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Behavioural Investing
Anomaly Attenuation
Anomalies are described as discrepancies in financial markets that are not predicted by behavioural finance theories such as EUT (e.g. Winners Curse, Equity Premium Puzzle, etc.) William G. Schwert in his research paper (2002) reported that these anomalies have disappeared
This situation can arise if we keep on giving the investor the same situation again and again. He would learn what to do and what not to do, as a result of which, the anomalies would disappear
It is found that Low-volume firm earns higher returns Momentum-Volume Strategy long low volume-high-momentum firms, earn 1.67%/month Short high volume-low momentum firms, earn 0.9%/month
Multivariate Approach
Statistical methods for analysis using multiple variables. 2 studies that have taken multivariate approach Beginning with Marc Reinganums workIn order to investigate whether winners tended to share certain common characteristics, he employed a sample of 222 firms whose stocks had at least doubled in price between year 1970 and 1983.
Multivariate Approach
Reinganum identified four key commonalties:
1. 2. 3. 4. A price to book ratio less than one- value Acceleration in quaterly earnings growth- may be a means of extracting diamonds in the rough (as in Piotroski) Fewer than 20 million common shares outstanding- proxying for market captalization. High relative strength- momentum
He applied these commonalities as screens over all AMEX and NYSE firms for the same period.
A buy signal was triggered After this the security was held for a two year period and then sold off.
Multivariate Approach
cumulative excess returns were calculated and impressive results were found. It outperformed the S&P 500 BY 37.14% (at a comparable risk level). Illiquid stocks need to have higher returns to compensate traders who must face higher transaction costs, so such logical factors as price per share and volume were inluded Growth potential factors point to the likelihood of higher growth in earnings and dividends,with various profitability measures being used as proxies in this regard. The idea is that, for a given price relative to accounting measures, indicators suggesting higher future growth might point to diamonds in the rough. Technical factors include momentum and reversal measures.
Following this approach, Robert Haugen and Nardin Baker investigated the predictive contribution of factors into five categories1. Risk
2.
3. 4. 5.
Liquidity
Price level Growth potential Technical Risk factors include such standard risk factors as beta and sensitivities to macroeconomic variables.
Multivariate Approach
Regression was done
Several salient points are first, the impact of the factors is remarkably consistent.
Style Rotation
Rotating ones portfolio from one style of investment to another.
Rotation is done using a feasible and accurate model. It requires a model describing the criteria/ condition for changing/ rotating the portfolio from one style to another.
Triggers could include a market fall/rise; interest rate hike/cut, level of consumer confidence, etc.
Portfolio style refers to the basis on which one forms a portfolio. For example, Investing in only value stocks, investing in high PE stocks, etc.
Portfolio style is usually chosen from a range of options available from a multi-dimensional matrix. The dimensions are usually pre-specified by investors/ model makers.
Default premium Aggregate dividend yield Time structure PE ratio Sales Growth etc.
Style investing is based on the assumption that not all types of investment do well at the same time. Rather than limiting their investments to only growth stock or only value stock, managers attempt to make gains by moving from one segment to another as conditions warranted. This could improve performance by rotating their portfolios among various investment segments.
The Morningstar Style Box is a nine-square grid that provides a graphical representation of the "investment style" of stocks and mutual funds. For stocks and stock funds, it classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis). Fixed income funds are classified according to credit quality (the vertical axis) and sensitivity to changes in interest rates (the horizontal axis). Process:
The grid/matrix is formed (pre-specified) Morningstar evaluates each stock and gives it an investment style on the basis of Price/Prospective Earnings. Ratios : Price/book, Price/sales, Price/cash flow, Dividend yield Long-term projected earnings growth, etc. Weights/score are given to each stock and they are placed in the grid. As their pre-specified factors are changed, so are their positions in the grid.
Hybrid
Mid Cap
Small Cap