Fin 4201/8001 Topic 2a: EMH, Risk, & Diversification

Conclusion “Traditional wisdom can be long on tradition and short on wisdom” “Traditional wisdom can be long on tradition and short on wisdom” “I’d be a bum on the street with a tin cup if the markets were always efficient.” “I’d be a bum on the street with a tin cup if the markets were always efficient.”

Three Stories, Three Lessons Stock Market behavior Stock Market behavior Herd mentality Herd mentality People will follow, anywhere People will follow, anywhere

Mr. Market You and Mr. Market are partners in a reasonably stable business. Each day Mr. Market quotes a price at which he is willing to either buy you out or sell you his share. You and Mr. Market are partners in a reasonably stable business. Each day Mr. Market quotes a price at which he is willing to either buy you out or sell you his share. Mr. Market isn’t always rational. He can be optimistic on business prospects and quote a high price. Other days he needs his meds and quotes a low price. Mr. Market isn’t always rational. He can be optimistic on business prospects and quote a high price. Other days he needs his meds and quotes a low price. Mr. Market also has a bad memory. He doesn’t remember if you rejected him yesterday. Mr. Market also has a bad memory. He doesn’t remember if you rejected him yesterday. Just DON’T fall victim to his moods. Just DON’T fall victim to his moods.

Lemmings Tundra based rodents known for herding behavior. Every three or four years they follow each other into the sea until they drown. Tundra based rodents known for herding behavior. Every three or four years they follow each other into the sea until they drown. Buffett equates the mob like behavior of institutional investors in the market to the suicidal behaviors of lemmings and holds it responsible for the wide swings in share price. Buffett equates the mob like behavior of institutional investors in the market to the suicidal behaviors of lemmings and holds it responsible for the wide swings in share price.

Put together = third story Oil prospector was met at pearly gates by St. Peter…. Oil prospector was met at pearly gates by St. Peter…. Herding of similar “investors” Herding of similar “investors” Fell victim to his own misinformation Fell victim to his own misinformation How does this fit with Buffett? A little more background. How does this fit with Buffett? A little more background.

Crashes The stock market crash of 1929 and the Great Depression that followed it. The stock market crash of 1929 and the Great Depression that followed it. Stock Market crash of Stock Market crash of Asian meltdown of late 1990s & Tech bubble of 2001 Asian meltdown of late 1990s & Tech bubble of 2001 Bear market and the recession of Bear market and the recession of Frustrated, investors turned to academics for answers Frustrated, investors turned to academics for answers Buffet held fast vs. modern finance Buffet held fast vs. modern finance

Three men and three concepts Modern Finance Modern Finance Harry Markowitz – Portfolio Selection 1952 Harry Markowitz – Portfolio Selection 1952 William Sharpe – Portfolio Analysis 1963 William Sharpe – Portfolio Analysis 1963 Eugene Fama – Behavior of Prices 1963 Eugene Fama – Behavior of Prices 1963 Diversification Diversification Risk Risk Efficient Market Hypothesis Efficient Market Hypothesis

Markowitz and Diversification Risk = volatility Risk = volatility Risk and return related Risk and return related If covariance negative – portfolio risk reduced If covariance negative – portfolio risk reduced Diversification → less risk Diversification → less risk

Sharpe and Beta Don’t need infinite covariance terms – just one per firm relative to some benchmark Don’t need infinite covariance terms – just one per firm relative to some benchmark Low beta (systematic risk) reduces risk Low beta (systematic risk) reduces risk Unsystematic risk CAN and SHOULD be diversified away Unsystematic risk CAN and SHOULD be diversified away

Fama and Efficient Markets Stock prices reflect information quickly Stock prices reflect information quickly Therefore the price = the value of the firm Therefore the price = the value of the firm Predictions, patterns, or systems CANNOT beat the market so why try? Predictions, patterns, or systems CANNOT beat the market so why try? So all of this is always true? Ask Warren. So all of this is always true? Ask Warren.

Buffett on Modern Finance Risk, Diversification, and Efficient Markets Risk = possibility of harm or injury, not volatility Risk = possibility of harm or injury, not volatility Decline in prices is time to buy. Price decline REDUCES risk. Decline in prices is time to buy. Price decline REDUCES risk. Take long-term view. Longer horizon REDUCES risk Take long-term view. Longer horizon REDUCES risk Lack of patience. Look at some charts. Lack of patience. Look at some charts. “intrinsic value risk” that the business is worth less, not price behavior of the stock “intrinsic value risk” that the business is worth less, not price behavior of the stock Will after tax return yield equal purchasing power and modest return? ≈ thorough analysis, safety of principal, and satisfactory return Will after tax return yield equal purchasing power and modest return? ≈ thorough analysis, safety of principal, and satisfactory return

Buffett on Modern Finance Risk, Diversification, and Efficient Markets Diversification for Buffett is a “remedy for ignorance and may increase risk Diversification for Buffett is a “remedy for ignorance and may increase risk Diversification reduces volatility, but also returns Diversification reduces volatility, but also returns Concentration Concentration Increases investor focus and raises comfort level with economics of firm Increases investor focus and raises comfort level with economics of firm Greater firm knowledge = less risk Greater firm knowledge = less risk

Buffett on Modern Finance Risk, Diversification, and Efficient Markets “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.” “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.” Arbitrage implies prices are right Arbitrage implies prices are right Prices are right = No Free Lunch Prices are right = No Free Lunch No Free Lunch ≠ Prices are right No Free Lunch ≠ Prices are right

More observations on market efficiency “Traditional finance is more concerned with checking that two 8 oz. bottles of ketchup are close to the price of one 16 oz. than in understanding the price of ketchup.” Lawrence Summers “Traditional finance is more concerned with checking that two 8 oz. bottles of ketchup are close to the price of one 16 oz. than in understanding the price of ketchup.” Lawrence Summers “The market can stay irrational longer than you can stay solvent.” Keynes “The market can stay irrational longer than you can stay solvent.” Keynes Here is where behavioral finance fits in Here is where behavioral finance fits in

Quick peek at behavioralism overconfidence overconfidence Reference points Reference points Representativeness = Law of small numbers Representativeness = Law of small numbers Conservatism = old dog, new tricks Conservatism = old dog, new tricks Confirmation bias = seek support Confirmation bias = seek support

Conclusion “I’d be a bum on the street with a tin cup if the markets were always efficient.” “I’d be a bum on the street with a tin cup if the markets were always efficient.” Sample exam questions Sample exam questions Next time topic 2a Next time topic 2a