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# Utility function

Where
U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
s2 = variance of returns

## Risky asset example

Total portfolio value
Risk-free value

= \$300,000
=

90,000

## Risky (Vanguard & Fidelity) = 210,000

Vanguard (V) = 54%
Fidelity (F)

= 46%

Vanguard
Fidelity
Portfolio P
Risk-Free Assets F
Portfolio C

113,400/300,000 = 0.378
96,600/300,000 =

0.322

210,000/300,000 =

0.700

90,000/300,000 =
300,000/300,000 =

0.300
1.000

## rc = complete or combined portfolio

For example, y = .75
E(rc) = .75(.15) + .25(.07)
= .13 or 13%
Combination without leverage

## Capital Allocation line with leverage

Borrow at the Risk-Free Rate and invest in stock.
Using 50% Leverage,
rc = (-.5) (.07) + (1.5) (.15) = .19
sc = (1.5) (.22) = .33

## Risk tolerance and asset allocation

The investor must choose one optimal portfolio, C, from the set of feasible
choices
Expected return of the complete portfolio is given by:

Variance is:

Utility levels for various positions in risky assets (y) for an investor with
risk aversion A=4

## Covariance and correlations

Portfolio risk depends on the correlation between the returns of the assets in
the portfolio
Covariance and the correlation coefficient provide a measure of the way
returns two assets vary
Two security portfolio : return

## Two security portfolio : return

= variance of security D
= variance of security E
= covariance of returns for security D and security E

Covariance

## Expected return and standard deviation with various correlation

coefficients

Correlation effects

Sharpe Ratio
Maximize the slope of the CAL for any possible portfolio, p
The objective function is the slope:

## Markowitz Portfolio selection model

Security Selection
First step is to determine the risk-return opportunities available
All portfolios that lie on the minimum-variance frontier from the global
minimum-variance portfolio and upward provide the best risk-return
combinations
We now search for the CAL with the highest reward-to-variability ratio
Now the individual chooses the appropriate mix between the optimal
risky portfolio P and T-bills

## Capital allocation and the separation property

The separation property tells us that the portfolio choice problem may be
Determination of the optimal risky portfolio is purely technical
Allocation of the complete portfolio to T-bills versus the risky portfolio
depends on personal preference
The power of diversification
Remember :

as:

universes

## The Efficient Market Hypothesis (EMH)

Behavioral Finance

## How is the political condition?

How is the economy and the currency trend? (domestic and global)

## What sectors are promising?

What companies you would thing could be included in your watch lists?

## Random walk theory

The movement of stock prices from day to day DO NOT reflect any pattern.

## Statistically speaking, the movement of stock prices is random (skewed

positive over the long term).

## Efficient Market hypothesis (EMH)

The hypothesis that prices of securities fully reflect available information about
securities.
EMH and competition

EMH

## Technical analysis: Research on recurrent and predictable stock price patterns

and on proxies for buy or sell pressure in the market.

## The key is a sluggish(lamban) response of stock prices to fundamental

supply-and-demand factors.

price history,

## Fundamental analysis: Research on determinants(penentu) of stock value,

such as earnings and dividend prospects, expectations for future interest
rates, and risk of the firm.

Difficult.

## It is not enough to do a good analysis of a firm

You can make money only if your analysis is better than that of your
competitors.

## If markets were inefficient and securities commonly mispriced, then resources

would be systematically misallocated.

## Active vs Passive Portfolio Management

Only serious analysis and uncommon techniques are likely to generate the
differential insight necessary to yield trading profits.

## By pooling resources in this way, small investors can gain from

economies of scale.

index fund

## each still poses(sikap) firm-specific risk that can be eliminated through

diversification.

Investors optimal positions will vary according to factors such as age, tax
bracket, risk aversion, and employment.

Rather than to beat the market, the role of the portfolio manager in an
efficient market is to tailor the portfolio to these needs.

Magnitude Issue

## Lucky Event Issue

After the fact there will have been at least one successful investment
scheme.

A doubter will call the results luck; the successful investor will call it
skill.

The proper test would be to see whether the successful investors can repeat
their performance in another period, yet this approach is rarely taken.

Long term

Weak-Form tests

## Returns over the Short Horizon

Could speculators find trends in past prices that would enable them to
earn abnormal profits?

Momentum effect

## pronounced (jelas) negative long-term serial correlation in the

performance of the aggregate market (Fama and French, 1988; Poterba
and Summers, 1988)

Reversal effect

## Several studies have documented the ability of easily observed variables to

predict market returns.

## The return tends to be higher when the dividend/price ratio, the

dividend yield, is high.

## Need to adjust for portfolio risk before evaluating the success of an

investment strategy.

joint tests of the efficient market hypothesis and the risk adjustment
procedure.

## superior returns: whether rejecting the EMH or rejecting the risk

usually, the risk adjustment technique is based on morequestionable assumptions than is the EMH.

## Empirical financial research that enables an observer to assess the impact of

a particular event on a firms stock price

Abnormal return due to the event is estimated as the difference between the
stocks actual return and a proxy for the stocks return in the absence of the
event

## Market Model approach

a. rt = at + brmt + et
(Expected Return)
b. Excess Return =
(Actual - Expected)
et = rt - (a + brMt)
Semi strong form test : anomalies or risk factors

Such minimal effort to yield such large rewards: Plausible (masuk akal) ?

## P/E Effect (Low P/E High P/E)

Small-Firm-in-January Effect

## Neglected (terabaikan) Firm Effect

Liquidity Effects

content)

## Strong Form Test : inside information

The ability of insiders to trade profitability in their own stock has been
documented in studies by Jaffe, Seyhun, Givoly, and Palmon

The tendency for stock prices to rise after insiders intensively bought
shares and to fall after intensive insider sales.

## SEC requires all insiders to register their trading activity can it be

replicated by other investors?

## may contain a relatively high proportion of distressed firms that have

suffered recent difficulties.

## Fama and French argue that these effects can be explained as

manifestations (perwujudan) of risk stocks with higher betas

Lakonishok, Shleifer, and Vishny argue that these effects are evidence
of inefficient markets

Mixed evidence

## Positive changes in analysts recommendations are associated

with increased stock prices of about 5%, and negative changes
result in average price decreases of 11%

## Firms with the most-favorable recommendations outperform

those with the least-favorable recommendations

Ambiguity in results

## Are superior returns following analyst upgrade due to revelation

of new information or

outlook?

Style changes

## Hot hands phenomenon

Persistence?

Survivorship bias

Behavioral Finance

## Investors Often Make Inconsistent or Systematically Suboptimal Decisions

(Not Random)
I will diversify later
I prefer to invest in local stocks

## Nobel Prize (2002) to Daniel Kahneman

Information Processing

High P/E

their abilities

## Herd: social interactions/follow-the-crowd behavior

Conservatism bias: investors are too slow (too conservative) in updating their
beliefs in response to new evidence.

## Sample Size Neglect and Representativeness: a small sample is just as

representative of a population as a large one.

## Mental Accounting: a specific form of framing in which people

segregate certain decisions

## Momentum in stock prices.

Behavioral Biases

Regret Avoidance: individuals who make decisions that turn out badly have
more regret when that decision was more unconventional.

## Buying a blue-chip portfolio vs. start-up firm.

The small size and high book-to-market effect by De Bondt and Thaler

## Prospect Theory (Kahneman and Tversky) modifies the analytic

description of rational risk-averse investors found in standard financial
theory.

comes to losses.