Psychological Biases

Loss Aversion

Behavioural finance asserts that investors exhibit loss aversion, that is, they dislike losses more than they like comparable gains.

This results in a strong preference for avoiding losses as opposed to achieving gains.

Advocates of this bias argue that loss aversion is more important to investors than risk aversion,, which is why the "overreaction" anomaly is observed.

While loss aversion can explain the overreaction anomaly, studies have shown that under reactions are just as common as overreactions, which counters the assertions of this bias.



Herding

Herding behaviour is a behavioural bias that explains both under reactions and overreactions in financial markets.

Herding occurs when investors ignore their own analysis, and instead make investment decisions in line with the direction of the market.



Overconfidence

Overconfdence bias asserts investors have an inflated view of their ability to process new information appropriately.

Overconfident investors are inaccurate when it comes to valuing securities given new information, and therefore stocks will be mispriced if there is an adequate number of such investors in the market.

Evidence has suggested that overconfidence has led to mispricing in most major markets around the world, but the bias has been observed predominantly in higher-growth companies, whose prices are slow to factor in any new information.

Another aspect of this bias is that overconfident investors tend to maintain portfolios that are less-than-optimally diversified because they tend to overestimate their stock-picking abilities.




Information Cascades

An information cascade refers to the transfer of information from market participants who are the first to take investment action upon the release of new information, and whose decisions influence the decisions of others.

Studies have shown that information cascades tend to be greater for stocks when reliable and relevant information about the underlying company is not easily available.




Representativeness

Investors assess probabilities of future outcomes based on how similar they are to the current state.



Mental Accounting

Investors tend to keep track of gains and losses from different investments in separate mental accounts.



Conservatism

Investors are slow to react to changes and continue to maintain their initial views.



Narrow framing

Investors focus on issues in isolation

Behavioural Finance

Behavioural finance looks at investor behaviour to explain 

• why individuals make the decisions that they do, 
• whether these decisions are rational or irrational.

It is based on the premise that individuals, due to the presence of behavioural biases:

• do not always make "efficient" investment decisions, or 
• do they always act "rationally" 

These behavioural biases include:

• Loss Aversion
• Herding
• Overconfidence
• Information Cascades
• Representativeness
• Mental Accounting
• Conservatism
• Narrow Framing

Whether investor behaviour can explain market anomalies is a subject open to debate.

• If investors must be rational for the market to be efficient, then markets cannot be efficient.
• If markets are defined as being efficient, investors cannot earn superior risk-adjusted profits consistently. 

Momentum and Overreaction Anomalies

Overreaction

Investors tend to inflate (depress) stock prices of companies that have released good (bad) news.

Studies have shown that "losers" (stocks that have witnessed a recent price decline due to the release of bad news) have outperformed the market in subsequent periods, while winners have underperformed in subsequent periods.


Momentum

Other studies have also shown that securities that have outperformed in the short term continue to generate high returns in subsequent periods (carrying on price momentum).



Note:  The overreaction and momentum anomalies go against the assertions of weak-form efficiency in markets.

Earnings Surprises

Several studies have shown that although earnings surprises are quickly reflected in stock prices most of the time, this is not always the case.

Investors may be able to earn abnormal returns using publicly available earnings information by purchasing stocks of companies that have announced positive earnings surprises.

However, recent evidence has suggested that abnormal returns observed after earnings surprises do not control for transaction costs and risk.

Closed-End Investment Fund Discounts

Several studies have shown that closed-end funds tend to trade at a discount (sometimes exceeding 50%) to their per share NAVs.

Theoretically, investors could purchase all the shares in the fund, liquidate the fund, and make a profit by selling the constituent securities at their market prices.

However, after accounting for management fees, unrealized capital gain taxes, liquidity and transactions costs, any profit potential is eliminated.

Objectives of Market Regulation

• Control fraud or deception of uninformed market participants.
• Control agency problems by setting minimum standards of competence for agents and by defining and enforcing minimum standards of practice.
• Promote fairness by creating a level playing field for market participants.
• Set mutually beneficial standards for financial reporting.
• Prevent undercapitalized financial firms from exploiting their investors by making excessively risky investments
• Ensure that long-term liabilities are funded.

Characteristics of a Well-Functioning Financial System

Timely and accurate information on the price and volume of recent transactions.  If timely information is not available, a seller may not get the best possible price and a buyer may end up paying too high a price.

