Aswath Damodaran – Investment Philosophies NYU Classes [Part IV]VW Staff
Aswath Damodaran just started uploading his NYU class lectures – we have posted the last batch below, which we hope readers will enjoy. Check back since there is a lot more coming or better yet, sign up for our free daily newsletter to ensure you never miss a post.
Also see The Little Book of Valuation: How to Value a Company, Pick a Stock and Profit, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset,Damodaran on Valuation: Security Analysis for Investment and Corporate Finance and Applied Corporate Finance.
Aswath Damodaran, in the last and part four of these investment philosophies videos, talks about pseudo and speculative arbitrage, market timing, passive investing, investor performance and provides a conclusion of the series.
Investment Philosophies: Not Riskless – Pseudo & Speculative Arbitrage
In this session, we focus on strategies that are often labeled as “arbitrage” but are really speculative, risky strategies that may or may not generate excess returns. First, we look at paired arbitrage, a practice of finding two companies that have historically moved together, where the current price relationship is not consistent with historic norms. While the strategy has made money for investors over time, the evidence suggests that the returns have come with risk and that the excess returns have faded over time. Second, we examine “merger arbitrage”, the practice of buying target company shares after a merger/acquisition is announced, hoping to make money from the price being higher when the deal is consummated. Again, while the returns are generally positive, it is exposed to the risk that the acquisition may fail, causing the stock price to drop back to pre-announcement levels. With speculative arbitrage strategies, we note the importance of adjusting borrowing (financial leverage) to reflect the risk in the strategy. We close the session by looking at hedge funds, noting three findings: that they have historically generated higher returns, given their risk exposures, than the rest of the market, that these higher returns come from a few big hedge fund winners (rather than from overall consistency) and that the worst hedge funds usually go out of business.
Investment Philosophies: Market Timing – Setting the Table
In this session, we begin by arguing that all investors are market timers, insofar as they decide how much to invest and when to invest, with the difference being more of degree. The allure of market timing comes from the payoff that it delivers to those who are successful at it, since successful market timers will easily beat their counterparts in stock picking. The cost of market timing is that you may end up out of the market at exactly the wrong times (the periods where the market is going up).
Investment Philosophies: Market Timing – Nonfinancial & Technical Indicators
In this session, we begin by classifying non-financial indicators that have been used to time markets into three groups: spurious indicators that are correlated the market but have no economic relationship, feel good indicators that try to measure investor optimism and often work better as contemporaneous rather than leading indicators of stock prices and hype indicators that attempt to measure the fad factor in stock prices, with the assumption that hype goes before a fall. With technical indicators, we note that past market price movements have generally not been good indicators of future movements but that trading volume and volatility shifts may provide more timing promise.
Investment Philosophies: Market Timing Approaches – Mean Reversion & Macro Fundamentals
In this session, we begin by looking at market timing approaches that are built on the presumption that there is a normal level for a financial market and that prices revert back to this normal level. In the context of stocks, this usually takes the form of a normal PE, computed using either current or normalized earnings, with the assumption that if stocks collectively are trading at a PE higher (lower) than the normal PE, they are over (under) priced. With interest rates, the norm is defined as a range of interest rates based upon history and an assumption that interest rates will revert back to this range over time. In the second part of the session, we examine whether you can use macro economic data on interest rates and real growth to forecast future stock prices and find little basis for trading profits.
Investment Philosophies: Market Timing Approaches – Valuing the Market
In this session, we look at extending valuation approaches developed for valuing individual stocks to valuing the entire market. We begin by using an intrinsic valuation model to value the S&P 500 as the present value of expected cash flows on the index. While the approach is promising, it is dependent upon historical data and can provide poor signals, if there has been a systematic shift in risk preferences or growth potential. We also look at valuing a market on a relative basis, by either comparing it’s pricing over time or by comparing pricing across markets
Investment Philosophies: Market Timing – Does it Work?
In this session, we look the track record of market timers. We begin with mutual funds and note that the cash holdings of mutual funds are implicit measures of market timing, increasing when funds are bearish and decreasing when they are bullish. We find little evidence of market timing ability either among mutual fund managers, in general, or even among just tactical asset allocation funds. The evidence is a little more positive for hedge funds, insofar as some of them are better at forecasting forthcoming changes in liquidity and adjusting their portfolios accordingly. Neither investment newsletter writers nor market strategists are investment banks seem to do well at timing markets. Notwithstanding this evidence, we look at four ways in which investors can bring market timing into their portfolios: through the asset allocation decision, by switching investment styles ahead of market shifts, by rotating through sectors as the economy evolves or by speculating using index options or futures.
Investment Philosophies: The case for passive investing – Active Investor Track Records
In this session, we make the argument for passive investing by looking at the performance of active investors. We begin by looking at individual investors and note that they collectively under perform the market and that the under performance gets worse as they get more active. There is some cause for hope, though, since the very best investors do substantially out perform the market, especially if they stick to the companies that they know and don’t diversify too much. With mutual funds, the evidence is not favorable, since mutual funds under perform indices and the under performance cuts across all classes of mutual funds. Collectively, active investing does not seem to provide much of a payoff.
Investment Philosophies: More in Investor Performance – Continuity & Consistency
In this session, we continue examining the payoff to active investing by evaluating how much continuity there is in performance. We find little overall evidence of consistency, with investors in the top quartile in any time period just as likely to drop to the bottom quartile, as they are to stay in the top quartile. While there is some predictive power in mutual fund rankings and ratings, it comes from “hot hands” in mutual funds where the very best and the very worst mutual funds see a continuation of performance into the following time period. The overall under performance of money managers can be traced to four factors: high transactions costs, greater tax costs for investors (often caused by too much trading), failed attempts at market timing and various problems that can traced to incentive structures and behavioral factors.
Investment Philosophies: Passive Investing Choices
In this session, we look at the choices available for investors who choose the passive investing route. The first option is to invest in index funds, which have grown in terms of both dollar value and variety over the last four decades. They offer the benefits of tracking indices (of whichever asset class you want) with very little cost. The second is to choose among an ever-increasing array of exchange-traded funds (ETF), which also try to mimic indices, but can be bought and sold like individual stocks. The third is to try to have your cake and eat it too, by investing in enhanced index funds that claim to offer the benefits of index funds (low costs and index integrity) while generating slightly higher returns (using derivatives or by over investing in the best stocks in the index).
Investment Philosophies: The Grand Finale
In this session, we close by looking at the process of finding the best investment philosophy for you, as an investor. To make this choice, you have to begin with a personal assessment (patience, your need to be part of a group, age) and follow up with a financial assessment (job security, funds to invest, tax status). You then have to follow up by developing a sense and understanding of how markets works (and do not) based upon both the evidence and your own investment experiences. At the end of the process, you can end up with the either an investment philosophy that best fits you or a collection of philosophies that complement each other.