About Behavioral Finance

Behavioral Vulnerabilities:



About Prospect Theory: An Analysis of Decision under Risk

The theory distinguishes two phases in the choice process: an early phase of editing and a subsequent phase of evaluation; the editing phase consists of a preliminary analysis of the offered prospects, which often yields a simpler representation of theses prospects, whereas the edited prospects are evaluated in the second phase and the prospect of the highest value is chosen.

Outcomes which are obtained with certainty are overweighted relative to uncertain outcomes. Certainty increases the aversiveness of losses as well as the desirability of gains

In the positive domain, the certainty effect contributes to a risk averse preference for a sure gain over a larger gain that is merely probable; in the negative domain, the same effect leads to a risk seeking preference for a loss that is merely probable over a smaller loss that is certain (the overweighting of certainty favors risk aversion in the domain of gains and risk seeking in the domain of losses)

Value function: Reference point + Magnitude of the change. (vs final welfare states)

The value function is normally concave above the reference point and often convex below it, meaning, the marginal value of both gains and losses generally decreases with their magnitude.

Losses loom larger than gains; the aggravation that one experiences in losing a sum of money appears to be greater than the pleasure associated with gaining the same amount (i.e.: the value function for losses is steeper than the value function for gains).

Because people are limited in their ability to comprehend and evaluate extreme probabilities, highly unlikely events are either ignored or overweighted, and the difference between high probability and certainty is either neglected or exaggerated.

... which leads to perceive both insurance and lottery/gambling as atractive.

It is suggested that a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise (e.g.: Leeson at Barings Bank, Citron at Orange County)

Value Investing

The three factor model to explain most of the differences in financial markets returns:

1. The premium return of the stock market when compared to riskless assets.Sharpe's Beta.
2. The premium return of small capitalization stocks over large cap stocks.Fama's size effect.
3. The premium return of value stocks over growth stocks.Fama's value effect.
... I don't think the momentum factor is at the same level.

The performance of the stock markets exceeded those of Bonds, T-Bills, Gold and Dollar.
(Siegel's "Stocks for the long run"). But we should also bear in mind certain factors:

1. Take the market's geometric return (not the arithmetic return.

2. Consider the survivorship bias: Siegel only considers the best market in the best century of the history. But Argentina was as wealthy as the US a century ago. Austrians lost all their money at the mid-century. Japan will have to wait some generations to see the 40,000 back, ...
So, to bear in mind: companies do fail (while S&P500 do not consider those), some currencies lose value, and markets / economies sometimes get exhausted for some generations.

Stock returns in developed countries - markets, have outperformed those in emerging countries, with an astonishing Sharpe ratio difference.

The average return of small (and medium) companies outgoes the average return of the big companies both in developed and emerging countries (Fama's size effect).

Relative price is often measured by a firm's book-to-market ratio (BtM). When stocks are ranked by relative price, high BtM (or "value") stocks tend to have higher average returns than low BtM (or "growth") stocks. This is known as the relative-price or value effect.

Active management is encouraged to rely on settled rules. My favorite guide is the 50 day Nasdaq moving average. On the other hand, passive management stands on solid theoretical grounds, has enormous empirical support, and works very well for investors.

Regarding the composition of the portfolio:
Between 5 and 15 different stocks provide enough diversification for a personal portfolio.
(although some behaviorist may call this "the rule of five", ... a rule of thumb that only leads to underperformance)

In that sense, a good long run strategy to apply could be:
% of our portfolio invested in the stock markets = 100 - our age.

A book that should be re read more frequently...
"The intelligent investor" by Graham,

From his best student, W. Buffet, we should learn that a continued and periodically buy, in the stock market, is not only more easy and relaxed than the timming and stock picking strategies, but it will generally provide better results (80% of the Funds fail to match market returns).

And regarding the company's management:
Natural, organic growth for a company is better than the M&A growth.
(stock markets reflect it very well, and the reason the second is so much practiced is mostly because the CEOs looking for perks (i.e. empire building).

Repurchase of its own shares on the market is a better way for the company to pay their shareholders than providing dividends (because by doing that, we are going to suffer double taxation: company's + shareholder's). I think most mutual funds do not suffer the double taxation though. Furthermore it is well documented that senior investors, who are already retired, do prefer not to sell capital (stocks) and perceive the dividends as a rent.

Carta Abierta a Doña Esperanza Aguirre

topic, tags: radio BBC in Spain / English improvement.

Buenos días.

Quería proponer que en la Comunidad de Madrid se valorara la posibilidad de tener una emisora de radio publica.
La emisión que propongo es: BBC World Service

Por qué:
El ingles se debería potenciar más. En España el nivel es bajo con respecto a nuestros vecinos europeos y eso nos hace menos competitivos. (Y a los jóvenes españoles mas esclavos de la deriva del país a manos del gobierno socialista. --> Cuando podriamos disfrutar mucho mas del mercado único laboral europeo si tuvieramos mejor nivel de inglés)


Mas tiempo en embotellamientos, atascos = Más tiempo perdido. Más paro = más horas libres. Etc.
Con esta emisión se avanza en la democratización del inglés: en que no haga falta pagar una academia, viajes o clases para mejorarlo, sino el interés y esfuerzo personal. En las ganas de superacion personales, atributos de la derecha de los que tendriamos que hacer gala mas a menudo.