Liquidity, which refers to the ability to buy or sell the asset quickly, at a price close to that of a recent market transaction, assuming no new information has been received.  To achieve price continuity, the market must be significantly deep.

Internal efficiency in that there are low transaction costs, which include the costs of reaching the market and brokerage costs.

External or informational efficiency, which is achieved when market prices reflect all external available information about an asset.  Prices should rapidly adjust to reflect any new information.

A Dealer Market

A dealer market (quote driven market or price driven market) consists of individual dealers who are assigned specific securities.

These dealers create liquidity by purchasing and selling against their own inventory of securities.

Competition between dealers ensures that competitive prices are available.

Private Placements

In a private placement, securities are not offered to the public.

Companies sell securities directly to a group of qualified investors, usually through an investment bank.

Qualified investors are generally those who understand associated risks and have sufficient wealth to withstand significant losses.

Private placements are typically cheaper than public offerings as they do not require as much public disclosures.

However, since privately placed securities do not trade on organized secondary markets, investors require a higher rate of return from them.

Risk Objectives

An example of an absolute risk objective would be that the client does not want to lose more than 5% of her capital over a particular period.

Relative risk objectives relate risk to a certain benchmark that represents an appropriate level of risk.

Risk tolerance is a function of BOTH:

• a client's ability to take risk, as well as,
• her willingness to take risk.

Ability to take risk

The ability to take risk is a function of several factors including:

• time horizon,
• expected income, and 
• net worth.

Generally speaking, a client with a longer time horizon, high expected income and greater net worth has a greater ability to bear risk.

Willingness to take risk

A client's willingness to bear risk, on the other hand, is based on more subjective factors including 

• her psychological makeup and 
• level of understanding of financial markets.

4 scenarios:

1.  Ability to take risk - below average.  Willingness to take risk - below average

The investor's overall risk tolerance is below average

2.  Ability to take risk - above average.  Willingness to take risk - above average

The investor's overall risk tolerance is above average

3.  Ability to take risk - below average.  Willingness to take risk - above average

The investor's overall risk tolerance is below average

4.  Ability to take risk - above average.  Willingness to take risk - below average

The investment manager should explain the conflict and implications to the client.

When there is a mismatch between a client's ability and willingness to take risk, the prudent approach is to conclude that the client's tolerance for risk is the lower of the two factors.

Any decisions made must be documented.

The Investment Policy Statement

The Investment Policy Statement (IPS)

An investment policy statement is an invaluable planning tool that adds discipline to the investment process.

Before developing an IPS, an investment manager must conduct a fact finding discussion with the client to learn about the client's risk tolerance and other specific circumstances.

The IPS can be thought of as a roadmap which serves the following purposes:

• It helps the investor decide on realistic investment goals after learning about financial markets and associated risks.
• It creates a standard according to which the portfolio manager's performance can be judged.
• It guides the actions of portfolio managers, who should refer to it from time to time to assess the suitability of particular investments for their clients.

Major components of an IPS

• An introduction that describes the client.
• A statement of purpose.
• A statement of duties and responsibilities, which describes the duties and responsibilities of the client, the custodian of the client's assets, and the investment manger.
• Procedures that outline the steps required to keep the IPS updated and steps required to respond to various contingencies.
• The client's investment objectives.
• The client's investment constraints.
• Investment guidelines regarding how the policy should be executed (e.g., whether use of leverage and derivatives is permitted) and specific types of assets that must be excluded.
• Evaluation and review guidelines on obtaining feedback on investment results.
• Appendices that describe the strategic asset allocation and the rebalancing policy.

Investment Constraints

Liquidity

Liquidity refers to the ability to readily convert investments into cash at a price close to fair market value.

Investors may require ready cash to meet unexpected needs and could be forced to sell their assets at unfavourable terms if the investment plan does not consider their liquidity needs.

Time Horizon

Time horizon refers to the time period between putting funds into an investment and requiring them for use.  

A close relationship exists between an investor's time horizon, liquidity needs and ability to take risk.
The shorter the time horizon the harder it would be for an investor to overcome losses.

Tax Concerns

Tax concerns play a very important role in investment planning because, unlike tax-exempt investors, taxable investors are really only concerned with after-tax returns on their portfolios.

Legal and Regulatory Factors

Investors also need to be aware of legal and regulatory factors.

For example, some countries impose a limit on the proportion of equity securities in a pension fund's portfolio.

Unique Circumstances

There may be a number of individual and unusual considerations that affect investors.

For example, many investors may want to exclude certain investments from their portfolios based on personal or socially conscious reasons.

