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By: Saman (30) Taruna (35) Aarti (37) Mrinalini (54)

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

Style Peer Group & Style Investing


Style of investing is given by firm size or growth (e.g. small cap firms, growth firms, etc) Portfolio managers are compensated based on the style of investor they are and the extra profits they generate for their clients based on this style to reap profits A portfolio manager can mix different styles of investing (e.g. diversification of stocks)

Refining Value Investing using Accounting Data


Value investing can be enhanced by conditioning on volatility and investor sophistication Joseph Piotroski has shown that financial statement information can also be useful 9 fundamental signals are used to measure three areas of a firms financial condition Profitability Financial leverage/ Liquidity Operating Efficiency Signals generates F-score(financial soundness) exhibited by firms due for a turnaround Buying value firms with very high(8-9) F-scores and shorting those with very low(0-1) generated 23% excess return between 1976 and 1996.

Returns to Long-Short Value Strategy

Refining Momentum Investing Using Volume


Volume is another possible screen Charles Lee and Bhaskaran Swaminathan shows that volume predicts both the magnitude and persistence of momentum
V1 R1 1.12 (-2.74) R5 1.36 (-5.37) R10 1.67 (-5.3) R10-R1 0.54 (-2.7) V2 0.67 (-1.61) 1.34 (-4.63) 1.78 (-5.41) 1.11 (-4.46) V3 0.09 (-0.2) 1.15 (-3.28) 1.55 (-4.16) 1.46 (-5.93) V3-V1 -1.04 (-2.74) -0.21 (-1.33) -0.12 (-0.67) 0.91 (-4.61)

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

Momentum Life Cycle

Momentum and Reversal


Mark Grinblatt and Tobias Moskowitz documented the gains available if one conditions on the entire term structure of past returns Negative serial correlation using short-term and long-term returns

Positive serial correlation present for medium-term returns


According to Grinblatt-Han model, consistent winner stocks have larger unrealized capital gains than stocks whose identical past returns was achieved by a month or two of price jumps

Monthly Stock Returns on a Set of Term Structure Variables


Independent variables Coefficient Abs. t-stats Previous month's return -0.0472 11.39 Previous month's return -0.0764 9.63 Previous month's return 0.0051 8.79 Return from -12 to -2 0.0028 2.5 Return from -12 to -2 (L) 0.0113 2.97 Return from -12 to -2 consistency indicator (W) 0.0046 5.8 Return from -12 to -2 consistency indicator (L) -0.0007 0.76 Return from -36 to -13 -0.0015 3.47 Return from -36 to -13 (L) -0.0052 2.04 Return from -36 to -13 consistency indicator (W) 0.0014 2.73 Return from -36 to -13 consistency indicator (L) -0.0007 0.8

Momentum and Value


Value works best for low-momentum stocks, and momentum works best for low value stocks
Value Low Low Momentum High Average 2 3 4 0.03 0.61 0.52 0.99 1.5 0.73 2 0.49 0.59 0.93 0.97 1.44 0.88 3 0.8 0.9 0.8 1.17 1.49 1.03 4 High Average 0.83 1 0.63 1.25 1.35 0.94 1.19 1.44 0.98 1.45 1.68 1.25 1.6 1.62 1.53 1.26 1.42

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.

Second, no risk measures appear.


Third, technical factors,price level factors and liquidity dominates. Momentum and value seem to be heart of it, other factors apparently matter as well. But when transaction costs are factored into analysis it should be noted that baker and haugen strategy entails monthly rebalancing- there appears to be no value added beyond momentum and value.

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.

Value Stocks Large Cap Stock A (with PE 2)

Hybrid

Growth Stock A (with PE 6)

Mid Cap

Small Cap