Friday, September 30, 2005

Don't Let Your Portfolio Get Caught Speeding [ Commentary] September 28, 2005

What great timing! We just covered bonds this week in class. So if you are in my class, you better read this one. It reviews the types of bonds and what bonds add to your portfolio.

Don't Let Your Portfolio Get Caught Speeding [ Commentary] September 28, 2005:
"we tend to focus most of our time and energy on stocks, believing that equities are the best way to stay ahead of the erosive effects of inflation and build wealth over time. The staid fixed-income sector, on the other hand, is seldom mentioned with any enthusiasm. It's not that we don't appreciate what bonds have to offer. We discuss their merits from time to time and have even devoted a section of our Investing Basics center to a comprehensive profile of their ins and outs. For many, though, bonds are ...deependable, polite, never reckless ... in a word, boring."

Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis by Ohad Kadan, Jun Yang

Executive compensation has changed in the aftermath of the corporate governance "crisis" (where we saw Enron, Tyco, Adelphia, WorldCom and others fall precitously due to accounting scandals). One such change is a shift away from stock options. Microsoft is the classic example but many other firms have also scaled back option progams for restricted shares (share that can not be sold for some period).

The restricted shares are better than options view is summed up by the AFL-CIO in a WSJ piece from 2003:
The AFL-CIO has submitted shareholder resolutions at American Express Co. and five other businesses urging a ban on stock options for senior executives and greater use of restricted stock. Labor officials call performance-linked restricted stock "a better motivator of performance," says the AFL-CIO's Brandon Rees.
However, that is not the final word. Kadan and Yang suggest that restricted shares may actaully worsen the earnings management problem and be more costly than traditional option grants.

Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis

How? They begin by showing that restricted shares are really little more than option grants with a strike price of zero. They then
" that lowering the exercise price (increasing the moneyness) of options intensifies earnings management. Therefore, for the same number of grants, restricted stock induces more earnings management than stock options. Additionally, using numerical examples, we show that to induce the same level of effort, optimally-designed stock options induce less earnings management and cost less to the firm than restricted stock. "
Very interesting.

Here are some more "visual bites":
  • "Stock-based compensation, on one hand, motivates executives to take real actions to increase firm value. On the other hand, it induces executives to engage in earnings management, which is essentially the difference between the firm’s reported earnings and the economic earnings"
  • "lowering the exercise price makes the options more in-the-money, and hence the marginal benefit from an increased stock price is higher. For this reason, it is more likely that the cost of earnings management will be outweighed by the benefit from the boost in stock price. As an extreme case of stock options, restricted stock is always in-the-money regardless of the stock price.Consequently, restricted stock induces more earnings management than do stock options." --This is presented more rigorously as their second propostion (page 13): Both the expected earnings management and the expected cost of earnings management strictly decrease in the exercise price K, strictly increase in the number of ESO grants, and strictly decrease in the stringency of the accounting standards....Proposition 2 is the main theoretical result used in our empirical analysis. It implies that the more in-the-money the option is, the higher the extent of induced earnings management. Everything else being equal, stocks induce more earnings management than options."
So it is very possible that the change to restricted shares (ie. in the money options) may lead to further accounting problems. Kadan and Yang investigate this empirically using cross sectional regressions where they measure the effect of restricted share usage on distretionary accruals. Their findings fit existing theories very well!
" a larger amount of stock-based compensation in year t induces managers to lower the earnings in this year. Perhaps, during the grant year, managers manipulate earnings downwards in order to better the conditions of the grants (to lower the exercise price) or to save accruals for future vesting years....bonus payments induce more earnings management, which is consistent with prior research; see, for instance, Healy (1985).... In contrast, salary payments appear to mitigate earnings management, perhaps, due to the wealth effect. Interestingly, the CEOs with longer tenures tend to manipulate earnings more. Moreover, large firms tend to have more discretionary accruals consistent with the observation in Coffee (2003). Firms with more growth opportunities and lower current operating performance are engaged in more earnings management, in line with Larcker and Richardson (2004). Not surprisingly, firms with a higher stock return have less incentives to manipulate earnings"
Which deserves a WOW!

I^3! (a rarity for a paper that still has some parts undone!)


Kadan, Ohad and Yang, Jun, "Executive Stock Options and Earnings Management - A Theoretical and Empirical Analysis" (March 15, 2005). AFA 2006 Boston Meetings Paper

Thursday, September 29, 2005

FPA Journal - Post-Modern Portfolio Theory

What is risk? It pains me greatly that we do not have a better measure of it. I remember when I took my first finance class and was told that risk was measured by standard deviation and was immeditely put off. Why? Because how many people are worried about making too much money?

Ask a person on the street (Main Street or Wall Street) and they will tell you a closer description of risk than the average quant. Why? Because we (and I will throw myself into the quant catergory) generally use normality (and hence symmmetry) for any number of solid reasons, to describing risk, somewhere deep inside we realize that there has to be a better risk measure.

In the FPA Journal--The Journal of Financial Planning-- Swisher and Kasten analyze this problem in their paper entitled Post-Modern Portfolio Theory. While I am not convinced they have the solution, their paper does offer important thoughts on the topic of risk and risk management. Undoubtedly a recommended read!

A few sneak peeks:

* "The primary reason MPT produces inefficient portfolios (even though the whole point is supposedly the building of efficient portfolios) is simple: standard deviation is not risk. Risk is something else, and we need a better mathematical framework to describe it. The primary purpose of this paper is to describe that framework and suggest a use for it—the building of better portfolios through downside risk optimization (DRO). We define DRO as optimization of portfolio risk versus return using downside risk as the definition of risk instead of standard deviation."

* "Downside risk (DR) is a definition of risk derived from three sub-measures: downside frequency, mean downside deviation, and downside magnitude. Each of these measures is defined with reference to an investor-specific minimal acceptable return (MAR)."

* "
Portfolios created using MVO and DRO are often similar and the differences in absolute risk and return values small—diversification works regardless of how you measure it. Yet DRO seems to avoid the known errors of MVO and provide a more reliable tool for choosing the "best" portfolio."