Return Objectives

Absolute return objectives sate the percentage return desired by the client.  The return may be expressed on a real or nominal basis.

Relative return objectives express the required return relative to a stated benchmark.  A good benchmark should be investable i.e., an investor should be able to replicate it.

The return objective may be stated before or after fees and on a pre- or post-tax bais.

It could also be expressed in terms of a required return, that is, the amount an investor needs to earn over the investment horizon to meet a specified future goal.

The portfolio manager must ensure that the client's return objective is realistic in light of her tolerance for risk

Measures of Returns

1. Holding period return
2. Arithmetic or mean return
3. Geometric mean return
4. Money-weighted return
5. Annualised return
6. Return on a portfolio 
7. Gross versus Net Returns
8. Pre-Tax versus After-Tax Nominal Returns
9. Real versus Nominal Returns
10. Leveraged Return

Return-Generating Models

A return generating model is a model that is used to forecast the return on a security given certain parameters.

A multi-factor model uses more than one variable to estimate returns.

• Macroeconomic factor models use economic factors (e.g., economic growth rates, interest rates and inflation rates) that correlate with security returns to estimate returns.
• Fundamental factor models use relationships between security returns and underlying fundamentals (e.g., earnings growth and cash flow growth) to estimate returns.
• Statistical factor models use historical and cross-sectional returns data to identify factors that explain returns and use an asset's sensitivity to those factors to project future returns.  

Risk Management

What is risk?

Risk encompasses all of the uncertain environmental variables that lead unpredictability of outcomes.

Taking risk is an integral part of conducting business and managing investment portfolios.

What is Risk Management?

While risk is generally seen in an unfavourable light, the challenge lies in carefully choosing, understanding and managing the risks entailed by your decisions.

• Risk management is not about minimising risk - It is about actively understanding and embracing those risks that offer the best chance of achieving organization's goals with an acceptable chance of failure.
• Risk management is not even about predicting risks - It is about being prepared for (positive or negative) unpredictable events such that their impact would have already been quantified and considered in advance.

Interaction between Risks

It is very important for organisations to recognise that risks interact, and that the interaction is more "toxic" in stressed market situations.

When different sources of risk come together, the combined risk is almost always non-linear in that the total risk faced is much greater than the simple sum of the individual risks, and this makes the situation even worse.

Most risk models and systems do not directly account for risk interactions.

PORTFOLIO MANAGEMENT

Portfolio of securities may offer equivalent expected returns with lower volatility of returns (lower risk) compared to individual securities.

The composition of the portfolio is an important determinant of the overall level of risk inherent in the portfolio.

By varying the weights of the individual securities, investors can arrive at a portfolio that offers the same return as an equally weighted portfolio, but with a lower standard deviation (risk).


Steps in the Portfolio Management Process

1.  Planning:

• The investment objectives - Understanding the investor's needs and constraints
•  Developing an investment policy statement (IPS) - The IPS is a written document that    describes the objectives and constraints of the investor.

2.  Execution:  

• Asset allocation - distribution of investable funds between various asset classes e.g., equities, fixed-income securities, alternative investments, etc.)
• Security Analysis - Analysis of companies and the industry to identify investments that offer the most attractive risk return characteristics from within each asset class.
• Portfolio construction - Constructing the portfolio, after determining the target asset allocation and conducting security analysis, in line with the objectives outlined in the IPS.

3.  Feedback

• Portfolio monitoring and rebalancing - The portfolio must be regularly monitored.  Changes in fundamental factors and investor's circumstances may require changes in the portfolio's composition.  Rebalancing may be required when changes in security prices cause a significant change in weight of assets in the portfolio.
• Performance measurement and reporting - This step involves measuring the performance (absolute or relative performance) of the portfolio stated in the IPS.

Does It Pay to Invest in Wide-Moat Stocks?

It sure does--but don't disregard valuation.

It makes sense, in theory: Companies with sustainable advantages--or those that Morningstar says have economic moats--should perform better over time than those companies without such advantages.


But does that translate into superior stock performance?

Morningstar analysts addressed that question Wednesday at the 2017 Morningstar Investment Conference.

Taking a step back, senior equity analyst Andrew Lane, a member of Morningstar's Moat Committee, reminded the audience that a moat represents a sustainable competitive advantage that should help a company generate superior profits over time. Narrow-moat companies are expected to out-earn their weighted average costs of capital over 10 years; for wide-moat companies, the expectation stretches 20 years.