Por último quería apuntar también que ya hay una iniciativa similar en España.
En concreto se trata de Talk Radio Europe - link. Una emisora de expatriados jubilados ingleses donde las producciones propias (shows normales de radio) se alternan con horarios donde directamente conectan con la BBC (todas las noches desde las 11:30 pm hasta las 07:00 am; de lunes a viernes de 06:00 a 07:00 pm, etc.).
Es una maravilla que sea ingles británico, que no haya anuncios en la emisión, que el acceso sea libre ...

Les mando un cordial saludo, Atte.
RT

Pairs-Trading Strategies @ personal portoflio

I have made some changes recently in my portfolio because I think we have to be prepared for uncertainty in the financial markets.

As a consequence of that, my strategy is almost market neutral.
These are my positions (for a 1700 eur power purchase) :

POP.MC - 600 @ 6.75 e
ACX.MC - 270 @ 14.11 e
MT + 123 @ 24.7 e
NOK + 400 @ 9.13 e

portfolio
--
I think Arcelor Mittal will outperform Acerinox. The last one have not dropped so much during the downturn in the financial markets, and that is just because it has fewer liquidity / # trades.

Secondly, Nokia makes good cellphones (Does Customer Satisfaction Translate to Excess Stock Returns?, the sector´s outlook is bright and the shares have underperformed the market and its sector recently. Certainly it is a risky proposition, since we do not know when the company will pick up again. But .... I like this moment to buy the stock, I think it may have been over-sold.

On the other hand, the Spanish bank, Popular will suffer from spain's PM.
Zapatero and his socialist ideas are not the best macro strategies to deal with the current recession. So the levered position of the bank in the spanish housing market has gloomy perspectives unless BIG! changes in public policy take place -diminishing the taxes, subsidies, government power, government cars, travels, # wages ... it is just not gonna happen.

Asset Allocation for personal portfolio

What if we had $100K to invest today for our own account? ... empirical simulation

The first thing we should do, is to establish the risk adversity we want.
Tough that is a personal decision, there is a pretty simple guide to do that:

% RISKY ASSETS = 100 – AGE (years).
… Bonds, T-bills and gold are good low-risk assets.

Since I am a follower of the Austrian School of economics, I find gold quite appealing, furthermore in such market (and policitcal) conditions.
But I think that a 10% allocation is in the highest range of alternatives. More than that is not an option: gold doesn't produce anything.

So … If we were 40 years old, we’ll end up with this proportions:
Risky assets: $60 000
Bonds / T-bills: $ 30 000
Gold: $ 10 000 (preferably in spot, rather than in financial products. Otherwise... we never know whether we will have it when it is more needed)

- RISKY ASSETS [leveraged]:
- Currencies: $ 20 000
aud.usd - 0
cad.usd - 28 (buy, wait)
chf.usd - 27 (BUY)
eur.usd - 18 (buy, wait)
gbp.usd - (neutral)
jpy.usd - 25 (inverted) (SELL if it is around 1/103 - BUY if it is around 103)
... so as June 19th, we start a position: CHF/JPY (at around: 89)

- Stock markets: $ 40 000
Hedge strategies: $ 20 000 [$ 100 000] : mt.acx / acn.ibm? / gas.oil /
Moving averages crossovers: $ 5 000 [x]
New maximums - New minimums hedged system: $ 5 000 [x]
MACD R2: $ 5 000 [x]
Seasonal trading opportunities: $ 5 000 [x] (1st month) / Options / Volatility / Option wRiting strategies (risks) ...

Trading Volatility / Writing Options

--> the title of the post is a link to a video of a fully developed strategy on option writing. video at fma.org <--

Suggested chart to work with options:
http://tiny.cc/kRlgP
(value of the options: time + volatility + spot _underlying asset)

Let's go to the point:

On a regular basis, we should rather write (sell) options, than to buy them.

The best moment to sell options is when the VIX is peaking / has already peaked.
That is, when it is coming down after a rally (moving averages crossing down).
Thus, the best Options to use are PUTs, never CALLs in such conditions.

On the other hand, the best moment to buy options is when the VIX is in its lowest levels. Consequently we'd rather buy PUTs than CALLs.
We can do it when the moving averages have crossed upward.
Sadly, with that strategy we can find a lot of different occasions when they have just crossed up for a short time of time, coming down afterwards. Such occasions will not provide good results, but among those... there will be the good ones!

Economic Outlook

Be carefull with the green shoots. Economic data / analysis is not all pointing towards a rosy future.
On the one hand, bigger than expected earning forecasts during the last week were released, supporting the rally experienced in the stock markets since march (because actually the earnings' improvement was in fact bigger than the rise by the stock markets).

But on the other hand, it was just released yesterday the June GEAB N°36, with gloomy perspectives for the months to come. Forecasting payment defaults in the UK and the US

... and (spanish):
Estas son las olas principales:
1- La ola del paro masivo. -> Massive unemployment.
2- La ola de las quiebras en serie, empresas, bancos, inmobiliario, estados, regiones, ciudades.
-> Wave of city councils, states, banks and corporation defaults.
3- La ola de la crisis terminal de los bonos del tesoro de EEUU, del dólar y de la libra y la vuelta a la inflación.
-> US' bond crisis. USD and GBP currency crisis, and back to (super)inflation times

Hope these guys are wrong bk otherwise the green shoots are going to get burned during the summer

So, be prepared for worst economic performance, and get a neutral/bearish market portfolio!
--
GEAB 36: http://tiny.cc/Qu0Qj