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Markets: Fooled By Randomness


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CastleGate's presentation to Patni Employees.

Published in: Business, Economy & Finance
  • This was a really nice presentation! I loved the book 'fooled by randomness' ... this presentation touches on some of the same ground, but is also a bit of a broader look at securities investing, and what can trip people up when making decisions about their investments.
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Markets: Fooled By Randomness

  1. 1. Fooled By Randomness CastleGate Capital Company
  2. 2. Financial Markets Brief Introduction To Some Aspects
  3. 3. What Is A Good Investment <ul><li>Minimum Transaction Cost </li></ul><ul><li>Minimum Constraint Of Choice </li></ul><ul><li>Ability To Identify Value </li></ul><ul><li>Increase In Value </li></ul><ul><li>Increase In Value Greater Then Criteria </li></ul><ul><ul><li>Inflation </li></ul></ul><ul><ul><li>Return Expectation </li></ul></ul><ul><ul><li>Opportunity Costs </li></ul></ul><ul><li>Ability To Exit </li></ul><ul><li>Should Satisfy Time Horizon </li></ul><ul><li>Whether an investment was a good or bad investment is only decided by the difference in the price you paid versus the price you get at the end of your time horizon </li></ul>
  4. 4. What is the market? <ul><li>Features Of a Free Market </li></ul><ul><ul><li>Transparency </li></ul></ul><ul><ul><li>Default Free </li></ul></ul><ul><ul><li>Settlement Procedures </li></ul></ul><ul><ul><li>Anonymity </li></ul></ul><ul><ul><li>Liquidity </li></ul></ul><ul><ul><li>Fair </li></ul></ul><ul><ul><li>Regulated </li></ul></ul><ul><ul><li>Free From Manipulations </li></ul></ul>
  5. 5. What is value <ul><li>Ways of measuring value </li></ul><ul><li>Dependence of value of assumptions </li></ul><ul><li>Role of subjectivity in assumptions </li></ul>
  6. 6. Components of a stock’s value
  7. 7. Indicators Method For Avoiding Madness
  8. 8. Indicators as Anchors <ul><li>What is an Indicator </li></ul><ul><li>How when every euphoria exists indicators can become good anchors of sanity </li></ul><ul><li>How are indicators calculated </li></ul><ul><li>Leading vs Lagging Indicators </li></ul>
  9. 9. Simple Indicators <ul><li>What’s a Book Value </li></ul><ul><li>P/BV Ratio </li></ul><ul><li>What Is Dividend Yield </li></ul><ul><li>During times of optimism more money is being paid for a stock, reducing it’s Dividend Yield and increasing P/BV ratio </li></ul><ul><li>The more they diverge, greater is the danger of bubble </li></ul>
  10. 10. Metal Stock Vs Price Indicator <ul><li>Here the stock piles of metals are measured as grey line </li></ul><ul><li>The metal prices, obviously are inversely related to stock piles. Higher the stocks lower the prices </li></ul><ul><li>This indicator can serve as a warning for not getting into Metal Companies for now, not investing in LONG METAL TRADES in commodities etc. </li></ul><ul><li>Almost doubling of prices since 2000 indicates Metal Stocks may be doubled in last 2-3 years, but this will not be a good time to buy them </li></ul>
  11. 11. Indicators Of Transition <ul><li>Consider a company with revenue of 100 Cr. </li></ul><ul><li>Small Cap Company </li></ul><ul><li>Default Level Caa-C </li></ul><ul><li>Probability of rev. 500 Cr </li></ul>
  12. 12. Complex Indicators
  13. 13. Where Money Will Flow Next
  14. 14. The Reality Of Complexity If You Not Inside, You Are Outside
  15. 15. Conflict Of Interest <ul><li>A deal begins at least 6 months before it arrives in press </li></ul><ul><li>Professionals working on it know the impact of the deal on markets </li></ul><ul><li>Information flows openly in India </li></ul><ul><li>Investment Research and Investment Banking </li></ul><ul><li>How real is the Chinese Wall </li></ul><ul><li>Triple layers of research reports </li></ul><ul><li>Insider networks </li></ul>
  16. 16. Broker Performances <ul><li>Lets consider the reports they write </li></ul><ul><li>For a buy report, </li></ul><ul><ul><li>Lets find the best price the stock reached </li></ul></ul><ul><ul><li>The worst price </li></ul></ul><ul><ul><li>How many days (as % ) since then did the stock stay above report days price </li></ul></ul><ul><li>Will you like a recommended stock whose best price was 5% up, worst was 30% down and was below report day’s price for 90% of the times </li></ul><ul><li>According to Bloomberg, best broker has been Merrill Lynch with 35% accuracy, can you imagine the rest? </li></ul>
