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

ConclusionConclusion

““Traditional wisdom can be Traditional wisdom can be long on tradition and short long on tradition and short on wisdom”on wisdom”

““I’d be a bum on the street I’d be a bum on the street with a tin cup if the markets with a tin cup if the markets were always efficient.” were always efficient.”

Three Stories, Three Three Stories, Three LessonsLessons

Stock Market behaviorStock Market behavior Herd mentalityHerd mentality People will follow, People will follow,

anywhereanywhere

Mr. MarketMr. Market

You and Mr. Market are partners in a You and Mr. Market are partners in a reasonably stable business. Each day Mr. reasonably stable business. Each day Mr. Market quotes a price at which he is willing Market quotes a price at which he is willing to either buy you out or sell you his share.to either buy you out or sell you his share.

Mr. Market isn’t always rational. He can be Mr. Market isn’t always rational. He can be optimistic on business prospects and optimistic on business prospects and quote a high price. Other days he needs quote a high price. Other days he needs his meds and quotes a low price. his meds and quotes a low price.

Mr. Market also has a bad memory. He Mr. Market also has a bad memory. He doesn’t remember if you rejected him doesn’t remember if you rejected him yesterday. yesterday.

Just DON’T fall victim to his moods. Just DON’T fall victim to his moods.

LemmingsLemmings

Tundra based rodents known for herding Tundra based rodents known for herding behavior. Every three or four years they behavior. Every three or four years they follow each other into the sea until they follow each other into the sea until they drown. drown.

Buffett equates the mob like behavior of Buffett equates the mob like behavior of institutional investors in the market to the institutional investors in the market to the suicidal behaviors of lemmings and holds suicidal behaviors of lemmings and holds it responsible for the wide swings in share it responsible for the wide swings in share price. price.

Put together = third storyPut together = third story

Oil prospector was met at pearly Oil prospector was met at pearly gates by St. Peter….gates by St. Peter….

Herding of similar “investors”Herding of similar “investors” Fell victim to his own misinformationFell victim to his own misinformation How does this fit with Buffett? A little How does this fit with Buffett? A little

more background.more background.

CrashesCrashes The stock market crash of 1929 and The stock market crash of 1929 and

the Great Depression that followed it.the Great Depression that followed it. Stock Market crash of 1987.Stock Market crash of 1987. Asian meltdown of late 1990s & Asian meltdown of late 1990s &

Tech bubble of 2001Tech bubble of 2001 Bear market and the recession of Bear market and the recession of

1973-74.1973-74. Frustrated, investors turned to academics Frustrated, investors turned to academics

for answersfor answers Buffet held fast vs. modern financeBuffet held fast vs. modern finance

Three men and three Three men and three conceptsconcepts

Modern FinanceModern Finance

Harry Markowitz – Portfolio Selection 1952Harry Markowitz – Portfolio Selection 1952 William Sharpe – Portfolio Analysis 1963William Sharpe – Portfolio Analysis 1963 Eugene Fama – Behavior of Prices 1963Eugene Fama – Behavior of Prices 1963

DiversificationDiversification RiskRisk Efficient Market Hypothesis Efficient Market Hypothesis

Markowitz and DiversificationMarkowitz and Diversification

Risk = volatilityRisk = volatility Risk and return relatedRisk and return related If covariance negative – portfolio risk If covariance negative – portfolio risk

reducedreduced Diversification Diversification → less risk→ less risk

Sharpe and BetaSharpe and Beta

Don’t need infinite covariance terms Don’t need infinite covariance terms – just one per firm relative to some – just one per firm relative to some benchmark benchmark

Low beta (systematic risk) reduces Low beta (systematic risk) reduces riskrisk

Unsystematic risk CAN and SHOULD Unsystematic risk CAN and SHOULD be diversified awaybe diversified away

Fama and Efficient MarketsFama and Efficient Markets

Stock prices reflect information quicklyStock prices reflect information quickly Therefore the price = the value of the Therefore the price = the value of the

firmfirm Predictions, patterns, or systems Predictions, patterns, or systems

CANNOT beat the market so why try?CANNOT beat the market so why try?

So all of this is always true? Ask So all of this is always true? Ask Warren.Warren.

Buffett on Modern FinanceBuffett on Modern FinanceRiskRisk, Diversification, and Efficient Markets, Diversification, and Efficient Markets

Risk = possibility of harm or injury, not Risk = possibility of harm or injury, not volatilityvolatility Decline in prices is time to buy. Price decline Decline in prices is time to buy. Price decline

REDUCES risk.REDUCES risk. Take long-term view. Longer horizon REDUCES Take long-term view. Longer horizon REDUCES

riskrisk Lack of patience. Look at some charts.Lack of patience. Look at some charts. ““intrinsic value risk” that the business is worth intrinsic value risk” that the business is worth

less, not price behavior of the stockless, not price behavior of the stock Will after tax return yield equal purchasing Will after tax return yield equal purchasing

power and modest return? power and modest return? ≈ t≈ thorough analysis, horough analysis, safety of principal, and satisfactory returnsafety of principal, and satisfactory return

Buffett on Modern FinanceBuffett on Modern FinanceRisk, Risk, DiversificationDiversification, and Efficient Markets, and Efficient Markets

Diversification for Buffett is a Diversification for Buffett is a “remedy for ignorance and may “remedy for ignorance and may increase riskincrease risk

Diversification reduces volatility, but Diversification reduces volatility, but also returnsalso returns

Concentration Concentration Increases investor focus and raises Increases investor focus and raises

comfort level with economics of firmcomfort level with economics of firm Greater firm knowledge = less riskGreater firm knowledge = less risk

Buffett on Modern FinanceBuffett on Modern FinanceRisk, Diversification, and Risk, Diversification, and Efficient MarketsEfficient Markets

““Observing correctly that the market Observing correctly that the market was was frequentlyfrequently efficient, they went to efficient, they went to conclude that the market was conclude that the market was alwaysalways efficient. The difference between efficient. The difference between these propositions is night and day.”these propositions is night and day.”

Arbitrage implies prices are rightArbitrage implies prices are right Prices are right = No Free LunchPrices are right = No Free Lunch No Free Lunch No Free Lunch ≠ Prices are right≠ Prices are right

More observations on More observations on market efficiencymarket efficiency

““Traditional finance is more concerned Traditional finance is more concerned with checking that two 8 oz. bottles of with checking that two 8 oz. bottles of ketchup are close to the price of one 16 ketchup are close to the price of one 16 oz. than in understanding the price of oz. than in understanding the price of ketchup.” Lawrence Summersketchup.” Lawrence Summers

““The market can stay irrational longer The market can stay irrational longer than you can stay solvent.” Keynesthan you can stay solvent.” Keynes

Here is where behavioral finance fits in Here is where behavioral finance fits in

Quick peek at behavioralismQuick peek at behavioralism

overconfidenceoverconfidence Reference pointsReference points Representativeness = Law of small Representativeness = Law of small

numbersnumbers Conservatism = old dog, new tricksConservatism = old dog, new tricks Confirmation bias = seek supportConfirmation bias = seek support

ConclusionConclusion

““I’d be a bum on the street I’d be a bum on the street with a tin cup if the with a tin cup if the markets were always markets were always efficient.” efficient.”

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