Quantitative Financial Analytics
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Quantitative Financial Analytics

The Path to Investment Profits

Edward E Williams, John A Dobelman;;;

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eBook - ePub

Quantitative Financial Analytics

The Path to Investment Profits

Edward E Williams, John A Dobelman;;;

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About This Book

0 Contents:

  • The Challenge: Can You Attain Wealth in Today's Investment Environment?
  • Financial Mathematics
  • The Securities Markets and Macroeconomics
  • Financial Statement Analysis
  • Forecasting Techniques
  • Analysis and Fixed Income Securities
  • Analysis of Common Stocks
  • Futures and Options
  • Risk, Uncertainty, Utility and Portfolio Theory
  • Capital Market Theory, Efficiency, and Imperfections

--> Readership: Academics, students, entrepreneurs and business operators interested in investment theory, security analysis, and portfolio theory and selection, as well as professionals preparing for the CPA, CFA, and or CFP examinations. -->
Investments;Quantitative Finance;Portfolio Management;CPA;CFA;CFP;Business;Entrepreneur;Capital Market Theory;Investment Theory;Security Analysis;Portfolio Theory Key Features:

  • This meets the need for advanced undergraduates and graduate students in the quantitative disciplines who wish to apply their craft to the world of investments
  • There is no other book like this available today. Most investment texts are encyclopedic in nature and do not provide the quantitative emphasis this book provides
  • This book is one of the few which offers a statistical analysis framework of the markets and institutions that its audience is lacking

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Chapter 1

The Challenge: Can You Attain Wealth in Today’s Investment Environment?

“You ought never to take your little brother’s chewing gum away from him by main force; it is better to rope him in with the promise of the first two dollars and a half you find floating down the river on a grindstone. In the artless simplicity natural to his time of life, he will regard it as a perfectly fair transaction. In all ages of the world this eminently plausible fiction has lured the obtuse infant to financial ruin and disaster.”
Mark Twain


The discussion in the coming chapters may well leave the reader under the impression that it is virtually impossible to attain great wealth from investing in the stock market. At best, it may appear that investors should be able to earn no more than average returns. This conclusion is not unwarranted, although the reader should bear in mind that all the evidence is not yet in. Our understanding of investments as an economic phenomenon is still limited, and only recently have scientific tools been employed to analyze the process. Furthermore, the discipline of investment analysis and its underlying theoretical constructs are being reconsidered in the light of an ever-expanding body of literature. The learned opinions of many leading scholars in the area differ widely even after surveying similar documentation.
On the one hand, there are those who argue that above-average market returns may be achieved by the investor who acquires sufficient expertise. The job of asset management, though interdisciplinary and frustrating, can be performed. It appears that through the use of a judicious combination of expert judgment and objective analysis, one can achieve superior returns consistently. The example of Warren Buffett immediately comes to mind.
At the other end of the spectrum, many academic financial economists suggest that the Warren Buffetts of the world are a rare breed. They maintain that, although some investors think that fundamental analysis may hold the key to beating the market, in reality stock markets are intrinsic-value, random-walk phenomena. As a result, most fundamental analysts will not be able to beat the market. Only a very few expert fundamental analysts who uncover hard to detect data will be able to earn above market returns. It takes years of hard work to become such an expert, and it is unlikely that any particular person will be able to consistently discover such data. In light of efficient market evidence, one may reflect upon the work required to analyze and select securities and ask: Why bother?
The answer should be clear. If investors see no need to insure that potential risk is balanced by potential return, then perhaps there is no need to bother. But many elements relevant to the behavior of companies, industries, and markets can be learned. Probabilities about the future behavior of those elements can also be quantified. Inputs determined by security analysis and manipulated by portfolio managers should lead to an optimum balance between risk and return in order to achieve maximization of long-run portfolio wealth.
In the effort to follow, we feel some obligation to apprise the reader of our views since we shall ask him or her to patiently traverse many pages of somewhat difficult (and perhaps even occasionally tedious) material. Although we will try to make our work as entertaining as possible, diversion is certainly no justification for spending the money required to buy this book.
First, we do believe that security analysis is a necessary task for every investor. There is no other way that one can make determinations of risk and return. Even if it is impossible to gain above-average rewards (a point on which we shall reserve judgment for the time being), forecasts of expected risk–return relationships are required for all but the most simple-minded decision algorithms. Moreover, we believe that entrepreneurs are especially qualified to be good investors. People who have operated businesses tend to take a longer term view and try to understand the real economic value of a business. This is the approach adopted by Warren Buffett, and it has proven to be very successful.
Second, we would argue that portfolio analysis is also a required activity if one is to decide in a rational framework which securities should be purchased. Although some aspects of portfolio analysis in the current state-of-the-art are rather abstract, we maintain that operational decisions can be made using the tools we will suggest. Entrepreneurs should pay particular attention to their portfolio of investments since they tend to have a major asset holding in the business(es) they own. Risk is an important aspect of portfolio construction, and the investor must be able to determine his or her personal risk preferences in order to make optimal selections.
Finally, an understanding of the constructs of capital market theory is essential if one is to grasp clearly the significance of many of the issues that we will raise in the pages to follow. Although capital market theory may not be as yet a completely accurate description of the operations of the capital markets, if markets become more efficient the theory becomes a better depiction of reality.

