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Class Note 9_S2010 - RSM 330 I nvest ment s Por t folio M...

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RSM 330 - Investments Portfolio Management – August 5, 2010 Maureen Stapleton, CFA 1 RSM 330_Class 10_Summer 2010
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Plan for Today Portfolio Management Efficient Market Hypothesis (EMH) An important assumption underlying CAPM and MPT Some Basic Issues Supportive Evidence for EMH Challenges against EMH Anomalies Multifactor Explanations Fund Performance & Evaluation More on your project 2 RSM 330_Class 10_Summer 2010
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Readings Bodie: Chapters 4,4; 10.1 -10.5; 12.3 ; 21.3- 21.5 - Multifactor Explanations – Fama & French Optional articles: “Does the Stock Market Over react?” Liquidity and the Post-Earnings Announcement Drift” New article to help you with Assignment 2 (Question 3) “The Style Roulette and RAFI © Strategy” 3 RSM 330_Class 10_Summer 2010
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Efficient Market Theory (EMH) ….…the basics EMH contends that market prices are correct. Market prices fully reflect all available information . – Expectations about future cash flows are correct. – The discount rate is correct. I f EMH is true, there is no “free lunch”. - The only way to earn higher average returns is by taking on more risk - No one can beat the market by stock picking or market timing. EMH is about the I nformational Efficiency of the market Prices react to new information quickly and to the right extent . 4 RSM 330_Class 10_Summer 2010
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Three forms of market efficiency: Weak form - information on past prices has been incorporated into current prices. Semi-strong form - all public information has been incorporated into current prices. Strong form - all public and all insider information has been incorporated into current prices. Basic Questions: Why would we expect market to be efficient? Arbitrage : Smart investors exploit the mispricing of securities until it disappears. Can markets be perfectly efficient? • If so, no one can beat the market & everyone would follow a passive strategy. • Then there would be no arbitrage to remove mispricing. How efficient are markets? Conclusion: Markets are somewhat efficient! 5 RSM 330_Class 10_Summer 2010
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2. How can we tell if markets are inefficient (ie not efficient) ? Look for stock-picking strategies that have earned higher returns with lower risk. Caveat …. it’s possible that we may not be measuring risk properly . – This is the “ Joint Hypothesis Problem .” 1. Does EMH imply that stock prices are random walks? Yes if risk is constant . I t is not true if risk changes over time .(ie if risk is time varying) – For example, D/P ratios may be correlated with risk and hence they can predict returns or changes in stock prices. – This is the risk story for the D/P regression, which is consistent with EMH. 6 RSM 330_Class 10_Summer 2010
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Supportive Evidence for EMH New information appears to be quickly incorporated into stock prices.
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