For the quants here today:
"The perfect investment, as everyone knows, is positively skewed, leptokurtic, and has low semi-variance. But these moments about the mean of an investment's return probability distribution are at least partially incompatible since investment returns are non-Gaussian, and variance/semi-variance obviously loses its utility in non-mesokurtic (that is, non-Gaussian) skewed distributions."
*"Risk is the potential for a bad outcome. Losing money, underperforming, failing to meet financial goals—those are real-life human concerns. Yet this risk definition—potential for an undesirable outcome—is fuzzy. Hard to quantify mathematically. But just because a concept has no clear mathematical equivalent does not mean that we cannot create mathematical models to describe it."

* Possibly my favorite quote of the paper is the following:
"As Brian Rom and Kathleen Ferguson report: "It has long been recognized that investors do not view as risky those returns above the minimum they must earn in order to achieve their investment objectives. They believe that risk has to do with the bad outcomes...and that losses weigh more heavily than gains." Investors are worried about downside deviation, not upside deviation.

Markowitz himself said that "downside semi-variance"would build better portfolios than standard deviation. But as Sharpe notes, "in light of the formidable computational problems...he bases his analysis on the variance and standard deviation." Markowitz did not have a Dell laptop with a 60 Gb hard drive and Microsoft Excel in 1959."
Read the rest for yourself. You will be glad you did--do not shy away from it just because you fear math. The paper has the enviable quality of being both quantitative and readable!

Swisher, Pete and Gregory W. Kasten. Post-Modern Portfolio Theory. FPA Journal, September 2005.

Interesting trivia: Kasten is an MD!

Valuation from 2003 FMA Conference

I realize this is not cutting edge (2 years old) and that I have mentioned the presentations before, but with the transient nature of a blog's readership, it is worth mentioning again! And besides, I want my class to watch at least one of them! All are from the FMA 2003 conference and are available at FMA Online.

Aswath Damodaran and Tim Opler on valuation. They are excellent!

I guess I like Damodaran's a small bit better, but if you have time, watch them both! (He also has Powerpoint slides)

Short version: DCF is theoretically preferred, but most use market multiples and comparables because they are easier, faster, and less sensitive to assumptions. Moreover the analyst assumes much less risk using the market based models than (s)he does using personal assumptions necessary in DCF based valuation models.


Wednesday, September 28, 2005

Corporate Investment and Asset Price Dynamics: Implications for SEO Event Studies and Long-Run Performance by Murray Carlson, Adlai Fisher, Ronal

Using option theory to understand and explain firm and investor behavior often yields important insight. This is no exception.

Carlson, Fisher, and Giammarino (CFG) use real option analysis (real options are essentially the application of option theory to “real” assets) to investigate the stock behavior around seasoned equity offers (SEO). Many researchers (probably most notably Ritter 2003) have shown that prior to a SEO stock prices rise, then fall on the announcement, and then underperform over the following period.

Potential explanations to this include market timing and inefficiency stories that have managers selling overpriced shares to investors who willingly buy the shares but at only a partial discount. The real option view allows us to add a more rational explanation to these behavioral models.

The very quick explanation is that firms have options on growth (i.e growth options). These options are more volatile than both the firms’ assets as well as the assets that make up the growth opportunities. So, when the firm uses the proceeds of the SEO to expand (which is to say to convert growth options into assets in place), the value of the firms’s equity drops.

In the authors’ words:

“Equity issues are associated with firm expansions. When firms invest, they convert growth options to assets in place. Even when the new assets are risky, they will be less risky than the options they replace. Although both size and book-to-market effects are present in our model, standard matching procedures fail to capture the dynamics of risk and expected return.”

How cool is that?!

And yes this is similar to the real option papers that try to explain the internet bubble away.

Carlson, Murray D., Fisher, Adlai J. and Giammarino, Ron, "Corporate Investment and Asset Price Dynamics: Implications for SEO Event Studies and Long-Run Performance" (December 5, 2004). 7th Annual Texas Finance Festival Paper.

FTR I stumbled upon this paper while researching Real options for my advanced corporate finance class. I feel bad I had missed it for so long. And yes I will have to be redoing my notes for the umpteenth time. :)

Tuesday, September 27, 2005

How Informative are Analyst Recommendations and Insider Trades? by Jim Hsieh, Lilian Ng, Qinghai Wang

Mixed signals. They happen all the time in and out of finance. Take for instance the starting pitcher saying he can go another inning while wearily dragging himself onto the field, or the spouse who is crying while saying things are fine, or the CEO selling shares while stock analysts write ringing endorsements.

While Hsieh, NG, and Wang may not be able to help you interpret the mixed signals on the field or at home, they do look at this issue with respect to analyst stock recommendations and insider trades. They find that "insider trading is informative when signaling positive information, and analyst recommendations are informative when conveying negative information...."

SSRN-How Informative are Analyst Recommendations and Insider Trades? by Jim Hsieh, Lilian Ng, Qinghai Wang:

In one of the best abstracts I have seen in a long time, the authors succiently summarize their paper:
"This study jointly evaluates the informativeness of insider trades and analyst recommendations. We show that the two activities often generate contradictory signals. Insiders in aggregate buy more shares when their firm's stock is unfavorably recommended or downgraded by analysts than when it is favorably recommended or upgraded. This result is robust to various controls such as varying degrees of analyst coverage, firm size, book-to-market ratios, and stock price momentum. We find that analyst recommendations affect insider trading decisions, but not vice versa. Our further analysis shows that insider trading is informative when signaling positive information, and analyst recommendations are informative when conveying negative information. The overall results imply that corporate insiders and financial analysts do not substitute each other's informational role in the financial market."
Wasn't that a great abstract?

A few points worth mentioning:

* "Using data on insider trading and analyst recommendations from 1994 through 2003, we
show that insider trades and analyst recommendations produce contradictory informational
signals: insiders trade against the recommendations from financial analysts."