But investing in companies with moats isn't a guarantee of superior stock returns.

"Valuation is critical," said Lane.

For proof, Dan Lefkovitz, content strategist for Morningstar Indexes, pointed to the performance of the Morningstar Wide Moat Focus Index, which has outperformed the S&P 500 during the trailing 1-, 3-, 5- and 10-year periods.

"The Wide-Moat Focus Index marries valuation and moat," he said. The index includes the least-expensive wide-moat stocks in Morningstar's coverage universe. (Read more about how the index is built here.)

What this means is that even in an overvalued market such as the one we're experiencing today (Morningstar's Market Fair Value graph indicates that the market is about 4% overvalued based on our estimates), investors should still be able to generate superior long-term returns by cherry picking undervalued stocks with moats.

Some areas ripe for the picking can be found in the healthcare sector--specifically among wide-moat drugmakers.

"This space has definitely been in the news during the past year plus," noted Michael Waterhouse, a senior analyst with Morningstar's healthcare team. "The pricing discussions have maybe been overblown. The long-term investor who's willing to ride out the volatility has opportunity."

Waterhouse suggested sticking with the undervalued wide-moat names with robust portfolios and superior pipelines, including Bristol-Myers Squibb (BMY), Roche Holding (RHHBY), Novartis (NVS), Sanofi (SNY) and Allergan (AGN).

Bridget Weishaar, a senior equity analyst who focuses on apparel for Morningstar, talked about wide-moat L Brands (LB), whose portfolio includes Victoria's Secret and Bath and Body Works. She likes the company's pricing power, sees tremendous growth potential in China, and expects e-commerce penetration to grow.

"Long-term, we think this is a wonderful company to own," she said.

Weishaar acknowledges that it may take time for the China and ecommerce stories to play out--and the company's mall exposure is a concern, given the falloff in mall traffic overall. In other words, expect some bumps along the way.

Her favorite name today is actually a narrow-moat company, Hanesbrands (HBI).

"The company is in category with fierce brand loyalty, and their pricing is appealing," she said. "We think they can be channel-agnostic in the next three years."

That would allow it to continue to compete successfully, as weak mall traffic can be offset by rising ecommerce sales.

http://news.morningstar.com/articlenet/article.aspx?id=804849

By Susan Dziubinski | 04-26-17
This analyst blog is part of our coverage of the 2017 Morningstar Investment Conference.
About the Author Susan Dziubinski is director of content for Morningstar.com.

Buying stocks at or below their historical valuation is the best way to guarantee superior returns.

Proper valuation of the equity market is necessary to project future stock returns.

Although those who wait long enough will eventually recoup losses on a diversified portfolio of stocks, buying stocks at or below their historical valuation is the best way to guarantee superior returns.

Nevertheless, there are persuasive reasons why the valuation of the market may in the future rise above the historical average.

This will lead to lower long-term returns on stocks but higher returns during the transition to a higher valuation.

Whether that transition takes place or not, stocks remain the most attractive asset class for long-term investors.



Reference:
Stocks for the Long Run
by Jeremy Siegel

For the great majority of investors, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

Stock prices will always be far more volatile than cash-equivalent holdings.

Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.

That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk.

Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents.

That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets.

Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant.

Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime.

For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things.

Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in “safe” Treasury bills or bank certificates of deposit.

People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.)

If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well (with many ups and downs, to be sure).

Investors, of course, can, by their own behavior, make stock ownership highly risky.

And many do.

Active trading, attempts to “time” market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy.

Indeed, borrowed money has no place in the investor’s tool kit: Anything can happen anytime in markets.

And no advisor, economist, or TV commentator – and definitely not Charlie nor I – can tell you when chaos will occur.

Market forecasters will fill your ear but will never fill your wallet.

The commission of the investment sins listed above is not limited to “the little guy.”

Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades.

A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers.

And that is a fool’s game.

There are a few investment managers, of course, who are very good – though in the short run, it’s difficult to determine whether a great record is due to luck or talent.

Most advisors, however, are far better at generating high fees than they are at generating high returns.

In truth, their core competence is salesmanship.

Rather than listen to their siren songs, investors – large and small – should instead read Jack Bogle’s The Little Book of Common Sense Investing.

Decades ago, Ben Graham pinpointed the blame for investment failure, using a quote from Shakespeare: “The fault, dear Brutus, is not in our stars, but in ourselves.”

http://www.berkshirehathaway.com/letters/2014ltr.pdf