Financial Modeling Self Study Program

Is investing in stocks really investing?

No.  Buying stocks is speculating.  Even if you’re buying value stocks.  Even if you’re planning to hold stocks for the long-term (whatever that means).  I wish more people understood this.  Anytime you spend money on the hope and prayer that the thing you bought appreciates in value, you are speculating, not investing.  Here’s another way to think about it.  If you have significant control over your spent money (say, starting a business or building a new factory) then you’re investing.  If you don’t then you’re speculating.

Oh, and one last thing:  speculating is just a more acceptable synonym for gambling.

Does technical analysis work?

Yes.  No.  Maybe.

I think all three are correct depending on how we define technical analysis.  Academics have known for about 15 years that stocks with positive momentum tend to outperform stocks with negative momentum.  Traders and speculators have probably known this for centuries longer.  If we define technical analysis as using information contained in historical prices (and other information such as trading volume) to predict future prices than there is no question the answer is yes, technical analysis does work.  Most quantitative trading methods (including high frequency trading) is based on this sort of analysis.  In fact, I would go as far as to say that much of what people view as fundamental analysis is actually technical analysis.  I would argue that much of value investing (e.g. buying stocks with low Price/Book Value ratios or Price/Earnings ratios is actually a reflection of technical factors (the stock has gone down in the past) than it is of fundamental factors such as its book value or earnings.

If, however, we define technical analysis as humans looking at charts looking for patterns which they then give cool names, I am more than a little skeptical.  Not because the charts don’t contain good information (they contain the same information used by the computers discussed above) but because I am skeptical that humans can consistently and correctly interpret this information.  I do leave open the possible that certain exceptional individuals can indeed profit from interpreting such charts.

I’ve stated that technical analysis is essentially just momentum investing (I use the word investing loosely).  I think its worth mentioning that virtually all trading is based on momentum investing.  Of course the downside of momentum (from the trader’s perspective) as a strategy is that it works until it doesn’t.   Which is to say you’ve got to get out in time (no easy task), making it a risky strategy.  From the market’s prospective, it is not difficult to see the relationship between momentum and frothy markets.

Does fundamental analysis work?

As we alluded to when we were discussing the efficiency of markets, fundamental analysis works if and only if you can discover important enough non-public information AND that non-public information will become public within a reasonable time frame.  It is not enough to discover the information because if other market participants don’t learn about it (there’s no “catalyst”), prices won’t reflect it and you can’t make money on it.

Now, one type of non-public information would be to have a different (better) view on the company’s prospects or on say, macroeconomic prospects.  Three things make this very difficult in practice.  Firstly, it is very difficult to be smarter than the market.  Second, even if you are correct, it often takes much longer to be proven right, hurting your returns (or worse).  This is analogous to Keyne’s famous statement that the market can remain irrational far longer than you can be solvent.  I would, of course, modify this to say that the market can remain stupid far longer than you can be solvent. Third, since the market tends to lean towards optimism most of the time, having a contrarian view usually means being short the market.  Shorting the market brings its own set of risks and is a strategy that is extraordinarily difficult with which to make money.  You may have noted that numbers 2 and 3 help illustrate why bubbles can persist for a long time.

If people are indeed rational, as you say, then how can bubbles arise and persist for so long?

Who cares if investors are rational or irrational?

To some extent this is really an academic argument.  Why does it matter if investors make rational and stupid decisions (as I say) or irrational ones (as everyone else says).  I do think knowledge for knowledge sake is cool and to better understand how people make decisions is cool too.  However I also think there is something very important about the distinction as it relates to policy.

Given today’s economic situation, the irrationality of investors and economic actors is being used to justify hugely significant policy decisions.  Instead we should be focusing on, for example, the horribly wrong incentive structures throughout the finance system that led to (rational) decision making which in turn led to the our current economic woes (much more to come about this under Current Economic Situation category).   We also should be focusing on how to educate people to make smarter decisions (i.e. to understand economic and finance decisions).

It is also important to understand the fallacy of irrationality because it is being used as key evidence of the inherent failure or instability of a free market system.   This couldn’t be further from the truth, as we will also discuss in other posts.