* It is surprising that insider trading does not impact analyst recommendations. I am not totally convinced.

And finally the bombshell:
"...analysis shows that insider trades are informative only when insiders are actively buying their company’s stock, and that analyst recommendations hold investment value only when they issue downgrade recommendations on stocks with no insider trading."
So ignore insider sells and analyst buy recommendations.

Definitely worth reading!

Hsieh, Jim, Ng, Lilian K. and Wang, Qinghai, "How Informative are Analyst Recommendations and Insider Trades?" (April 12, 2005). AFA 2006 Boston Meetings Paper

Financial Advice-KISS

I was asked recently by FreeMoneyFinance for a brief piece on the best financial advice possible. Unfortuntately I was too busy at the time to do it, but FMF was nice enough to run it anyways. The following is what I wrote.
KISS-Keep It Simple Stupid.

Oftentimes financeprofessors tend to make things too complicated. Such is the often the case when it comes to investing. Sure, we might be able to better with derivatives and complex investment schemes, but these plans probably scare off as many people as they help.

So the best financial advice I could give someone is to let compounding work for them. That is, save as much as you can as often as you can for as long as you can at as of high of rate as you can without taking major risks and start as soon as possible.

To implement this idea, I tell my friends and students to set up automatic investment programs whereby money is automatically invested for both your retirement plans as well as well as savings outside of retirement plans for “life expenses”. It is important to do this because it takes the emotion out of your investment decisions and also you are much more apt to stick to the investment program. Moreover, if you set aside the money prior to actually having the money, you will never miss it.

This savings plan should be examined annually to make sure you are still setting aside as much as you can. For instance, if you earned a pay raise or get a bonus, make sure you save more. Also if you do need (and I stress need) to take money out of the account,as soon as possible increase your payments to make up for the withdrawl.

As for what to invest in, make sure you are diversified and take the view that the basket that counts more than the eggs in the basket. Thus, worry more that you invest in the right class of securities (equity, fixed income, etc.) than what specific securities you hold within each class.

A final important bit of advice: watch transaction costs and taxes. They will destroy your returns. While your mileage may vary, for me this means using tax-advantaged accounts and investing largely in index funds and ETFs that both lower transaction costs and the tax bite of frequent trading.

So nothing earth shattering, but I hope useful.

Monday, September 26, 2005

-Political Connections and Corporate Bailouts by Mara Faccio, Ronald Masulis, John McConnell

SSRN-Political Connections and Corporate Bailouts by Mara Faccio, Ronald Masulis, John McConnell:

Faccio, Masulis, and McConnell report that politically connected firms are more apt to receive government bailouts. This fits with prior evidence that leverage ratios at politically connected firms are higher. Thus, it may be inferred that lenders are more apt to make loans if they feel that the government will bail the firm out if things go bad.

While not surprising, it is VERY interesting.

A look in:
The paper is a "systematic examination of the link between political connections and
corporate bailouts. To do so, we study 450 politically-connected firms in 35 countries over the six-year period 1997-2002 along with a set of matching peer firms."
On why firms with connections have higher leverage:
"The anecdotal and empirical evidence that politically-connected firms make greater use of leverage is subject to a number of possible interpretations. One possibility is that lenders are irrational. A second is that they are coerced into making poor loans to politically-connected enterprises. A third is that lenders receive offsetting government benefits for making such loans. Yet another possibility is that lenders factor into their lending decisions the likelihood that borrowers will be bailed out when they encounter economic distress and, thus, lend more to politically-connected firms who are, in turn, more likely to be bailed out than their nonconnectedpeers."
"The evidence that we present is consistent with the last interpretation: politically-connected firms do borrow more than non-connected firms...our evidence indicates that lenders are willing to lend more to connected borrowers because they can reasonably anticipate a future bailout of troubled loans...."
"the data do not rule out the possibilities that lenders may also sometimes be pressured into making weak loans and/or that lenders may receive benefits in other forms."
See, I told you it was interesting!

Faccio, Mara, Masulis, Ronald W. and McConnell, John J., "Political Connections and Corporate Bailouts" (March 1, 2005). AFA 2006 Boston Meetings Paper

BTW while this has a March date, it appears to have been just updated on Sept 16.

Financial Fruition: Crappy TV -- Jim Cramer's Mad Money -- Let's Turn It OFF!

Financial Fruition has a pretty interesting article on Jim Cramer of CNBC. Cramer probably will not be sending FF a Chirstmas card anytime soon:

Some highlights:

** "Jim Cramer and the ill effects of active trading and preaching to to a world-wide audience. "

** "Yes, Cramer says he is just giving advice to those that have side money and want to dabble in the market, but does he know if that person's portfolio is already overweighted in the sector that he is recommending a buy of a certain stock in that same sector?"

** "One thing I don't think is reflected in Jim's return at the above link, is the commission charges for executed trades, or the short term capital gains one would have to incur on a winning pick"

My take on Cramer? He is really smart BUT mainly a showman and I would be VERY VERY hesitant to take any of his advice. But that said, he is occassionally fun to watch, just don't fall into his short term trading trap.

Saturday, September 24, 2005

Is It Better to Buy or Rent? - New York Times

Is It Better to Buy or Rent? - New York Times: "But renting might deserve another look right now. After five years in which rents have barely budged while house prices in New York, Washington, Los Angeles and elsewhere have doubled, renting has become a surprisingly smart option for many people who never would have considered it before"

Something I have been saying for quite a while. Renting is also a whole lot easier. Not saying it is always right, but it is also not always wrong!

(PS the link was wrong originally, sorry!)

Friday, September 23, 2005 - Cash in demand, but supply short - Cash in demand, but supply short
"Cash-hungry residents who had to deal with Hurricane Rita also drained automatic teller machines throughout the city.

Machines at some of Chase's 37 Houston branches, which were open for part of Thursday, ran out of cash, spokesman Greg Hassell said. He wasn't sure how many.

