Technical Analysis
Castle in the Air Theory
technique that uses charts of past trends in currency prices and other factors to forecast future value
Technical Analysis studies three things
Price over time (support = lowest point in the past, resistance = highest point in the past)
Volume over time
Indicators over time
Why does Technical Analysis work? 3 things
Mass psychology - those who think it is going up buy and then others follow along which increase prices further
Underreaction - leads to price momentum
Unequal access to fundamental information
Why does technical analysis fail? 4 things
Missing the boat
Predictions are early
Self defeating as more rely on technical analysis
Profit maximizing behavior makes market efficient (prices will reflect all available information already)
Consequences of overreaction and underreaction in TA
Underreaction leads to price momentum
Overreaction leads to price reversals
What is Fundamental Analysis?
...
What are the 4 things that matter for value DCF
1. Cash flow
2. Risk free rate
3. Risk (capm model)
4. Growth rate
Caveats to Firm-Foundation Theory?
Can't predict future accurately
Best analysts are poached
Faulty accounting from firms
Estimates do not converge
Efficient Market Hypothesis
Price of securities fully reflect available information - so TA or Firm-Foundation can't be utilized
Investment Companies Categories (3)
Open-End Fund (mutual funds) these funds buy and sell shares, are price once per day after market hours, do not fluctuate during the day, and net asset value on fund per share
Close-End Fund - IPO'd once and fixed amount of shares, prices fluctuate, share
Benefits of investing in mutual funds (6)
1. Diversification
2. Versatile size
3. Professionally managed
4. Liquid
5. Ease of trade/management
6. Fee/expense economy
Types of fees for mutual funds (4)
Load Fees, front-end and back-end (One-time)
Loads reduced from greater purchases, letter of intent, and purchase to existing holdings
12-b1 Fee (sales, marketing, fee to professional manage)
Management Fee
Trading Cost
Mutual Fund Categories (2)
Short Term
Investing in money-market instruments such as govt and corporate debt
Long Term
Investing with diversification and equity orientation in equities and bonds
Active - styles, market cap, sector, geography, balanced
Passive - index
Total Expense Ratio
Expense Fees as percentage of assets
ETF
Exchange Traded Fund
Open end characteristic of issue/redeeming shares
close end characteristic of trading on exchange
Both active and passive
Benefits of ETF (4+2)
1. Execution Control
2. Tax Control
3. Liquid
4. Trades like a stock
5. Margins
6. Options, sell-short
Uses of ETF
Hedging
Asset portfolio allocation
Portfolio adjustment
Momentum Trading
Statistically based trading
Risk Management
Rational Models
Believe agents will act rationally
Modern Portfolio Theory
Investors will maximize returns and minimize variance, resulting in mean-variance portfolio (efficient portfolio)
CAPM
Capital Asset Pricing Model
return = risk free rate + Beta*market risk premium
Higher beta = higher returns
Fails - no correlation to returns, but good measurement of risk and volatility
How many stocks to remove idiosyncratic risk?
40-60 suggested by Malkiel
Arbitrage Pricing Model
Using systematic risk factors to develop more returns, adding more than just the market risk premium
Farma French 3 model
Market Price premium (rm - rf)
Size premium (small - large)
Value premium (high book/market minus low book/market)
Carhart Model
1. MRP
2. Size
3. Value
4. Momentum (Up minus Down)
Farma French 5 Factor Model
1. MRP
2. Size
3. Value
4. Profitability (Robust - Weak or REV - COGS)
5. Investment (C - A or Investments growth/total assets eOY)
Behavioral Models
Agents are not rational, psychological behavior deviates from rational behavior
This is due to limited attention - cost of gathering and processing information
Heuristics (shortcuts rather than mathematical optimization)
5 Factors of why agents are irrational
1. Overconfidence - underestimate risk, overestimate ability to control events
2. Biased Judgement - illusion they are in control (hindsight error)
3. Herd Mentality - mass crowds influencing them to believe what is incorrect to be correct
4. Loss Aversio
Framing
different ways of presenting information
Active Management
Managers wish to outperform the market with new information
What does Active management maximize/minimize
Portfolio returns over benchmark returns
Tracking Error
What is tracking error
Risk due to active management - Difference between portfolio return and benchmark return
Portfolio Construction
More/less risk depends on time-horizon
Efficient Frontier is risk free rate and market return
Short-term horizon Portfolio Construction
Money-market instruments valuing liquidity and certainty of value (corporate debt and govt debt)
Long-term horizon Portfolio Construction
Equity orientation and diversification, higher risk assets and lower liquidity
Personal situation and portfolio needs categories (5)
T2RGD
1. Time-horizon
2. Risk tolerance
3. Growth
4. Distribution
5. Risk capacity
Rebalancing
Rebalancing assets to long term weights
Buy and hold will generate geometric mean but that is always lower than arithmetic so we have to rebalance
Excess return from rebalancing over weighted average growth of assets
Smart Beta
Certain qualities have produced excess returns - identify those factors - Weighting assets based on a style/strategy - assuming greater risk
Momentum
Low volatility
STyle
Size (large cap)
Value (large value)