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8.3. Summary and Conclusions

By now you appreciate that financial analysis is not an exact science and the theories upon which it is based may even be "bad" science. The fundamental problem is that real world economic decisions are characterised by uncertainty. By definition uncertainty is non-quantifiable. Yet, rather than bury their heads in sand, academics continue to defend financial models, such as the CAPM based on simplifying assumptions that rationalize a search for investment opportunities in the chaotic world we inhabit. See Fama and French (2003).

New mathematical theories and statistical models of investor irrationality and market inefficiency, characterised by non-random walks are being crystallized. These post-modern "Quants" reject the assumptions of a normal distribution of returns. See Peters (1991) for a comprehensive exposition. Scientific "catastrophe theory" is also being applied to stock market analysis to explain why "bull" markets crash without warning. See Varian (2007).

Academics and financial analysts are also returning to twentieth-century economic theorists for inspiration, from John Maynard Keynes to the behaviouralists who dispensed with the assumption that we can maximise anything.

Today's proponents of behaviouralism, such as Montier (2002) reject the neo-classical economic profit motive and the wealth maximisation objectives of twentieth-century finance They believe that finance is a blend of economics and psychology that determines how investor attitudes can determine financial decisions. Explained simply, investors do not appreciate what motivates them to make one choice, rather than another. Behavioural Finance therefore seeks to explain why individuals, companies, or institutions make mistakes and how to avoid them.

Suffice it to say, that much of the "new" Quants is so complex as to confuse most financial analysts, let alone individuals who wish to beat the market (think the millennium dot.com fiasco and the 2007 meltdown). Likewise, the "new" behavioural finance (just like the "new" behavioural economics of the1960s) seems to prefer "a sledgehammer to crack a walnut" (see Hill 1990).

As a parting shot, let us therefore return to first principles and common sense with a guide to your future studies or investment plans, which places Modern Portfolio Theory in a human context.

Ignore forecasts: Evidence suggests that predictions are invariably wrong. The behavioural trait to avoid is known as anchoring, whereby you latch on to uncertain data that is hopelessly wrong. Develop a strategy that does not depend on them.

Information Overload: The financial services industry believes that to "beat" the market they need to know more than everybody else. But empirical studies reveal too much information leads to overconfidence, rather than accuracy. So concentrate on an investment's "key" elements.

Overconfidence: Most investors overestimate their skills. Prepare a plan based on your risk-return profile and ability. Then stick to it.

Denial: Investors are more attracted to good news, rather than bad. Prior to the millennium, the market did not want the dot.com boom to fail. So, any information suggesting that techno-shares were overvalued was ignored. The lesson is not to be complacent.

Overreaction: Investors become optimistic in a rising (bull) market and pessimistic in a falling (bear) market. When a significant proportion of investors believe that the market will rise or fall it may be a signal that the opposite will happen.

Crowd Behaviour: People feel safer herded together, which is why investors mimic the behaviour of others and buy fashionable securities and funds. Speculative investors turn this to their own advantage by acquiring stocks that are cheap and unfashionable.

Selective Memory: Most investors tend to forget failure but remember success. To beat the market and keep ahead of the crowd, keep a record of your decisions (good or bad) and learn from your mistakes.

Ignore Current Market Sentiment and Noise: Today, most investors are doing the opposite. The average holding period for a share on the New York Stock Exchange is eleven months, compared with eight years in the 1950s.

Go for long-term investment: Over time, most shareholder returns come from dividends. But remember the expected return from a stock is equal to the dividend yield, plus any dividend growth, plus any changes in valuation that occur. The strategy to adopt is "value investing", where you buy stocks that are cheap with high dividend yields.

To summarise:

Short-term gain equals long-term pain: According to Patrick Hosking (2010) the global financial crisis, which has cost somewhere between one and five times the entire world's financial output, started with reckless bankers lending to poor Americans. Since 2007, other contributory factors have also been suggested for the meltdown. Central banks ignored rising asset prices, governments talked up a global economic boom and financial regulators still adhered to efficient market theory by using a light touch.

However, these are merely the consequences of a more fundamental problem, motivated by greed, referred to throughout our analyses (including the SFM texts), namely:

The principal-agency conflict associated with inappropriate short-term, managerial reward structures that arise from a bonus culture and lack of corporate governance, first explained by Jensen and Meckling (1976).

As Hosking observes, these flawed incentives still exist today not just in banks, but also within financial institutions and companies whose management (agents) hold shares on behalf of their owners (principles). Management rarely accept responsibility if things go wrong, but always accept rewards, even if their strategies have no lasting value. Thus, managerial short-termism rarely coincides with the long-term income and capital aspirations of their shareholders.

If proof be needed that professional portfolio management has lost its way, let us conclude with two telling UK statistics from the London School of Economics' Centre for the Study of Capital Market Disfunctionality.

In real terms, pension fund returns grew by an average of 4.1 per cent per annum between 1963 and2009, but by only 1.1 per cent a year in the last 10 years.

Unless corporate management are held personally responsible for their bonuses long after their receipt (perhaps a decade) it is therefore difficult to see how the rational objectives of efficient portfolio theory can ever match the rational expectations of a portfolio's clientele.

 
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