'We weren't able to get cash in because of the roadways, and there was very heavy demand,' he said. 'There were some cash shortages.'"
After disasters it has become standard practice for the Fed to increase liquidity (see post 9-11 for textbook response), but it would be interesting to see what the preparation for hurricanes at the Fed is. Or at local banks even. Both the main Federal Reserve page and that of the Atlanta Fed have comments on the hurricanes but neither is very specific. The Dallas Fed page actually is much more informative in this regard but sort of dry for class use.

If anyone has a good contact at either Fed or a major bank in path of Hurricanes who would like to be interviewed for a podcast (and blog entry) please email me. I think it could be very informative and a great way to use current events in a Money and Banking course.

Thursday, September 22, 2005

SSRN-Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards by James Linck, Jeffry Netter, Tina Yang

SSRN-Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards by James Linck, Jeffry Netter, Tina Yang: "Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards"

Using firms in the Disclosure database, Linck, Netter, and Yang report that the Sarbanes-Oxley Act has increased the size of boards and has created more committees within boards. They also provide almost mind blowing evidence that the costs of boards--and more specifically the cost of compliance with the Sarbanes-Oxley Act (SOX)-- is significantly higher for small firms.

A very short look at some highlights:
"...although SOX does not explicitly prohibit unitary leadership (same person holds the two titles of the CEO and the Chairman of the Board), we see a distinct trend of firms moving away from this consolidated leadership structure..."

"the documented board changes are most significant for firms that are targeted by SOX – firms that originally do not have majority independent boards or firms that do not have completely independent audit committees."
"...small firms paid $5.91 to non-employee directors on every $1,000 in sales in the pre-SOX period, which increased to $9.76 on every $1000 in sales in the post-SOX period. In contrast, large firms incurred 13 cents in director cash compensation per $1,000 in sales in the Pre-SOXperiod, which increased only to 15 cents in the Post-SOX period."
Interesting stuff!

Linck, James S., Netter, Jeffry M. and Yang, Tina, "Effects and Unintended Consequences of the Sarbanes-Oxley Act on Corporate Boards" (March 15, 2005). AFA 2006 Boston Meetings Paper

Wednesday, September 21, 2005

SSRN-Brand New Deal: The Google IPO and the Branding Effect of Corporate Deal Structures by Victor Fleischer

Brand New Deal: The Google IPO and the Branding Effect of Corporate Deal Structures

Fleischer provides us with a series of case studies that shows that firms use contract design to signal various traits about the firm to stakeholders.

In the author's own words:
"This Article claims that the legal infrastructure of deals sometimes has a branding effect - that is, an effect on the brand image of the company. Deal structure affects the atmospherics of the brand. "
Or to put it another way: firms draw up contracts both for the traditional legal and incentive reasons generally mentioned in economics and finance but also for marketing (or branding) reasons. Which, while obvious, is often missed.

For instance, Fleischer uses the examples of the Google IPO and the Ben and Jerry's IPO. In each of these cases, the firm significantly altered the traditional IPO process. Why did they do so? One explanation is this branding story: the firms wanted to stand out as different. The IPO process was just one other way that they could signal this message to all stakeholders.

A few look-ins:
"From a traditional corporate finance perspective, the goal of a properly structured IPO is to manage the information asymmetry between the issuer and potential buyers in order to raise the most amount of money possible per share of stock sold. From this perspective, the success of the Google deal is questionable. Few would call the deal elegant or efficient. But this is not really what the Google IPO structure was about, or at least it is not the full story. When Google structured its IPO as an auction, it reinforced Google’sidentity as an innovative, egalitarian, playful, trustworthy company."
"Similarly, the Ben & Jerry’s deal structure may not have been terribly efficient.
By selling its stock only to Vermont residents, the company saved a few thousand dollars in legal and accounting fees. On the other hand, the geographic restriction artificially limited demand for the stock, and the offering price might have been higher if the offering had not been geographically limited.11 But without considering consumers, this sort of cost-benefit analysis fails to capture the essence of the deal. The offering was not just about selling stock and raising capital. It was also about selling ice cream. Selling stock to Vermonters helped build the brand image of the company."
and later:
"What can we learn from these case studies? Deal structure sometimes allows us to peer through the gossamer corporate veil and spy the values of the company’s founders and managers. Unusual deal structures, in particular, tend to anthropomorphize the firm. Google is not just a network of connected contracts;18 it is playful and innovative. Ben & Jerry’s is not just a manufacturer of a dessert product; it is a companion. For some products, consumers seek a personal bond. We crave more than mere product functionality. Deal structure serves as a specialized advertising medium, providing early adopters with quality assurance or enhancing the expressive value of the purchasingdecision"
This idea fits in well with the Demers and Lewellen that find that web hits are higher following underpriced IPOs.

Definitely recommended. The examples will make great class material! And its a fun paper too!
Indeed one of the more fun reads I have had in a while (which either says something about me or the paper or both ;) )

Fleischer, Victor, "Brand New Deal: The Google IPO and the Branding Effect of Corporate Deal Structures" (September 7, 2005). UCLA School of Law, Law-Econ Research Paper No. 05-18

How the BBC, Fortune and the New York Times went overboard claiming that the prediction markets had foreseen the name of the new pope!

This deserves another look. Hopefully this afternoon. But for now I at least wanted to point the article out to you.

Super Short version: The bettering markets (decision markets) may not have done as well in predicting the pope as the NY Times and others suggested.


"The questions I pose today to Enterprise Commanders are these:

* How did the prediction markets at TradeSports/InTrade fare with anticipating Joseph Ratzinger as the new pope?
* Was it really "another triumph" [sic] for the prediction markets, as the Beeb trumpeted (and as Fortune and the New York Times echoed)?"
* What are the lessons that we can draw from this string of media failures?
o Are journalists (and bloggers) just stenographers, republishing Press releases from the exchanges?"

India's MBA Gold Rush

India's MBA Gold Rush: "To get an edge in the country's exploding economy, more Indian students are seeking business degrees -- both abroad and at home "

Given that one of my classes has an extra credit assignment of reading "The World is Flat" I really could not skip this one!

