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June 13 - June 29, 2018
the correct insight underlying the CAPM: The only risk that investors should be compensated for bearing is the risk that cannot be diversified away. Only systematic risk will command a risk premium. But the systematic elements of risk in particular stocks and portfolios may be too complicated to be captured by beta—the tendency of the stocks to move more or less than the market. This is especially so because any particular stock index is an imperfect representative of the general market. Hence, beta may fail to capture a number of important systematic elements of risk.
Changes in interest rates also systematically affect the returns from individual stocks and are important nondiversifiable risk elements.
Changes in the rate of inflation will similarly tend to have a systematic influence on the returns from common stocks.
risk. Two factors are used in addition to beta to describe risk. The factors derive from their empirical work showing that returns are related to the size of the company (as measured by the market capitalization) and to the relationship of its market price to its book value.
The mystical perfect risk measure is still beyond our grasp.
there are four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion.
people deviate in systematic ways from rationality in making judgments amid uncertainty.
that people set far too precise confidence intervals for their predictions. They exaggerate their skills and tend to have a far too optimistic view of the future.
They found that the more individual investors traded, the worse they did. And male investors traded much more than women, with correspondingly poorer results.
hindsight bias. Such errors are sustained by having a selective memory of success.
Overoptimism in forecasting the growth for exciting companies could then be one explanation for the tendency of “growth” stocks to underperform “value” stocks.
Aside from the long-term positive direction of the stock market, streaks of excessively high stock returns do not persist—they are typically followed by lower future returns.
It is this illusion of control that can lead investors to see trends that do not exist or to believe that they can spot a stock-price pattern that will predict future prices.
research shows that groups tend to make better decisions than individuals. If more information is shared, and if differing points of view are considered, informed discussion of the group improves the decision-making process.
the market as a whole does not invariably make correct pricing decisions.
the study found that when people went along with the group in giving wrong answers, activity increased in the area of the brain devoted to spatial awareness. In other words, it appeared that what other people said actually changed what subjects believed they saw.
an epidemic model, in which investors quickly and irreversibly spread information about stocks by word of mouth.
Prospect theory challenges that assumption. People’s choices are motivated instead by the values they assign to gains and losses. Losses are considered far more undesirable than equivalent gains are desirable.
Kahneman and Tversky concluded that losses were 2½ times as undesirable as equivalent gains were desirable. In other words, a dollar loss is 2½ times as painful as a dollar gain is pleasurable.
In the face of sure losses, people seem to exhibit risk-seeking behavior.
“framing” effect. The way choices are framed to the decision maker can lead to quite different outcomes.
Behavioralists also stress the importance of the emotions of pride and regret in influencing investor behavior. Investors find it very difficult to admit, even to themselves, that they have made a bad stock-market decision. Feelings of regret may be amplified if such an admission had to be made to friends or a spouse. On the other hand, investors are usually quite proud to tell the world about their successful investments that produced large gains.
Behavioralists believe that important limits to arbitrage exist that prevent out-of-whack prices from being corrected.
The market can remain irrational longer than the arbitrageur can remain solvent.
Sophisticated speculators such as hedge funds were not a correcting force during the bubble period. They actually helped inflate the bubble by riding it rather than attacking it.
there are also times when short selling is not possible or at least severely constrained.
Arbitrages may also be hard to establish if a close substitute for the overpriced security is hard to find.
It is clear that one cannot rely completely on arbitrage to smooth out any deviations of market prices from fundamental value.
The first step in dealing with the pernicious effects of our behavioral foibles is to recognize them. Bow to the wisdom of the market.
Don’t be your own worst enemy: Avoid stupid investor tricks.
1. Avoid Herd Behavior
Any investment that has become a topic of widespread conversation is likely to be especially hazardous to your wealth.
Invariably, the hottest stocks or funds in one period are the worst performers in the next.
2. Avoid Overtrading
Behavioral finance specialists have found that investors tend to be overconfident in their judgments and invariably do too much trading for their own financial well-being.
3. If You Do Trade: Sell Losers, Not Winners
4. Other Stupid Investor Tricks
Be Wary of New Issues.
deal. In measuring all IPOs five years after their initial issuance, researchers have found that IPOs underperform the total stock market by about 4 percentage points per year.
Stay Cool to Hot Tips.
Distrust Foolproof Schemes.
Over short holding periods, there is some evidence of momentum in the stock market.
The core of every portfolio should consist of low-cost, tax-efficient, broad-based index funds.
As long as there are stock markets, mistakes will be made by the collective judgment of investors.
prices can never be “correct.”
What the EMH implies is that we never can be sure whether they are too high or too low at any given time.
Even if stock prices move randomly, you shouldn’t.
The harsh truth is that the most important driver in the growth of your assets is how much you save, and saving requires discipline.
The secret of getting rich slowly (but surely) is the miracle of compound interest.
There are also low-expense REIT index funds (listed in the Address Book), and I believe these funds will continue to produce the best net returns for investors.
