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.

If you can meet with Triumph and Disaster And treat those two impostors just the same;

Yesterday was a tough day to Brazil. We played beautifully in the first half, but failed miserably in the second, losing to the Dutch by 2-1. 

Today we have Argentina vs Germany, and Spain vs. Paraguay. Now that Brazil is out, I'm 150% behind Spain.

Tomorrow we have the 2010 Wimbledon final. In the tunnel that leads to Wimbledon's Centre Court, the players pass under two lines of poetry in Rudyard Kipling's ``If'' poem (the title of this post). Very inspiring for victories and defeats.

Here is the whole poem read by Roger Federer and Rafa Nadal:

Clearly there was something wrong with this...

From Brad DeLong's blog he quotes this article:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

I'm a true believer of the contribution to society by financial instutions, but when they are generating more profits than other industries, there is clearly something wrong going 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.

Exciting Day

Today I finally got the teach the first case study I've written:
  
Volkswagen AG: Valuation in 2009

This is a case on multiples valuation based on Volkswagen around on May 2009, right at the peak of the crisis.

I think the session went well and students enjoyed themselves. Hope I'm right!

Stock Analysts are Still Optimistic

The picture below comes from a McKinsey report (you need to register to read it all) showing that stock analyst tend to be overoptimistic.

Two things draw my attention:
i) In 2008, because of the crisis, the difference between January forecasts and the realized EPS is huge (almost 40%).

ii) The over-optimism in itself is not that surprising given the skewed incentives analyst have. Not even with regulatory changes seemed to have reduced the problem.

Complexity

Today I followed this link from Brad Delong's and read a very nice story on how quickly the Internet would change the business model of TVs. Here is the into:

"I gave a talk last year to a group of TV executives gathered for an annual conference. From the Q&A after, it was clear that for them, the question wasn’t whether the internet was going to alter their business, but about the mode and tempo of that alteration. Against that background, though, they were worried about a much more practical matter: When, they asked, would online video generate enough money to cover their current costs?

That kind of question comes up a lot. It’s a tough one to answer, not just because the answer is unlikely to make anybody happy, but because the premise is more important than the question itself.

There are two essential bits of background here. The first is that most TV is made by for-profit companies, and there are two ways to generate a profit: raise revenues above expenses, or cut expenses below revenues. The other is that, for many media business, that second option is unreachable.

Here’s why...."

 The article then goes on and talks about how too much complexity can destroy societies. This reminded me of Collapse by Jared Diamond, which I highly recommend, on what made several different societies collapse over our history.

More important that how TV will be affected by the Internet, is how Western developed countries (Europe, the US, and Canada) will manage their complexity and the emergence of China.

Profits

I still think that the US Treasury might make a profit on assets it bought during the crisis:

Martin Wolf @ IESE

Today we had Martin Wolf giving a special lecture at IESE on  "Development and Globalization after the Crisis". His daily column on the Financial Times is very good and interesting, I recommend it to everyone. It was nice to meet him in person, but it is a shame that I don't have the slides of his presentation to show. It was also very good.

In summary, he is still very worried with the recovery of developed economies in the future. The fiscal outlook looks bleak for US/Europe and that the recovery can only be sustained if the private sector can replace public spending.

Hedging World Cup Risk

Today I was walking around Barcelona and saw this interesting time-deposit offer from Banesto (a local bank). They promise you 3%/year, but IF Spain wins the World Cup, the investor gets 4%.

Around the World Cup we see all kinds of offers like this (in Spain, the UK, and Brazil at least): buy a flat-screen TV and if Brazil wins you get another one, etc.

An interesting question is how much money does the bank expects to spend with this offer? How should  this be hedged?  Of course, based on historical probabilities they won't lose a dime, but with Spain being one the favourites, what to do to at least find an estimate? 

Supose that the bank's reinvestment rate is 4%. If Spain does not win the World Cup, they make a 1% profit. If Spain does win, they make zero. The expected return is the 1%*(Prob Win), which looks good on their side given previous history.

I wonder if they could hedge this against a portfolio of online bets held by betting houses. 

Any ideas? This might turn into a nice exam question or topic for the derivatives course.

Incredible Mistake

This story is in Spanish, but it is so good that I had to post the video here. Basically, the Romenian army wanted to help the humanitarian effort in Haiti by sending a battalion of mountain troops and 2,000 tons of supplies. However... their defense ministry messed up the names and sent everyone and everything to Tahiti instead!

I guess this is the kind of mess that we only expect to see in financial markets!

UPDATE: Just found out it was a hoax. I guess I should have done my due diligence better! :) Nice one though.

UPDATE2:  The story did appear in Spanish news, but THEY didn't do their due diligence. The story was in fact a hoax from a Romanian website. Nothing like blaming others... ;)

Spanish Mess

Paul Krugman has written a nice summary of how Spain has reached its current (poor) economic situation.

http://krugman.blogs.nytimes.com/2010/02/09/anatomy-of-a-euromess/

The comparison with Germany is also nice. We can definitely see all the rent income earned by Germans who invested in Spanish real estate. I bet that if we look at the UK we might see the same thing.

I wonder what will happen with the deficit as this rental income (due to smaller demand for real estate) goes down.

Financial Bets

This is funny: the directors of the Indianapolis Museum of Art waged an online bet with the New Orleans Museum of Art which depends on who wins the Super Bowl this Sunday (the Indiana Colts play the New Orleans Saints). The losing city will lend a good paiting to the winning one for three months (Indianapolis waged a Turner, while New Orleans waged a Claude Lorrain).

Here is a quick suggestion for how to solve the problem with the Chinese yuan overvaluation: if the US has more medals than China during the next Summer Olympic Games, the Chinese agree to revalue their currency by say 20%. If they lose, the US government refrains from calling for a revaluation for at least 20 years...

Something to Relax the Eyes

Possibly my favorite painting:

I really should have gone to the d'Orsay last time in Paris. I'll pay the National Gallery a visit next time I go to London to see its cousin.