Remember, there is a great deal of competition from all corners of the earth! Study hard!

Tuesday, September 20, 2005

Emotionless Trading

Sorry, I liked the title Emotionless Trading better than Yahoo's version:
"Psychopaths could be best financial traders?"

Not sure what to say about this one. Just that it goes to show emotions should not play a roll in investment decisions.

Psychopaths to rule fin markets?: "A team of US scientists has found the emotionally impaired are more willing to gamble for high stakes and that people with brain damage may make good financial decisions, the Times newspaper reported Monday.

In a study of investors' behavior 41 people with normal IQs were asked to play a simple investment game. Fifteen of the group had suffered lesions on the areas of the brain that affect emotions.

The result was those with brain damage outperformed those without.

The scientists found emotions led some of the group to avoid risks even when the potential benefits far outweighed the losses, a phenomenon known as myopic loss aversion."

Thanks to Dave and Paul Harvey for pointing this one out to me!

Friday, September 16, 2005

Kimmunications: Investment Return Doesn't Mean Diddly

Even when the stock market goes up, investors may lose out if they try to time the market. The extent to which market timing occurs is debateable but no doubt substantial. That is the gist of a recent blog entry over at Kimmunications.

Kimmunications cites a Dalbar study that finds individual investors lose a great deal as a result of this attempt to time the market.
"over the 19 year period 1984 to 2002, the S&P 500 was up an average of 12.9%. U.S. stock mutual funds had a return over the same period of only 9.6%. That is the investment return of U.S. equity mutual funds. But the stock mutual fund investor had a return of only 2.7%!"
Without seeing more of the study, I have always had by questions on how investors could do that poorly (I would have to guess that many investors got in right at the top), but unfortunatley the paper is not available online (I did email them for a copy).

That said, the idea is sound and I absolutely love the figure that shows that actual stock picking makes up only a small portion of overall returns---it will be an excellent teaching tool!

Thursday, September 15, 2005

Modern Finance vs. Behavioural Finance: An Overview of Key Concepts and Major Arguments by Panagiotis Andrikopoulos

It is about the time of the semester when many finance classes turn their attention to market efficiency. Thus, it is perfect timing for Andrikopoulous' refresher comparing and contrasting Modern Fiance and Behavioural Finance.

SSRN-Modern Finance vs. Behavioural Finance: An Overview of Key Concepts and Major Arguments by Panagiotis Andrikopoulos:

A quick look in:
  • "Modern Finance has dominated the area of financial economics for at least four decades. Based on a set of strong but highly unrealistic assumptions its advocates have produced a range of very influential theories and models."
  • "The importance of these two psychological biases in the under- and overreaction hypotheses is that investors under conservatism will only partially evaluate new publicly available information, or even disregard it altogether if it is not in favour of their beliefs"
  • "Under the representativeness heuristic, investors will consider a series of positive company performances as representative of a continuous growth potential, and ignore the possibility that this performance is of a random nature."
  • "Overreaction and under-reaction to new information may be viewed as a combination of three distinct inefficiencies; firstly, the inability of investment players to correctly distinguish between the length of the short-run and the long-run...; secondly, the excessive optimism of all investment agents due to biased self-attribution, and thirdly, the influence that one investment group has on another."
Of course, not everyone believes this new Behavioural School of thought. Again from the paper:

"Soon after the first empirical papers on behavioural finance were published, their claims came in for considerable criticism from supporters of the modern finance paradigm."

"important counter-argument disputes the existence of certain regularities and argues for the existence of research biases and other methodological shortcomings in behavioural finance studies. More commonly, the evidence on the existence of pricing anomalies is accepted but in that case, the most important response concerns the existence of additional risk factors, e.g. value premium can be explained as compensation for bearing additional systematic risk."
In this light of continually counter-punching against evidence suggesting rationality does not dominate
"It is also claimed that the positive contributions of modern finance are at an end and that its energies are now devoted to protecting itself in various ad hoc ways from the threat posed by the vast and growing anomalies literature. The simplifying models of modern finance, under this view, should be regarded as merely rough first approximations to how markets really behave, and that they stand in need of substantial revision and extension."
Andrikopoulos concludes:
"Nevertheless, the rational expectations model and the efficient markets model can never become obsolete, since they represent an ideal market. Should the behavioural finance revolution succeed, its applications in practice will simply move real markets closer to the ideal of semi-strong market efficiency."
Very nice. I like the perspective it gives even though at times I thought he made the division stronger than it generally appears to be.

My view? Probably be that modern finance is a very good first approximation and more often than not, the correct view. That said, I will concede (and indeed stress) that markets are far from perfect and behavioural finance is rightly here to stay for it does add to our understanding and (as Andrikopoulos points out) most assuredly moves markets closer to the ideal held by modern finance.

Andrikopoulos, Panagiotis, "Modern Finance vs. Behavioural Finance: An Overview of Key Concepts and Major Arguments" (June 2005).

Tuesday, September 13, 2005

IESE Insight - Finance

Jeff B. just sent me an email about this site. It had somehow slipped under my radar. Man do I feel stupid. It is really, really good! Recap of what the people at IESE are doing.
IESE Insight - Finance

Articles include fascinating looks at the "bubble", M&A in Europe, and the Euro.

I definitely bookmarked this one and will add it to my FinanceProfessor Links as well.

(PS Thanks Jeff!)

Look at Me Now: The Role of Cross-Listing in Attracting U.S. Investors by John Ammer, Sara Holland, David Smith, Francis Warnock

SSRN-Look at Me Now: The Role of Cross-Listing in Attracting U.S. Investors by John Ammer, Sara Holland, David Smith, Francis Warnock:

Ammer, Holland, Smith, and Warnock provide an interesting look at what leads non-US firms to cross-list (sell their securuties on US markets).

Several key points:

* relatively few foreign firms do cross list.