The Nature of Investment Management

Every individual who has more money than he or she needs for current consumption is potentially an investor. Whether surplus funds are placed in a bank at a guaranteed rate of interest or used to invest in an oil well, an investment decision must be made. These decisions may be made wisely or foolishly, but the intelligent investor will seek a rational, consistent approach to managing one’s money. The best method for many is simply to turn their funds over to someone else for management. A significant number of investors do indeed follow this policy, and it is quite likely the correct decision for them. Others, however, manage their own money or even become professionals and manage other people’s. This book is written for these individuals.
In the succeding chapters, any mysteries about getting rich quickly are not obviated. Indeed, if such secrets existed, it is doubtful that anyone would be willing to reveal them. There are systematic procedures for making decisions, however, that can enable the intelligent investor to achieve solid performance. There is generally a positive correlation between the returns one expects from an investment and the amount of risk that is assumed. Thus, decisions must be made that reflect the ability and desire of the investor to assume risk. In the final portions of this volume, we shall examine in both theoretical and practical terms the nature of this correlation.
As has been observed elsewhere (Thompson, Williams and Findlay, 2003, p. 2):
“Although intelligence is about the only important requisite for any kind of decision making, there are other traits that may be helpful to the money manager. In particular, a certain amount of scientific curiosity may be very important to successful investors. By scientific curiosity we do not mean knowledge or even interest in disciplines generally considered ‘science,’ such as biology or chemistry, although the scientifically trained analyst may have an advantage in scrutinizing the stocks of high-technology companies. Rather, scientific curiosity refers to the systematic pursuit of understanding. An investor should be willing to take the time and spend the energy to know himself and his environment.”
“It is unfortunately true that many otherwise successful people make poor investors simply because they do not have a logical investment policy. They have only vague objectives about what they want (such as ‘capital appreciation’ or ‘safety of principal’), and they often substitute general impressions for solid fact gathering. How many highly competent doctors, for example, go beyond the recommendations of their brokers (friends, relatives, or patients) when selecting a security? How many business people take the time to familiarize themselves with the income statements and balance sheets of the firms in which they hold stock?”
We might add: How many professional portfolio managers make decisions based on a well-researched, documented effort to uncover investments that others have not discovered? Even in the case of professional portfolio managers, other factors than solid analysis may be allowed to dominate. Of course, the doctor may not have the time or knowledge to make a sound investment decision and the business person may be too occupied with his or her own company to do the required due diligence. If so, these individuals should not attempt to manage their own money. The professional manager who bases decisions on what one “feels” the market will do, however, is being negligent. Although knowledge of what other managers are doing may be important and an experienced person’s market “feel” may be superior to any professor’s theoretical model, too often even the professional tends to substitute rumor and hunch for sound analysis and thorough investigation.
The sophisticated investor needs to be reasonably versed in mathematics and statistics. In this book, we provide a review for those who are somewhat hazy on these subjects. This review is not intended as introductory expositions to the investor who has never heard of compound interest or a standard deviation, but it should serve as an adequate guide and handy reference for those who have a basic knowledge of mathematics and statistics.

Investment Media and the Environment

Numerous investment media exist that the investor may consider. The simplest is the insured deposit at a commercial bank. Such accounts provide safety of principal and liquidity. Historically, they have also provided yields that closely track the rate of inflation. The insured bank deposit account requires little analysis as an investment vehicle, but it is not entirely riskless. A failed bank may be taken over by the government, and the depositor may be required to wait weeks or longer to get his or her money back. Moreover, deposit insurance offered by the Federal Deposit Insurance Company (Uncle Sam) is limited in amount, and this makes it impossible for managers of large amounts of money to take advantage of this opportunity. Investors of this sort typically invest in U.S. Treasury Bills, or equivalents, which will be discussed later in Chapter 2.
At the opposite end of the asset spectrum are highly illiquid investments (real estate, oil well interests, paintings, coins, stamps, antiques, and even ownership of business enterprises). These investments require very specialized due diligence, and are beyond the scope of this book. In between the insured bank deposit (or Treasury Bill) and the very illiquid assets are a host of investments that can generally be described as securities. A security is an instrument signifying either ownership or indebtedness that is negotiable and that may or may not be marketable. Securities are by far the most popular form of semi-liquid investment (that is, an investment that is marketable but that may not be salable near the price at which the asset was purchased). Moreover, they can be analyzed in a systematic, consistent fashion.
Pension fund assets, life insurance reserves, bank portfolio holdings, and so on are far more heavily invested in bonds than equities. Thus, the bond markets are far more important to both issuing corporations and many investors than equities (stocks). Bond analysis is not simple or even uninteresting. Indeed, some of the most sophisticated minds in the investments business are engaged in the bond market. We shall devote a chapter of this book to bond analysis, and the reader will be convinced that bonds have a place in many portfolios. However, it is the stock market that engenders the interest of most investors. This is undoubtedly true because the rewards (and penalties) of stock market investment well exceed those obtainable in the bond market. Furthermore, equity analysis is more complicated than bond appraisal, and greater skill is required in selecting common stocks than fixed income securities.

