Question

1. Explain 3 Versions of EMH; Implications:Technical vs Fundamental Analysis; Activeversus Passive Portfolio Management, etc.

2. Discuss behavioral biases(covered in lecture)and the impact on investment performance;give examples for each bias; explainprospect theory and what behavioral biases it will lead to.

Answer 1

Solution

(1) EMH says that, an efficient market is one where we have large number of active investors, who independently and actively carry out market research such that,

- current market price of security reflects all available information, &

- New information comes to the market on random basis, affects security prices instantly, leaving no sope for super profits

nobody can earn super normal profits.

Versions of EMH

Weak	Semi- Strong	Strong
Suggets that all past information is used in pricing of thesecurities. Fundamental analysis of securities can provide an investor with informtion to produce returns above market averages in short term, but there are no "patterns" that exist. hence fundamental analysis does not provide long term advantage and technical analysis will not work.	Implies that neither further fundamental analysis nor technical analysis can provide an advantage for an investor, that new information is instantly priced into the securities	All information, both, oublic and private is priced into securities and no investor can gain advantage over the market as a whole. It doesn't say some investors or money managers are incapable of capturing abnormally high returns because that there are always outliers included in that averages.

Implications of EMH:

The implication of EMH is that investors shouldn't be able to beat the market because all information that could predict performance is already built into the stock price. It is assumed that stock prices follow a random walk, meaning that they're determined by today's news rather than past stock price movements.

It is reasonable to conclude that the market is considerably efficient most of the time. However, history has proved that the market can overreact to new information (both positively and negatively). As an individual investor, the best thing you can do to ensure you pay an accurate price for your shares is to research a company before purchasing their stock and analyze whether or not the market appears to be reasonable in its pricing.

Fundamental Analysis Vs Technical Analysis

(a) Fundamental Analysis : Evaluates stocks by attempting to measure their intrinsic value. Fundamental analysts study everything from the overall economy and industry conditions to the financial strength and management of individual companies. Earnings, expenses, assets and liabilities all come under scrutiny by fundamental analysts.

(b) Technical Analysis : Differs from fundamental analysis, in that traders attempt to identify opportunities by looking at statistical trends, such as movements in a stock's price and volume. The core assumption is that all known fundamentals are factored into price, thus there is no need to pay close attention to them. Technical analysts do not attempt to measure a security's intrinsic value. Instead, they use stock charts to identify patterns and trends that suggest what a stock will do in the future.

Active Vs Passive Portfolio Management

(a) Active Portfolio Management :

The investor who follows an active portfolio management strategy buys and sells stocks in an attempt to outperform a specific index, such as the Standard & Poor's 500 Index or the Russell 1000 Index.

An actively managed investment fund has an individual portfolio manager, co-managers, or a team of managers all making investment decisions for the fund. The success of the fund depends on in-depth research, market forecasting, and the expertise of the management team.

Portfolio managers engaged in active investing follow market trends, shifts in the economy, changes to the political landscape, and any other factors that may affect specific companies. This data is used to time the purchase or sale of assets.

Proponents of active management claim that these processes will result in higher returns than can be achieved by simply mimicking the stocks listed on an index.1

Since the objective of a portfolio manager in an actively managed fund is to beat the market, this strategy requires taking on greater market risk than is required for passive portfolio management.

(b) Passive Portfolio Management :

Passive portfolio management is also referred to as index fund management.

The portfolio is designed to parallel the returns of a particular market index or benchmark as closely as possible. For example, each stock listed on an index is weighted. That is, it represents a percentage of the index that is commensurate with its size and influence in the real world. The creator of an index portfolio will use the same weights.

The purpose of passive portfolio management is to generate a return that is the same as the chosen index.

A passive strategy does not have a management team making investment decisions and can be structured as an exchange-traded fund (ETF), a mutual fund, or a unit investment trust.

Index funds are branded as passively managed rather than unmanaged because each has a portfolio manager who is in charge of replicating the index.2

Because this investment strategy is not proactive, the management fees assessed on passive portfolios or funds are often far lower than active management strategies.

Question

(2)(a) Behavioural Biases & their impact on investment decsions

Confirmation : First impressions can be hard to shake because we tend to selectively filter, paying more attention to information that supports our opinions while ignoring the rest. Likewise, we often resort to preconceived opinions when encountering something — or someone — new. An investor whose thinking is subject to confirmation bias would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it.

Regret : Also known as loss aversion, regret aversion describes wanting to avoid the feeling of regret experienced after making a choice with a negative outcome. Investors who are influenced by anticipated regret take less risk because it lessens the potential for poor outcomes. Regret aversion can explain an investor’s reluctance to sell losing investments to avoid confronting the fact that they have made poor decisions.

Disposition: This refers to a tendency to label investments as winners or losers. Disposition effect bias can lead an investor to hang onto an investment that no longer has any upside or sell a winning investment too early to make up for previous losses. This is harmful because it can increase capital gains taxes and can reduce returns even before taxes.

Hindsight : Another common perception bias is hindsight bias, which leads an investor to believe after the fact that the onset of a past event was predictable and completely obvious whereas, in fact, the event could not have been reasonably predicted.

Familiarity : This occurs when investors have a preference for familiar or well-known investments despite the seemingly obvious gains from diversification. The investor may feel anxiety when diversifying investments between well known domestic securities and lesser known international securities, as well as between both familiar and unfamiliar stocks and bonds that are outside of his or her comfort zone. This can lead to suboptimal portfolios with a greater a risk of losses.

Self-attribution : Investors who suffer from self-attribution bias tend to attribute successful outcomes to their own actions and bad outcomes to external factors. They often exhibit this bias as a means of self-protection or self-enhancement. Investors affected by self-attribution bias may become overconfident.

Trend-chasing : Investors often chase past performance in the mistaken belief that historical returns predict future investment performance. This tendency is complicated by the fact that some product issuers may increase advertising when past performance is high to attract new investors. Research demonstrates, however, that investors do not benefit because performance usually fails to persist in the future.

Worry: The act of worrying is a natural — and common — human emotion. Worry evokes memories and creates visions of possible future scenarios that alter an investor’s judgment about personal finances. Anxiety about an investment increases its perceived risk and lowers the level of risk tolerance. To avoid this bias, investors should match their level of risk tolerance with an appropriate asset allocation strategy.

(b) Prospect Theory : It is a behavioural model that shows how people decide between alternatives that involve risk and uncertainty (e.g. % likelihood of gains or losses). It demonstrates that people think in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute outcomes. Prospect theory was developed by framing risky choices and indicates that people are loss-averse; since individuals dislike losses more than equivalent gains, they are more willing to take risks to avoid a loss.

Prospect Thoey Leads To:

The certainty effect is exhibited when people prefer certain outcomes and underweight outcomes that are only probable. The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain. It also contributes to individuals seeking risk when one of their options is a sure loss.

The isolation effect occurs when people have presented two options with the same outcome, but different routes to the outcome. In this case, people are likely to cancel out similar information to lighten the cognitive load, and their conclusions will vary depending on how the options are framed.