The New Finance

CHAPTER ONE SEARCH FOR THE GRAIL

Why “New” Finance For decades, students and academics have studied the “numbers” to attempt and find the answer to the investing question. How do prices react and how can I profit from a forecast of that reaction? Recently the market has changed. The historical research does not seem to fit. How long will this last? Is the change permanent?

What is happening? Investors seem to over-react to past performance. – Pricing growth stocks too high – Pricing value stocks too low The outcome seems to be that value stock produce higher returns than growth stocks.

Fama and French The stock market is efficient. Any difference between stocks must be due to differences in risk. Focus on differences between – Book value of equity – Market value of stock Expensive growth stocks should have low book to value ratios – Value stocks the opposite

FF results Shows value stocks outperform growth stocks. – Book to market ratio is a good predictor of future returns for well-diversified portfolios. What does this mean for retirement investors?

What is the “Golden Opportunity”? Long-term strategy. – Not get rich quick; but also not disappearing quick If we assume market corrections are aberrations most believe that stocks outperform bonds over the long-term. Why do we not see the proper growth of GO? – Institutional investors drive the market. – Fiduciaries and are scared of short-term under-performance If institutional investors do not “follow” GO, then it is available for us. – We can follow it; and invest more effectively.

How does risk impact investing in GO? Expensive stocks are riskier than cheap stocks. FF measure risk by beta. They also looked at how beta was related to market / book ratio. Shows that high betas are related to growth stocks. Seems to contradict “Modern Finance” and the high risk- high return concept. This what is referred to as “The New Finance”.

CHAPTER TWO THE OLD FINANCE

What is “Modern Finance” Three primary concepts – Possible to build the lowest possible risk portfolios given your choice of return. Use “The Tool” – The tool is cool but not many use it. – If everyone uses “The Tool”, we can create a theory of pricing referred to as the CAPM, “The Theory”. Since not many use it, the theory is not correct. – If prices reflect all information we know, we would have market efficiency, “The Fantasy”. Stocks do not react quickly to new information.

The Tool Markowitz – Father of Modern Finance Expected return is the weighted average of the returns of the stocks in the portfolio. Risk is dependent on relationships between the stocks. To find the lowest risk for a given return, you can find “The Bullet”

The Theory We all choose something on the efficient frontier. To work we all must use the tool. Economic models work is we can predict how investors will react and then how their collective efforts impact prices. – But investors must act as we assume. Do we use the tool? – Money managers do not care mush about volatility. They watch their bets and minimize how much they invest in individual stocks. – Managers do care about tracking error. – What is tracking error?

The Fantasy Is the market driven by disciplined rational investors? Do investors search diligently for all relevant information about an investment? Do investors react quickly, when new information is placed before them? What can you say about the fantasy?

CHAPTER THREE HOW LONG IS THE SHORT RUN?

Short and Long Run Normal profit – reasonable returns given amount of capital, interest rates, and risk. Abnormal profit – anything above or below that. Companies may be able to earn abnormal profits in the short-run, but eventually they revert to normal profits. The important question: How long is the short-run?

Short Run Certainly varies from industry to industry. A couple years. Prices in an inefficient market do not work this way. – Prices and performance are typically project to last much longer than this. – Growth companies are then expected to grow longer than they will. – Investors in growth stocks are then ultimately disappointed.

Jegadeesh and Titman (JT) Ranked stocks into best and worst performers. Measured 3-day performance for the next 3 years. Good companies outperform but only for a short time frame. Companies revert to the mean in terms of growth rates. Market over-reacts with a lag.

Inertia How will stocks act in the future? We saw that in the short term +’s follow +’ and –’s, -’s. However, in the long-term investors see this is wrong and make corrections. Choosing value stocks today, should lead to positive returns in the long-run.

How does volatility fit into the mix? Lo and MacKinley (LM) looked at volatility over time segmented by size. Shows that volatility increases as time increases and also by inversely by size. Longer time and smaller firms have more inertia volatility.