Can You Make Money in the Stock Market?

For 50 years now, a school of thought has developed that argues that only insiders and those privileged to have information not known to the rest of us can make large profits in the stock market. These people subscribe to a theory of stock prices called the efficient market hypothesis (EMH). EMH advocates argue that the current price of a stock contains all available information possessed by the market and only new information can change stock prices. Since new information becomes available randomly, there should be no reason to expect any systematic movements in stock prices or returns.
Believers in the strongest form of the EMH feel that the stock market is perfectly efficient and the cost of research and investigation cannot be justified by any “bargains” (that is, undervalued stocks) that can be found. The efficient market hypothesis was initially tested many years ago by a number of scholars (see Fama, 1965, 1970). These researchers have considered various hypotheses about the behavior of the stock market, from notions that past stock prices can be used to forecast future prices (the belief held by stock market chartists or “technicians”) to opinions that there are stocks that are undervalued by the market and that these stocks can be uncovered by a thorough investigation of such fundamental variables as reported earnings, sales, price-to-earnings multiples, and other economic, accounting, or financial data.
The latter view of the market has long been held by most investors, and the whole profession of security analysis is founded on it. From the early days of the first edition of Graham and Dodd (1934) down to the present (see Graham and Dodd, 2008) analysts believed that there are overpriced stocks, and underpriced stocks, and the securities analyst searches to determine both. EMH advocates have maintained, however, that the presence of so many analysts trying to find bargains (and overpriced stocks to sell short, a technique discussed later in this book) makes it impossible for any one of them to outperform the general market consistently. Thus, as the economy grows and corporate earnings increase, it is possible to make money in the stock market, but it is not reasonable to expect to earn more than “average” (risk-adjusted) returns over the long run.
The EMH hypothesis is based on the observation that there are many buyers and many sellers in the market who have a great deal of similar information about stocks. If any one stock were “worth” more than the price for which it was currently selling, analysts would recommend buying until its price rose to the point at which it was no longer a bargain. Similarly, if a stock were selling for more than its intrinsic value, analysts would recommend selling. The price of the security would fall until it was no longer overpriced.
The efficient market hypothesis became quite popular among academic economists over the past 50 years. Nevertheless, most practitioners have rejected it for a number of reasons. In the first place, if the EMH were correct, it would be hard for professionals to justify the salaries that they are paid to find better-than-average performers. Second, many analysts have suggested that their very presence is required for the EMH to work. If they could not find undervalued stocks, they would not come to their desks each day, and if they did not appear, there would no longer be that vast army of competitors to make the stock market efficient and competitive!
Moreover, many analysts point out that there are substantial differences of opinion over the same information. Thus, although every investor may have available similar information, some see favorable signs where others find unfavorable ones. Furthermore, various analysts can do different things with the same data. Some may be able to forecast future earnings, for example, far more accurately than others simply because they employ a better analytical and more systematic approach.

The Stock Market as a Speculative Institution

Others (including many academic historians) maintain that the stock market is neither competitive nor efficient. It has been observed that securities speculation in the past has been far from scientific and that emotion rather than reason has usually guided the path of stock prices. These inefficiency proponents believe that people are governed principally by their emotions and that bull and bear markets are merely reflections of the optimism or pessimism of the day. Most of us have been tempted by the thought that economics plays an unfortunately slight role in the market and that investor psychology may in fact be more important. Indeed, there is good historical reason for one to feel that people are anything but rational when it comes to investing. Charles Mackay, in his Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, points out (1869, pp. vii–viii):
“In reading the history of nations, we find that, like individuals, they have their whims and their peculiarities; their seasons of excitement and recklessness, when they care not what they do. We find that whole communities suddenly fix their minds upon one object, and go mad in its pursuit; that millions of people become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first. We see one nation suddenly seized, from its highest to its lowest members, with a fierce desire of military glory; another as suddenly becoming crazed upon a religious scruple; and neither of them recovering its senses until it has shed rivers of blood and sowed a harvest of groans and tears, to be reaped by its posterity. . . . Money, again, has often been a cause of the delusion of multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper.”
Mackay’s history outlines a number of ...

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