* cross listed firms are owned by US investors at a greater rate than non cross-listed firms:
"in 1997, U.S. investors held roughly 17 percent of the market capitalization of foreign companies that listed on the NYSE, NASDAQ or AMEX, but less than 3 percent of other foreign companies."
As the authors write: "what is it about cross-listing that makes previously unwanted shares more attractive to U.S. investors? " Is it lower transaction costs? less of a home country bias? increased investor protections? all of the above?

A few interesting findings:

* US investors already own a greater percentage of firms that eventually cross list than firms that do not eventually cross list, but the percentage grows even more following cross-listing:
"Our estimates imply that U.S. investors would have held an average of 6 to 8 percent of the market capitalization of cross-listed firms even if these firms had not listed in the United States, more than the average 3 percent held in foreign firms that are not cross-listed. Nonetheless, firms that cross-list experience an economically and statistically significant increase in U.S. holdings, equivalent to 8 to 11 percent of thefirms’ equity"
* This increase is most pronounced in firms that had lacked transparency priot to cross-listing (and the accompanying compliance with US accounting practices but NOT and regulatory rules/investor protections):
"...the cross-listing effect is closely tied to improvements in investor access to value-relevant information. Firms that use poor accounting practices, or that come from countries with weak accounting standards, experience a statistically larger cross-listing effect thando firms from a strong accounting background."
"By contrast, our results provide little support for the idea that firms with weak investor protections increase their attractiveness bybonding themselves to U.S. securities laws"
See? I told you this was interesting. Long, but interesting.

Ammer, John Matthew, Holland, Sara B., Smith, David C. and Warnock, Francis E., "Look at Me Now: The Role of Cross-Listing in Attracting U.S. Investors" (March 11, 2005). Board of Governors of the Federal Reserve System International Finance Discussion Paper No. 815


Hi everyone...

I just wanted to let you know that contrary to popular opinion I have not gone anywhere, just a tad busy. I got a bit too involved in a few different relief "missions" (not sure if that is the right word or not) for the Katrina Victims.

One for the animal victims (we are collecting and shipping down pet supplies, medicines, towels, etc) and then organizing a trip down for the finance club at St. Bonaventure as well to help load trucks and hopefully clean up some in Southern Mississippi. If you would like to donate to either, by all means let me know :)

Added to trying to get a house painted before bad weather, and I just have fallen behind. As I always say, I think things are getting better, and I hope to have two new entries done today.

I also will try to catch up the emails that I have sort of let go.


BTW PSU is 2-0 :) Bills 1-0 and well, I will just ignore the Mets' recent fall from grace.

Sunday, September 11, 2005

Are casinos really important for national security?

Don't do it France! I hope they come to their senses. This would entrench management even more.

French Anti-Takeover Plan Under Fire: Financial News - Yahoo! Finance: "A soon-to-be-published decree, touted by ministers after rumors of a PepsiCo Inc. bid for French food company Danone SA provoked a political outcry in July, would give the government a veto over takeovers in 10 industries deemed sensitive to national security.

Sectors on the list, already confirmed by the Finance Ministry, include several over which most states retain tight control, such as arms manufacturing and encryption.

But the decree also covers companies with activities in biotechnology, data security, casinos and antidote production -- fueling concern that it could lead to a broader kind of protectionism."

Friday, September 09, 2005

Who Loses from Trade? Evidence from Taiwan by Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, Terrance Odean

Who Loses from Trade? Evidence from Taiwan by Brad Barber, Yi-Tsung Lee, Yu-Jane Liu, Terrance Odean:

In a paper that finds the exact opposite of San 2005, Barber, Lee, Liu, and Odean report individual investors lose when trading with individuals. This finding, which fits with previous work much more than San's surprise finding, is based on stock trades in Taiwan from 1995 to 1999.

From the paper:
"The trade data include the date and time of the transaction, a stock identifier, order type (buy or sell), transaction price, number of shares, and the identity of the trader. The trader code allows us to broadly categorize traders as individuals, corporations, dealers, foreign investors, and mutual funds. The majority of investors (by value and number) are individual investors."
Not surprisingly, this is many many many trades: "For the five-year period, ...more than 500 million buys and 500 million sales."

The methodology?
"On each day for each stock, we sum the value of buys made by a particular investor
group (corporations, dealers, foreigners, mutual funds, or individuals). The intraday return on these purchases is calculated as the ratio of the closing price for the stock on that day to the average purchase price of the stock. On each day, we construct a portfolio comprised of those stocks purchased within the last ten trading days."
"Statistical tests are based on the monthly time-series of returns, where we calculate three measures of risk-adjusted performance. "
1. "market-adjusted abnormal return by subtracting the return on a value-weighted index"
2. "estimate Jensen’s alpha by regressing the monthly excess return earned by each
investor group’s buy (or sell) portfolio on the market risk premium."
3. " intercept test using the four-factor model developed by Carhart (1997)." [these factors are "the return on a value-weighted portfolio of small stocks minus the return on a value-weighted portfolio of big stocks...the return on a value-weighted portfolio...of high book-to-market stocks minus the return on a value-weighted portfolio of low book to-market stocks, and...the return on a value-weighted portfolio of stocks with high recent returns minus the return on a value-weighted portfolio of stocks with low recent returns."

The findings?

When trading with institutions, individuals systematically lose:
"Institutions appear to gain from trade, though the gains from trading reach an
asymptote at approximately six months (140 trading days). After one month (roughly 23 trading days), the stocks bought by institutions outperform those sold by roughly 80 basis points. After six months, stocks bought outperform those sold by roughly 150 basis points.

In contrast, stocks sold by individuals outperform those bought. The magnitude of the difference is smaller than for institutions since most trades by individuals are with other individuals and do not contribute to the difference in performance between stocks sold and stocks bought. The large gains by institutions map into small losses by individuals merely because individuals represent such a large proportion of all trades."
This finding does fit existing theories on the informational advantages of instititions and once again reminds us that markets are not perfectly efficient. The question now appears to me more of how far from this perfect efficiency we lie.

