Why There is No System Like Capitalism...

Many in Brazil are fond of socialism, tough none moved to Cuba or China. Here is maybe why:

Behavioral FInance

Wow. Summer is busy even after classes are over! I thought I'd have more time to post but, as usual, we can't get what we want... Anyway, this is an interesting article that appeared in the FT about a hedge fund that uses behavioral finance techniques to invest.

Personally, I believe that behavioral finance brings essential insights on how financial models should strive to incorporate the idiosyncracies of human behavior rather than to take the easy way out and assume that investors are perfectly rational. However, up to now at least, I think that behavioral finance is still at a point in which is more like a collection of results challenging the current paradigm ("mainstream" finance) but still not able to come up with a good alternative theory. I'm not sure it ever will given how "strange" human beings can be whenever money is involved (or generally).

Altogether the article is very interesting and contains a useful introduction to behavioral finance. The trading strategy looks interesting too! Here is the beginning:

Before you even started reading this article, it had already been electronically scanned and its language examined by dozens of computers at hedge funds and investment banks.

At MarketPsy Capital in Santa Monica, California, remote servers will have rated how positive or negative it is on the economy and checked for emotional content on thousands of companies. Finding nothing useful, the computers will then move on.

Equity Premium Puzzle

Today I received a very interesting email from one of my MBA students. Here is what he wrote:

"Professor Saffi,

I noted an article of interest on one of the financial blogs I read, titled "Revisiting the Equity Premium" (http://blogs.reuters.com/felix-salmon/2010/05/20/revisiting-the-equity-premium/). The blogger advances three main points in the article;
1) most managers are not sure why they use an equity premium of 5%-8%

2) That two noted researchers indicate the premium is really 0%-2%
http://alephblog.com/2009/07/15/the-equity-premium-is-no-longer-a-puzzle/
http://falkenblog.blogspot.com/2009/07/is-equity-risk-premium-actually-zero.html

3) That we assume that equities MUST yield more than treasuries based on efficient market hypotheses, however, rather than must, we should be using the word HOPE and recognize the incentives in the system and that the past will not reflect the future.

Please let me know what you think."

Here is my reply:

At the end of the day, the magnitude of the risk premium depends on the risk aversion of investors and the future cash-flows of firms that capture productivity gains (i.e. their average returns). The idea behind using past data is exactly to try to have an estimate of its current value, which can also fluctuate over time. Is it possible that investors have been greatly exaggerating this future estimated performance? Yes, it could. In my humble opinion, this is also related to the Malthusian theory that mankind won’t be able to keep raising food productivity. People have been saying that for 210 years and we’re still going strong

To be honest, one reason why managers don't why they use 5-8% is because most have never seriously studied its determinants. This guy here probably doesn't as well:

Schrager then continues her argument with this:

“Equities are inherently riskier than Treasuries. Equity prices must ultimately reflect and compensate investors for that risk or no one would hold them in their portfolio.”

I’m not sure where that “must” comes from: maybe it’s some kind of corollary of the efficient markets hypothesis. Investors certainly hope that returns on equities will be commensurate with the risk that they’re taking. But there’s no rule saying that any given asset class will “ultimately reflect and compensate” those hopes. After all, if there were such a rule, then really there wouldn’t be any risk at all!

This has nothing to do with the efficient market hypothesis. We could still have rules for things that are inherently uncertain (just think about quantum physics or the Heisenberg uncertainty principle). There is nothing that says that the equity premium MUST be around 5% in the future, it is just our current understanding of it that allows us to forecast this. Sure, some factors are likely to reduce the premia, like taxes, transaction costs, and etc, but saying that the market premium is zero seems a bit of a stretch to me.

Not as bad as it seems...

Personally I think that the likelihood of any sovereign default of Spanish bonds is much lower than thought by the financial press. If you're read the FT it feels like Spain will follow the path of Greece really soon, when in my opinion, the situation in the UK is not much better.

Anyway, a friend of mine (Jason Sturgess) sent me this picture below that is really interesting to show the linkages between EU countries. While Greece's overall impact is very small, with Spain things have a much bigger magnitude.

Chance Favors the Prepared Mind

Just read on the FT that "Traders at Goldman made more than $100m in profits on 36 of the 65 days of the third quarter".

I guess that with less competition, those prepared for it and quick to adapt to the new times are making huge tons of money...

Why is it so difficult for foreign firms to suceed in China?

The Economist this week is full of interesting articles as usual. One that caught my attention is a piece on why foreign firms face so many difficulties in the country. Language and political regime (a capitalist dictatorship) do not explain as many other countries have the same characteristics.

The article says that firms "... they complain about subsidized competition, restricted access, conflicting regulations, a lack of protection for intellectual property and opaque and arbitrary bureaucracy."

I wonder whether China will ever open their domestic market enough to enable serious competition by foreign firms.