1. Fin 4201/8001 1 Conclusion “I’d be a bum on the street with a tin cup if the markets were always efficient.” Warren Buffett.

2. Fin 4201/8001 2 Three stories, three lessons Stock Market behavior Herd mentality People will follow, anywhere.

3. Fin 4201/8001 3 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.

4. Fin 4201/8001 4 The business that you both own is fortunate to have stable economic characteristics, but Mr. Market’s 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.

5. Fin 4201/8001 5 Mr. Market has another endearing characteristic, said Graham. He does not mind being snubbed. If Mr. Market’s quotes are ignored, he will be back again tomorrow with a new quote. Graham warned his students that it is Mr. Market’s pocketbook, not his wisdom, that is useful. If Mr. Market’s 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.

6. Fin 4201/8001 6 Lemmings Case 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.

7. Fin 4201/8001 7 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.

8. Fin 4201/8001 8

9. 9 Modern Finance and Buffett “Traditional wisdom can be long on tradition and short on wisdom.”

10. Fin 4201/8001 10 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.

11. Fin 4201/8001 11 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.

12. Fin 4201/8001 12 Fixed income securities depreciated because of low coupons. Oil prices skyrocketed. Mortgage rates were unaffordable

13. Fin 4201/8001 13 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

14. Fin 4201/8001 14 Modern finance stream Frustrated by the failures, investment professionals looked at the academic world which offered an edifice that changed the entire industry.

15. Fin 4201/8001 15 Three concepts and three men Diversification Risk Efficient Market Theory Harry Markowitz William Sharpe Eugene Fama

16. Fin 4201/8001 16 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.

17. Fin 4201/8001 17 Risk = variance / standard deviation (deviation from the expectation/average) Concept of efficient frontier – portfolios giving highest return for a given level of risk.

18. Fin 4201/8001 18 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.

19. Fin 4201/8001 19 William Sharpe and Risk “A Simplified Model of Portfolio Analysis” in Journal of Finance, 1963. Birth of CAPM – Capital Asset Pricing Model. Simplified Markowitz’s idea of efficient frontier.

20. Fin 4201/8001 20 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.

21. Fin 4201/8001 21 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.

22. Fin 4201/8001 22 Sharpe divided the total risk (variance) into systematic and unsystematic risk. Systematic risk = beta (how stock moves with the market) This cannot be diversified.

23. Fin 4201/8001 23 Unsystematic or idiosyncratic risk: unique to a stock. This can and should be diversified. Thus, there is no reward for bearing this risk.

24. Fin 4201/8001 24 Eugene Fama and EMT Inspired by French mathematician Benoit Mandelbrot. Mandelbrot’s 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.

25. Fin 4201/8001 25 “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.

26. Fin 4201/8001 26 Buffett on Risk Diversification Efficient Markets

27. Fin 4201/8001 27 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.

28. Fin 4201/8001 28 Buffett definition: possibility of harm or injury. A factor of the “intrinsic value risk” of the business, not the price behavior of the stock.

29. Fin 4201/8001 29 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.

30. Fin 4201/8001 30 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.”

31. Fin 4201/8001 31 Risk and time horizon Short term: investment = speculation = high risk. Extend the time horizon out to several years and risk reduces meaningfully.

32. Fin 4201/8001 32 Conclusion “For owners of a business – and that’s the way we think of shareholders – the academics’ definition is far off the mark, so much so that it produces absurdities”.

33. Fin 4201/8001 33 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.

34. Fin 4201/8001 34 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.

35. Fin 4201/8001 35 Conclusion Diversification is a remedy for ignorance. If you don’t 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.

36. Fin 4201/8001 36 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?

37. Fin 4201/8001 37 Behavioral Finance, arguements against EMT Barberis and Thaler, 2001 Investors are not always rational: Research in psychology shows biases and beliefs. Overconfidence Representativeness Optimism and Wishful Thinking More…

38. Fin 4201/8001 38 Example: Representativeness Kahneman 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.

39. Fin 4201/8001 39 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.

40. Fin 4201/8001 40 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

41. Fin 4201/8001 41 “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.”

42. Fin 4201/8001 42 Belief in EMT is good for Buffett “In any sort of a contest – financial, mental, or physical – it’s an enormous advantage to have opponents who have been taught it’s useless to even try.” “From a selfish standpoint, we should probably endow chairs to ensure the perpetual teaching of EMT.”

43. Fin 4201/8001 43 Conclusion “I’d be a bum on the street with a tin cup if the markets were always efficient.” Warren Buffett.