You will want to read this one. Very interesting!

Barber, Brad M., Lee, Yi-Tsung, Liu, Yu-Jane and Odean, Terrance, "Who Loses from Trade? Evidence from Taiwan" (January 2005). EFA 2005 Moscow Meetings Paper

Thursday, September 08, 2005

The Firing of a manager

One of the coolest things about finance, and in particular about teaching finance, is that almost any news item can be used to demonstrate various finance lessons. Indeed, just today Kimmunications gives us financial lessons we can take from the Hurricane Katrina disaster.

The story I wanted to point out however has received very little national coverage. Indeed, it really is not that big of story outside of Pittsburgh: The firing of Pirates' manager Lloyd McClendon. Huh? Bear with me.

The firing of a coach or manager (in any sport) can be used to demonstrate numerous aspects of finance. Possibly the simplest point is the decision process that owners (and General Managers) use to evaluate managerial performance. It is easy to understand why simple win-loss percentage may not be a good measure. (for instance the team may not have enough skilled players, may have had many injuries, or may just have experienced some bad luck.) The thought process necessary to remove a coach or manager is very similar to that necessary to replace a money manager.

Just looking at raw investment returns (which is analogous to looking at winning percentage) is not sufficient; it is a starting point only. A money manager may be doing a very good job but the fund's raw returns may be negative because of a down market, or the fund may lag peers because of a more constrained investment philosophy. Of course finance has tools to measure portfolio performance on a market adjusted basis, but none of these tools (Sharpe Ratio, Treynor Measure, and Jensen's Alpha are most common), is perfect and consequentially some good money managers are fired while some poor managers retain more funds under management than their performance warrants.

A second way that the firing of a sports coach/manager can be used effectively in a finance class is to use the tendency of sports' coaches to “clean house” upon being hired. This house-cleaning is common place in most sports as the new hire wants to bring his/her “own people” to the team. Scherbina and Jin (2005) find that new mutual fund managers are more likely to sell those “losers”, that had been acquired by the former fund manager.

While there is (and should be) debate as to why this behavior is common (did the former managers hold on to poor performers—both players and stocks-- because of a reluctance to make mistakes or because they had better information as to the true worth of the stock/player than the new manager?), it is consistent with the behavioral finance tenant of people being reluctant to admit their own mistakes.

One final problem in all of this is that it is difficult to test. In both sports and finance, poor performance generally precedes the firing. And in each case the performance improves following the firing, but what is more difficult to test (especially in sports) is whether this improved performance is merely a reversion to the mean (a new sector is hot, bad luck reverses, players' injuries heal etc), or if the new manager is the cause of the improved performance.

So with this in mind, you no longer need to feel guilty about watching ESPN or reading about sports, you're just looking for class material. ;)

Brain Regions Blamed for Bad Investment Ideas

How cool is this? Behavioral finance meets neural science.

Brain Regions Blamed for Bad Investment Ideas:
"Researchers say two different brain regions may be involved in making risky vs. conservative investment mistakes, a finding that may eventually help economists build better models of people's investment behavior.'Overall, these findings suggest that risk-seeking choices (such as gambling at a casino) and risk-averse choices (such as buying insurance) may be driven by two distinct [brain regions],' write Camelia Kuhnen of the Stanford University School of Business and colleagues in the Sept. 1 issue of Neuron."
The key finding:
"anticipation of reward stimulates the risk-seeking area of the brain and may increase the likelihood of individuals switching from conservative, risk-aversion investment behavior to risky investment behavior. A similar story in reverse may also apply to marketing strategies used by insurance companies."
For the record I think this is the first time I have ever blogged an article for from WebMD!

Wednesday, September 07, 2005

Why we should not cap gas prices

I found this when I was researching gas prices for a friend who is convinced that prices should be capped. I disagree! Let markets work.

The FinancialRounds does a good job of explaining why capping is not a solution:

"we have to have some mechanism to allocate the available gas among the people
who want it. You can do it by lottery, by government fiat (i.e. you get a
"ration card"), by random chance, by staying in line, or by market mechanisms
(i.e. prices)....If supply decreases (say, following a hurricane), prices rise. If they rise high enough, you might decide that it's not worth it to drive to your favorite restaurant, and instead you might choose to drive to one closer so that you have more money to spend on other things. This leaves more gas available to the folks who place a higher value on it.

Well said!

Tuesday, September 06, 2005

Assorted Topics

Trying to catch up some:

  1. FreeMoneyFinance is doing an amazing thing. Matching donations upto $5000 for aid to Hurricane victims! GO and give now! I hate to make cyclists pay extra, but in this case, I want him to pay the full amount ;)
  2. Speaking of the Hurricane, a few more financial points to note. The IRS has relaxed some rules and deadlines for those affected and even has advice for those who give to charities.
  3. Bloomberg reports on New Orleans' Muni debt:
    "The reconstruction of New Orleans and the other ports on the Gulf Coast that were devastated by the hurricane is going to be a municipal market story. The bankers who design and sell municipal bonds, ordinarily a much-maligned group, are going to figure as superheroes in this modern Battle of New Orleans. Rated Baa2 by Moody's Investors Service and BBB+ by Standard & Poor's -- in other words, almost junk -- New Orleans already carried what the rating companies call a ``high debt burden'' and low financial reserves. So it would probably be a good idea for the state to set up a special authority to sell several billion dollars in bonds designed to help rebuild the city."
In related news, Bllomberg also reports that the economy may not be hurt by as much as some fear from Katrina.

"This paradoxical economic benefit can be seen on a large scale as well. Woodward found that South Carolina's rebuilding efforts following Hurricane Hugo in 1989 delayed the start of the early 1990s recession for the state. The U.S. Bureau of Economic Analysis doesn't estimate the effects of a disaster on the national economy, but my own analysis of gross domestic product data from 1947 to 2005 shows that, with a two-quarter lag, a hurricane will boost growth by 0.3 percentage points.

