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Utility function

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


Risky (Vanguard & Fidelity) = 210,000

Vanguard (V) = 54%
Fidelity (F)

= 46%

Portfolio P
Risk-Free Assets F
Portfolio C

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


210,000/300,000 =


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


Expected returns for combinations

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
Trade-off between risk and return
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

Spreadsheet calculations of indifference curves

Expected returns of four indifference curves and the CAL

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


Correlation coefficients : Possible values

Descriptive statistics for two mutual funds

Computation of portfolio variance from the covariance matrix

Expected return and standard deviation with various correlation


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
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
separated into two independent tasks
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 :

If we define the average variance and average covariance of the securities


We can then express portfolio variance as:

Risk reduction of equally weighted portfolios in correlated and uncorrelated


Mission: in searching for alpha.

News and investment

The Efficient Market Hypothesis (EMH)

Behavioral Finance

News and investment

How is the outlook of IHSG?

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?

How is the price?

When is the time to buy?

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
EMH and competition

Stock prices fully and accurately reflect publicly available information

Once information becomes available, market participants analyze it

Competition assures prices reflect information


Weak Form Efficiency

Semi-Strong Form Efficiency

Market prices reflect all historical (past trading) information

Market prices reflect all publicly available information

Strong Form Efficiency

Market prices reflect all information, both public and private

EMH implication to Technical analysis

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.

As investors compete to exploit their common knowledge of a stocks

price history,

drive stock prices to levels where expected rates of return are

exactly commensurate(sepadan) with risk.

EMH implication to fundamental analysis

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.


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

Implications of the EMH

If markets were inefficient and securities commonly mispriced, then resources

would be systematically misallocated.

Implications for business and corporate finance

Implications for investment

Active vs Passive Portfolio Management

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

economically feasible only for managers of large portfolios

The small investor probably is better off investing in mutual funds.

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

economies of scale.

passive investment strategy

index fund

The role of portfolio management in an efficient market

Even if all stocks are priced fairly(cukup),

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


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.

Are markets efficient

Magnitude Issue

Selection Bias Issue

Lucky Event Issue

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

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

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

After transaction cost

Weak-Form tests

Returns over the Short Horizon

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

a test of the efficacy of technical analysis.

Momentum effect

Returns over Long Horizons

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

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

Reversal effect

the appearance of fluctuating around its fair value.

Predictor of broad market returns

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.

The predictability of market returns is due to predictability in the risk

premium, not in risk-adjusted abnormal returns.

Semi strong Form test

Anomalies: patterns of returns that seem to contradict the EMH.

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

superior returns: whether rejecting the EMH or rejecting the risk

adjustment technique.

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

Semi strong Form test : event studies

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

How test are structured

Returns are adjusted to determine if they are abnormal

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

Book-to-Market Ratios (High = underpriced)

Post-Earnings Announcement Price Drift (Earnings Surprise = news


Bubbles and market efficiency

most bubbles become obvious only after they have burst.

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?

Interpreting the evidence

Risk Premiums or market inefficienciesdisagreement here

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

Anomalies or Data Mining

The noisy market hypothesis

Pricing errors or noise

Fundamental indexing vs. cap-weighted indexing

Stock market analysis

Do Analysts Add Value

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

Associated trading costs

Ambiguity in results

Are superior returns following analyst upgrade due to revelation

of new information or

due to changes in investor demand in response to the changed


Are these results exploitable adjusting for trading costs?

Mutual fund performance

Some evidence of persistent positive and negative performance

Potential measurement error for benchmark returns

Style changes

May be risk premiums

Hot hands phenomenon


Survivorship bias

Behavioral Finance

Use psychology and economics to understand finance

Asset pricing: value anomaly, bubbles, sentiment

Corporate finance: IPO timing, superstar CEOs

Personal finance: Procrastination, emotional choice,

Investors Do Not Always Process Information Correctly

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

Forecasting Errors: heuristic simplification (extrapolating from recent events)

High P/E

Overconfidence: overestimate the precision of their beliefs or forecasts and

their abilities

Only 10% invest in index funds

Herd: social interactions/follow-the-crowd behavior

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

Under react to news give rise to momentum in stock market returns

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

representative of a population as a large one.

Behavioral biases even if information is perfect

Framing: decisions affected by how choices are framed.

Risk averse in terms of gains but risk seeking in terms of losses

Mental Accounting: a specific form of framing in which people

segregate certain decisions

Different risk averse behavior to different investment objective.

Investors hold on to loser and sell winners.

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

Loss aversion: investors to be risk seeking than risk averse when it

comes to losses.