How can you say that people are rational given all of the research that seems to show otherwise in addition to all of the booms and busts throughout history?

Okay, this is really important.  To really understand this point, let’s first understand how economists usually define rationality.  An economic actor (that is to say, a person)  is rational if he or she always makes decisions which will maximize his or her economic well being.  Now, there is an enormous body of research in psychology and behavioral economics (the same field by the way – just that the economics know how to use statistics) that shows otherwise.  This we do not dispute in the least.

What we dispute is the above definition of rationality.  It is wrong in three ways.  The most obvious way it is wrong is that we don’t maximize our current economic well being but the present value of our well being.  Now, I would guess that almost all economists would probably agree with this modified definition.  But it is a very important distinction because people have very different discount rates.  That is to say, some people place much more value on well being today versus well being in the future.  To place more value on well being today is not irrational if one’s discount rate at the time is higher.

The second error in the definition of rationality is that people don’t seek to maximize their economic being (that is to say, their wealth or income) but their overall well being or their “utility”.  (I have a lot more to say about the definition utility but for now leave it as one’s overall well-being).  Now again, most economics would agree with this modification to the definition but alas, fail to internalize the distinction.  Understanding that many decisions (even investing ones) are affected by things are than income or wealth goes far to explain many of the experiments that claim to prove that people are irrational.  For example, many studies have shown that individual investors trade too much even though they know that trading costs hurt their overall investment performance.  Therefore, they are irrational, right?  Not necessarily.  Most individuals who trade in and out of stocks get other utility out of their actions.  That is to say, trading is fun, not unlike, say, going to Las Vegas.  In other words, the entertainment value of trading adds more to their utility than the lost money due to trading costs subtracts.  There is nothing irrational about that.

The third and final error is probably the most important one and also the least understood.  Many experiments have shown that when faced with a probability based decision many people make the wrong choice (that is one that results in lower expected value) or given two sets of decisions, make inconsistent choices.  These types of experiments are used to demonstrate the irrationality of human beings.  But this is wrong.  What they demonstrate mostly is that humans are bad at probabilities (they demonstrate other things as well – for example that most of us would rather not lose money than gain money).  Perhaps we’re all dumb, perhaps we all slept through statistics class in college or perhaps our incentives are messed up.  That we don’t fully understand the question or that we didn’t bother (or don’t know how) to do the expected value arithmetic does not demonstrate irrationality.  So the third distinction that we need to make to our definition of rationality is that we make decisions to maximize the present value of our utility based on the decision maker’s understanding of the decision and NOT the experimenter’s understanding of the decision.

Assuming you’re still reading this and haven’t fallen asleep, you might be wondering so what?  Who cares if people are rational or  not?  Let’s talk about that next.

Even if markets are efficient then surely a boom or subsequent bust proves that market participants are irrational, right?

Wrong.  Not just wrong, but WRONG.  This is one question that everyone and I mean everyone gets wrong.  People are rational.  Period.  Full Stop.  (No, I’m not Milton Friedman writing from the grave).

I still don’t get it. How can fundamental value change in such a short period of time?

Now you’re thinking.  Fundamental value doesn’t change because there is no such thing as fundamental value.  Let me repeat that again:  there is no such thing as fundamental value.  This is perhaps the most important myth of finance (and economics).  There is only relative value.  Those of you that are on this site doing  investment banking interview prep know that the way you value a company is by comparing its value to other similar companies (even our so called “intrinsic value” DCF analysis uses comparisons to come up with forecasts, terminal values and WACC).  So, if Amazon in 1999 trades at a 100x P/E ratio than why shouldn’t Ebay or Pets.com?  Similarly, if my neighbor’s ocean front Miami beach condo sells for $1 million shouldn’t my identical one also be valued at $1 million?  That there is no such thing as fundamental value is true for not only financial assets but applies to all assets.

Aren’t you saying that there is no such thing as a bubble?