Similarly, when a hurricane-force storm struck Denmark in December 1999, causing extensive and serious damage, the Danish Ministry of Finance calculated that the effect of the storm was to lift GDP by 0.8 percent in 2000 compared with what it would have been, and by a further 0.3 percent in 2001."

And one more hurricance related story: The SBU Finance Club is in the planning stages of a trip (or trips) down to the Gulf Coast. I will keep you posted, but if you know what 20-25 people will be able to help in early October, let me know! Also if you want to organize a similar trip down to help, contact me.

In non hurricane news:

1. Call for papers:

March 15-17, 2006: The Academy of Finance is accepting submissions of both abstracts and completed papers for the forthcoming 20th Annual Meeting, March 15-17, 2006. We are also accepting proposals for special panels.... This information and more may also be found at their website,

2. The NASD has a pretty useful site with advice for saving for college. Definitely worth checking out!

And don't forget to make FreeMoneyFinance pay the entire amount! (i.e. don't forget to donate!)

Explanation for lack of posts

Just wanted to apologize for paucity of posts in recent days. The combination of watching too much Katrina news, classes starting, and network problems have combined to eat up any posting time.

I think the computer problems are past so hopefully I will be back posting either tonight or tomorrow.

BTW if you have not done so, please donate to the charity of your choice for the hurricane victims.

Friday, September 02, 2005

Is the sky falling?

I had an email this week from a former student. I answered him today. The answer was very long but I do think it may interest some of you. I guess it should be labeled as an editorial, so it is an editorial.

A quick look:
"As for your questions on the gloom and doom that you feel pervade the world. Please do not take this personally, but totally disagree. In fact that is why I waited a while before responding. I wanted to be sure I had read your mood correctly and not just reply off the cuff.

Writing this in the aftermath of Hurricane Katrina with its amazing suffering, destruction, egregious looting, and apparent lack of recovery planning, it is easy to get caught up in the idea that things are not good, that the world is doomed, and that people are inherently evil. I disagree. Of course things are not perfect, but they are much better for most people than they ever have been.

“Things” are by and large good. Indeed arguably things are better than they have ever been. Yes that is a massively large statement, but I do believe it to be true. "

Full letter.

Dr. James Lorie

I missed this totally. The finance profession definitely owes the late Dr. Lorie a great deal. He is one of the people behind CRSP.

Victor Niederhoffer and Laurel Kenner: Daily Speculations:
" Much of the mystery shrouding the stock market dissolved when James H. Lorie began documenting the historic rise and fall of stock prices.

The idea was simple but laborious: chart stock prices from 1926 to1960 and beyond. Dr. Lorie, a University of Chicago professor, helped establish the Center for Research in Security Prices at the Graduate School of Business.

Dr. Lorie, who lived in Chicago's Lincoln Park neighborhood, died of pancreatic cancer Saturday, Aug. 6 in Northwestern Memorial Hospital in Chicago."

SBU's response to Hurricane Katrina

Do me a favor, pass this one on. I played a small part in the idea so I really want it to work.

St. Bonaventure is offering free room and board and one-half tuition scholarships to students from higher education institutions in areas affected by the hurricane so those students can continue their studies here at St. Bonaventure on a temporary basis.

“Our doors — and our hearts — are open,” said Sr. Margaret Carney, O.S.F., S.T.D, University president. “We have put into motion every effort to accommodate students from higher education institutions affected by the hurricane and invite them to contact us. Our goal is to help these students continue their education without interruption.”

We're asking all faculty, staff and students to help us by sharing this information with any professional or social organizations you're affiliated with.

"We expect students to return to their home institutions at the earliest possible moment and will make every effort to help them with that transition," said Mary Piccioli, dean of enrollment. "Our classes began August 29, so it’s important that students contact us as soon as possible if they’re interested in attending classes at St. Bonaventure."

Interested students can contact St. Bonaventure via Mary Piccioli at (800) 462-5050, or via e-mail at For full information on St. Bonaventure’s response to Hurricane Katrina, please visit the University’s Web site.

Thursday, September 01, 2005

Seasonal, Size and Value Anomalies by Ben Jacobsen, Abdullah Mamun, Nuttawat Visaltanachoti

SSRN-Seasonal, Size and Value Anomalies by Ben Jacobsen, Abdullah Mamun, Nuttawat Visaltanachoti: "

Uh, oh. Here is one that will cause my notes to be redone!

Jacobsen, Mamum, and Visaltanchoti use the Fama-French data library to look at three types of anomalies. Their findings may surprise you!

The anomalies are broken down into three categories:
  1. Seasonal--the Halloween Effect (that is that stocks do better from November to April) and the January Effect.
  2. Value--The Book to Market anomaly and the Earnings to Price anomaly.
  3. Size Effect-the small firm effect
The authors use a "time series of (log) portfolio returns starting with the random walk model and then include a January dummy, a Halloween dummy, or both, to study the interaction between these effects and the different portfolio returns." (See equation 1)

The findings?

1. Returns appear lower in the summer (thus the so-called Halloween effect is supported) :
  • "excess returns on almost all portfolios are during summer not significantly different from zero and negative in approximately half of all portfolios. This confirms the finding of Bouman and Jacobsen (2002) for international results also for the US: excess returns in the US on many portfolios are close to zero and often negative during summer months."
2. Value anomalies appear to be largely year-round phenomena
  • "Size effect and the well known value effects, like Book to Market, Earnings to Price,
    Cash Flow to Price and Dividend to Price effects are not affected by the Halloween
    effect. These anomalies persist in summer and winter."
3. The size effect appears to be dependent on the measure of comparison and disappears (or even reverses sign!) when the January effect is controlled for!
  • "After controlling for a January effect we find no evidence of a size effect in equally weighted portfolios and a reversed size or, in other words, a ‘large firm effectÂ’ in value weighted portfolios."
Which deserves a WOW! I told you I would have to edit my notes!

Jacobsen, Ben NMI1, Mamun, Abdullah and Visaltanachoti, Nuttawat, "Seasonal, Size and Value Anomalies" (August 2005).