correct, fully ratinal, and that they reflect all available information.”
EHM—price is unpredictable
Behavioralis – stock price is weakly predictable
How Does the EMH Account for trading volume?
Malkiel: trading basically driven by re-balancing and liquidity needs; the principle “EHM, there’s little room for differences among investors, because the only reason for differences in belief would be differences in information”
Mullainathans: the principle “In behavioral view, however, people can have differences of opinion because they have different biases, not just different information:, those different create the ability for behavioral model to generate tons of volume
Rationally and Arbitrage
EHM: profit maximization and self-interest are what drive investor’s activity.
Behaioralist: there are other models of human endeavor and utility, including altruism, or caring for someone else.
Malkiel: Individual may act altruistically, butt that doesn’t make the market altruistic—there are enough rational trader that there are no arbitrage opportunities.
Mullainathans: Sometimes there are good arbitrage opportunities in market that are just opening up, where the arbitrageurs haven’t had a chance to enter completely.
Investors Choice and public policy
Malkiel: As a nation, we are under savers
Mullainathans: feel that choice is goods, and more choice is better, which has clear policy implication. But behavioral finance suggest that more choice may not be good, which has very different policy implication.
How do the experts invest their money
Malkiel: suggest thei put the money majority in index fund, but he do buy some individual stock
Mullainathans: “I’ve given up that type of activity, mainly because this is not how you make money. I’ve learned that it is too far too easy to convince yourself that you’ve found a good opportunity.
Will EMH survive?
Malkiel: I think they can do co-exist, because there are some insight from behavioral finance that are very important for investors, but I think the bottom line is that whether you’re a behavioralist or an efficient markete person, you’re both coming out with the same advioce. The behavioralist and I my disagree about some things, but we both have exactly the same advice for investors: buy an index fund

HOW TO PROFIT FROM THE COMING ECONOMIC COLLAPSE

The US economy condition today, becomes a phenomenal story that is very interested to be discuss. Because this country are change from the world’s largest creditor to its greatest debtor.
Peter Schiff, The author of this article is a person that for more than a decade not only observes the US economy, but also helped people to reposition their investment portfolio in order to avoid the economic risk.

“Unless you take measures to protect yourself your dollar dollar-denominated assets are going to collapse in value and your standard of living will be painfully lowered. I can't pinpoint the date this will happen - the government has been successful in hiding the problem and buying time - but there is going to be a day of reckoning and it's already overdue." And so the book continues. Warning after warning of slippery slopes, fatal flaws, and reality checks that pierces the myth that the American economy is too big to fail.”

The big question in this article is how to build your portfolio in this situation?
Schiff give three steps;
Step One is to 'rethink your stock portfolio'. Basic enough you would expect, but the author is urging readers to replace their endangered US dollar holdings with a portfolio of foreign securities that are safer, significantly higher yielding, and appropriate for any investment objectives. For those unconvinced, the reader is asked to consider what happened in the 1970s. "In 1972, after we broke from the gold standard and floated the dollar (which, of course, didn't float at all, but sank like a stone), you could buy 4.25 deutsche marks for a dollar, the Swiss franc was worth about 25 cents, and you'd get about 360 yen for the dollar. By 1980, the dollar had lost two-thirds of its value. The deutsche mark was at 1.5 instead of 4.25, the Swiss franc had tripled, and the yen was at 150 or 160."
Gold Rush’s examines the various ways the reader can capitalize on the bull market in gold, as well as silver, and explains how these precious metals can add both safety and exiting growth potential to a conservative foreign stock portfolio
In the final step, the author discusses the importance of liquidity in times of financial uncertainty - from having enough money for living expenses to keeping a reserve of uncommitted cash that can be used to acquire assets at bargain prices

UNDERSTANDING RISK and RETURN, the CAPM, and the Fama-French Three-factor Model

RISK AND RETURN

• General concept: high risk high return
• “One widely accepted measure of risk is volatility”--- Risk of owning an asset comes from surprises-unanticipated events —
• Risk divided by two:

Systematic risk—influence large number of asset also market risk --- ex: uncertainty about general economic condition

Unsystematic risk/unique/asset specific risk – influence most a small number (can reduced without lowering expected return by using concept of diversification)

“Investing can (and should) be fun. It can be educational, informative and rewarding. By taking a disciplined approach and utilizing the diversification, buy-and-hold and dollar-cost-averaging strategies, you may find investing rewarding even in the worst of times” (investopedia)

• Beta as a measured of systematic risk

CAPM

• “risk free assets, definition has no systematic risk (or unsystematic risk), so a risk free has beta of zero”
• CAPM attempts to quantify the relationship the beta of an asset and its corresponding expected return.
• Logic thing:
1. first consider an assets that has no volatility and thus, no risk: thus the its return do not vary with the market; as a result, the asset has a beta equal to zero and an expected return
2. second consider an assets that moves in lock-step with the market, or has beta of one
3. lastly think about an assets that experience greater swing in periodic return than a market.

“(E(Rx) – Rf ) / βx “ = “(E(Rm) – Rf) / βm”

E(Rx) = Rf + βx [ E(Rm) – Rf ]

Essenctially, the CAPM states that an assets is expected to earn the risk-free plus a reward for bearing risk as measured by that asset’s beta

• CAPM model gives us an estimate of what the return should be given
• CAPM as a tools to Evaluate Fund Managers

“The presence or absence of a positive alpha can be used to evaluate a manager’s performance”

• Regression Analysis: A tool to Employing the CAPM
• Critique of the CAPM
• The CAPM’s true predictive power is questionable
• Many researcher believe that other risk factor have significant impact on expected return in market

• Additional factors increases predictive power

It is obvious that there are a myriad of risk factor facing companies today from market risk, bankruptcy risk, currency risk, etc; and given that the CAPM uses a single factor to describe aggregate risk.

“Addition of independent variables to a regression often improves the explanatory power of model”

FAMA AND FRENCH AND THE THREE FACTOR MODEL

• Size and value Factor create Additional Explanatory Power.

“Value” n “Size” to be the most significant factors outside the market risk

• The SMB and HML factors
• SMB –Size- (small minus Big): designed to measure the additional return investors have historically received by investing in stock of companies with relatively small market capitalization
• HML –value- (High minus Low): constructed to measured the “value premium “ provided to investors for investing in companies with high book-to-market values
• Interpretation of the factor

“Used simply because they work”

• SMB: small company logically should be expected to be more sensitive to many risk factors.
• HML: big valued company gives more return.
• Three factor model

E(Rx) = Rf + βx [ E(Rm) – Rf ] + SxSMB + h_XHML

S_x = Mesaures the level of exposure the size risk

H_x= Measures the level of exposure the value risk

• SMB and HML, provide added descriptive Dimension for riskiness
• Categorizing fund with the Three factor model
• Classifying Fund into Style Buckets
• Specifying Risk Factor Exposure inform investor Choice
• Multivariate Regression and evaluating Managers with the Three Factor Model

CONCLUSSION

CAPM basically is a good tool to represent the relationship between the risk and return but this tool just uses the Market Risk to represent the “risk” in calculation.

Fama and French add this tool –CAPM- with additional factor (Size and value), in order to give more explanatory power.