| Home | My photos | Forex | My trading | Contacts |
|
|
You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
|
They point out to the frequency with speculative bubbles have formed in financial markers, as investors buy into fads or get-rich-quick schemesLong-term Price Movements While most of the earlier studies of price behavior focused on shorter return intervals, more attention has been paid to price movements over longer periods (one-year to five-year) in recent years. Here, there is an interesting dichotomy in the results. When long term is defined as months rather than years, there seems to be a tendency towards positive serial correlation. Jegadeesh and Titman present evidence of what they call price momentum in stock prices over time periods of up to eight months when investors winner and loser stocks. However, when long term is defined in terms of years, there is substantial negative correlation returns, suggesting that markets reverse themselves over very long periods. Fama and French examined five-year returns on stocks from 1931 to 1986 and present further evidence of this phenomenon. Studies that break down stocks on the basis of market value have found that the serial correlation is more negative in five-year returns than in one-year returns, and is much more negative for smaller stocks rather than larger stocks. Figure 6.2 summarizes one-year and five-years serial correlation by size class for stocks on the New York Stock Exchange. This phenomenon has also been examined in other markets, and the findings have been similar. There is evidence that returns reverse themselves over long time period. Winner and Loser portfolios Since there is evidence that prices reverse themselves in the long term for entire markets, it might be worth examining whether such price reversals occur on classes of stock within a market. For instance, are stocks that have gone up the most over the last period more likely to go down over the next period and vice versa? To isolate the effect of such price reversals on the extreme portfolios, DeBondt and Thaler constructed a winner portfolio of 35 stocks, which had gone up the most over the prior year, and a loser portfolio of 35 stocks, which had gone down the most over the prior year, each year from 1933 to 1978, and examined returns on these portfolios for the sixty months following the creation of the portfolio. Figure 6.3 summarizes the excess returns for winner and loser portfolios . This analysis suggests that loser portfolio clearly outperform winner portfolios in the sixty months following creation. This evidence is consistent with market overreaction and correction in long return intervals. Jegadeesh and Titman find the same phenomenon occurring, but present interesting evidence that the winner (loser) portfolios continue to go up (down) for up to eight months after they are created and it is in the subsequent periods that the reversals occur. There are many, academics as well as practitioners, who suggest that these findings may be interesting but that they overstate potential returns on loser portfolios. For instance, there is evidence that loser portfolios are more likely to contain low priced stocks (selling for less than $5), which generate higher transactions costs and are also more likely to offer heavily skewed returns, i.e., the excess returns come from a few stocks making phenomenal returns rather than from consistent performance. One study of the winner and loser portfolios attributes the bulk of the excess returns of loser portfolios to low-priced stocks and also finds that the results are sensitive to when the portfolios are created. Loser portfolios created every December earn significantly higher returns than portfolios created every June. Speculative Bubbles, Crashes and Panics Historians who have examined the behavior of financial markets over time have challenged the assumption of rationality that underlies much of efficient market theory. They point out to the frequency with speculative bubbles have formed in financial markers, as investors buy into fads or get-rich-quick schemes, and the crashes with these bubbles have ended, and suggest that there is nothing to prevent the recurrence of this phenomenon in todays financial markets. There is some evidence in the literature of irrationality on the part of market players. a. Experimental Studies of Rationality Some of the most interesting evidence on market efficiency and rationality in recent years has come from experimental studies. While most experimental studies suggest that traders are rational, there are some examples of irrational behavior in some of these studies. One such study was done at the University of Arizona. In an experimental study, traders were told that a payout would be declared after each trading day, determined randomly from four possibilities - zero, eight, 28 or 60 cents. The average payout was 24 cents. Thus the shares expected value on the first trading day of a fifteen day experiment was $3.60 (24*15), the second day was $3.36 ... . The traders were allowed to trade each day. The results of 60 such experiments is summarized in figure 6.4. There is clear evidence here of a speculative bubble forming during periods 3 to 5, where prices exceed expected values by a significant amount. The bubble ultimately bursts, and prices approach expected value by the end of the period. If this is feasible in a simple market, where every investor obtains the same information, it is clearly feasible in real financial markets, where there is much more differential information and much greater uncertainty about expected value. It should be pointed out that some of the experiments were run with students, and some with Tucson businessmen, with real world experience. The results were similar for both groups. Furthermore, when price curbs of 15 cents were introduced, the booms lasted even longer because traders knew that prices would not fall by more than 15 cents in a period. Thus, the notion that price limits can control speculative bubbles seems misguided. b. Behavioral Finance The irrationality sometimes exhibited by investors has given rise to a whole new area of finance called behavioral finance. Using evidence gathered from experimental psychology, researchers have tried to both model how investors react to information and how prices will change as a consequence. They have been far more successful at the first endeavor than the second. For instance, the evidence seems to suggest the following: a. Investors do not like to admit their mistakes. Consequently, they tend to hold on to losing stocks far too long, or in some cases, double up their bets (investments) as stocks drop in value. b. More information does not always lead to better investment decisions. Investors seem to suffer both from information overload and a tendency to react to the latest piece of information. Both result in investment decisions that lower returns in the long term. If the evidence on how investors behave is so clear cut, you might ask, why are the predictions that emerge from these models so noisy? The answer, perhaps, is that any model that tries to forecast human foibles and irrationalities is, by its very nature, unlikely to be a stable one. Behavioral finance may emerge ultimately as a trump card in explaining why and how stock prices deviate from true value, but their role in devising investment strategy still remains questionable. Behavioral Finance and Valuation In 1999, Robert Shiller made waves in both academia and investment houses with his book titled Irrational Exuberance. His thesis is that investors are often not just irrational but irrational in predictable ways- overreacting to some information and buying and selling in herds. His work forms part of a growing body of theory and evidence of behavioral finance, which can be viewed as a congruence of psychology, statistics and finance. While the evidence presented for investor irrationality is strong, the implications for valuation are less so. You can consider discounted cash flow valuation to be the antithesis of behavioral finance, because it takes the point of view that the value of an asset is the present value of the expected cash flows generated by that asset. With this context, there are two ways in which you can look at the findings in behavioral finance: * Irrational behavior in finance may explain why prices can deviate from value (as estimated in a discounted cash flow model). Consequently, it provides the foundation for the excess returns earned by rational investors who base decisions on estimated value. Implicit here is the assumption that markets ultimately recognize their irrationality and correct themselves. * It may also explain why discounted cash flow values can deviate from relative values (estimated using multiples). Since the relative value is estimated by looking at how the market prices similar assets, market irrationalities that exist will be priced into the asset. |
|
|||||||||||||||
Previous Issues
|
| ©2007 Olesia | Home • My photos • Forex • News • My trading • Contacts |