No.  Prices of financial assets can certainly rise to unsustainable levels due to overly optimistic forecasts.  And this is actually pretty easy to spot, at least near its peak.  You may recall that plenty of market commentators and academics spoke of an Internet bubble in the late ’90s and a real estate bubble in the last few years.  What I am saying is that just because asset prices may vary greatly over time (say NASDAQ at over 5000 in March 2000 and at about 1100 two and a half years later) doesn’t mean that markets are inefficient.  It just means that public information (i.e. market sentiment and forecasts) changed.

If you say markets are efficient, then explain the dot-com bubble or the real estate bubble.

Ah ha!  You think you’ve got me, don’t you?

Recall the definition of an efficient market:  that all public information is priced in.  I never said that prices were fundamentally correct (more on this in the next question).  I merely said to be efficient prices must reflect all publicly available information.  If the consensus amongst the public (i.e. market participants)  is that we’re in a new era of phenomenal growth to which the world has never seen before, then that public sentiment (or more precisely, that economic outlook or forecast) will be priced into stocks (or other financial assets).  That overly optimistic sentiment may be ultimately shown to be foolish or short-sighted, but it does not mean that markets are inefficient, or even wrong.

So how do you make money in the “markets?”

Since luck is pretty hard to control, let’s talk about the second factor:  having non-public information.  Now, of course there are two types of non-public information.  The legal type and the illegal type.  Here at IBankingFAQ, we recommend the legal type, at least in the United States (we give no such recommendation for those investing outside the U.S. )  Most of you probably know what the illegal type is – usually called “insider information.”  An example of this would be investing in an airline of which your Dad has influence over union decisions.

The legal type would be any information not known by the broader investing community that has not been obtained illegally (i.e. in violation of SEC or other regulatory body regulations).  For example, hedge funds that cover retailers might send consultants to a retail store to count cars in the parking lot or peak into stock rooms to count inventory levels, given them non-public insight into the financial results of the retailer.   Or perhaps a doctor, due to his or her own specialty has indirect insight into the likely success or failure of a new drug in clinical trials.  Or maybe a mutual fund manager has the ability to meet directly with a management team.  Even if no non-public information is disclosed by the CEO during that meeting, the fund manager might have insight into the quality of the CEO that other market participants, who do not have the ability to meet management, cannot have.  Keep in mind that often there is a very fine line between legally obtained non-public information and illegal insider information.

So how does one go about legally obtaining non-public information?  Well, aside from the examples I’ve given above, the answer is that it is usually extraordinarily difficult as an individual investor and still extremely difficult as an institutional investor.   The short answer is if you’re going to try to make money in financial markets,  concentrate on less efficient markets such as small cap stocks or emerging markets but ONLY if you have the ability to uncover non-public information.

The even shorter answer is, its nearly impossible for an individual investor (or institutional investor such as a hedge fund) to outperform the market so don’t even try.

What does it mean for a market to be efficient?

Essentially it means you can’t make money, without one of the following (1) luck or (2) non-public information.  Now, to be precise, the phrase “you can’t make any money” really means, “you will not consistently achieve risk-adjusted above market returns.”  And by “you” I do mean YOU, whether you’re a Harvard undergrad day-trading in your dorm, a retiree with a 401K, or  you’re running a $10 billion mutual fund or hedge fund.

Are markets efficient?

Let’s start with an easy one, albeit important one, albeit one that most people, academics included, don’t really understand.   And the answer is:  it depends on the market – but in most cases, for all practical purposes the answer is yes.  But before we can really answer this question, we need to define market efficiency very clearly (and very simply).  Forget what you’ve learned about weak forms and strong forms and the other stuff coming out of academia.

An efficient market is a market where all publicly available information is priced in.    What is public information?  Basically, any information that affects the price of that asset, such as information reported by the company, by its competitors, suppliers and vendors, macroeconomic data, etc.

So which markets are efficient and which less so?  For the most part, the larger and more liquid the market, the more efficient.  Large cap U.S. stocks, U.S. treasuries, currency markets?  All extremely efficient.  Small to mid-cap U.S. stocks?  Still pretty efficient but certainly less so than large caps.   Microcap stocks and emerging market stocks – less efficient still.