  17. 17. Top Broker’s Predictions: ENAM
  18. 18. Enam Downside
  19. 19. Top broker’s predictions: SSKI
  20. 20. Mutual Funds <ul><li>Large institutions are 70% of funds </li></ul><ul><li>They have specific requirements in terms of risk and time </li></ul><ul><li>Not to mention the kick backs paid to get in such large clients </li></ul><ul><li>The funds are run to manage their requirements and not small investors </li></ul><ul><li>When a large guy gets out with his funds, the fund manager has to sell for redemption irrespective of good or bad time </li></ul><ul><li>The broker’s bill is paid by the investors who stay behind reflected through NAV which nobody notices </li></ul><ul><li>Margins have upper cap of 1%, cost cant be reduced, only way to make money is to collect more funds </li></ul><ul><li>Fund Managers Incentive structure </li></ul><ul><li>On Mutual Fund distribution structure </li></ul><ul><li>29 Fund houses 2000 schemes which one to buy. </li></ul><ul><li>Too few fund managers managing too many funds with diverse objectives </li></ul>
  21. 21. Derivatives <ul><li>Futures </li></ul><ul><li>Options </li></ul><ul><ul><li>Put </li></ul></ul><ul><ul><li>Call </li></ul></ul><ul><li>Leverage </li></ul><ul><ul><li>Non linearity of returns </li></ul></ul><ul><ul><li>Magnification of gains/losses </li></ul></ul><ul><li>Underlying Dangers </li></ul><ul><ul><li>Too Many Parameters </li></ul></ul><ul><ul><li>Quick Exit Scenarios </li></ul></ul><ul><ul><li>Margin Calls/ Position Liquidation </li></ul></ul><ul><ul><li>Stop Loss Triggering </li></ul></ul>
  22. 22. Dangers Of Derivatives <ul><li>Legendary investor Warren Buffet compares derivatives to Financial Weapons of Mass Destruction </li></ul><ul><li> </li></ul>
  23. 23. Options: If you can’t calculate this you are gambling on slim chance
  24. 24. Psychology Of Finance Sins Of Fund Management
  25. 25. Folly Of Forecasting <ul><li>Roots in pride of being smarter then others </li></ul><ul><li>Anchoring: Tendency to stick to numbers for support </li></ul>
  26. 26. Experiments
  27. 27. The Point Being <ul><li>Pride </li></ul><ul><li>Ego Defense Mechanism </li></ul><ul><li>Debasing </li></ul>
  28. 28. Past Versus Future Earnings
  29. 29. The Illusion Of Knowledge <ul><li>More Information is not better judgment </li></ul><ul><li>More information only increases confidence </li></ul><ul><li>Over information can be detrimental to decision making </li></ul><ul><li>Information vs Noise </li></ul><ul><li>Few key information is preferred </li></ul>
  30. 30. Experiments
  31. 31. Davis Et Al (1994) <ul><li>Davis asked people to forecast 4Q earnings based on last 3 Q EPS, Sales, and Stock Price </li></ul><ul><li>This was baseline info </li></ul><ul><li>Later Extra (Relevant and irrelevant information was added </li></ul><ul><li>Just the presence of extra information increases errors </li></ul><ul><li>Both redundant and relevant information increase confidence with relevant information to a greater extent </li></ul><ul><li>Accuracy remains just declines redundant or relevant </li></ul>
  32. 32. Knowing Management Helps <ul><li>Corporate Managers Cognitive Illusions </li></ul><ul><li>Confirmatory Bias </li></ul><ul><li>Figures of Authority </li></ul><ul><li>Separating Deception From Truth </li></ul>
  33. 33. The Overoptimistic Manager
  34. 34. Confirming To The Manager <ul><li>Leeper, Lord and Ross (1979) on confirmatory bias </li></ul><ul><li>Mind finds information that agrees with its views </li></ul><ul><li>Contradicting information is hard to assimilate </li></ul><ul><li>Biased Assimilation </li></ul><ul><li>Capital punishment studies </li></ul><ul><li>Information distortion to favor current leading view </li></ul><ul><li>Distortion higher in professionals then in students </li></ul>
  35. 35. Obeying Authority <ul><li>Milgram (1974) paper on why people obey authority </li></ul><ul><li>‘ Students’ and ‘Teachers’ experiment for seeing effect of ‘Shock On Memory’ </li></ul><ul><li>Man in white coat and glasses made as teachers </li></ul><ul><li>Three levels of shocks </li></ul><ul><li>Subjects can only hear the screams but cannot see them </li></ul><ul><li>People delivered highest levels of shocks only because they were told by ‘Figure of Authority’ </li></ul>
  36. 36. Telling Deception <ul><li>Kassin Et Al studies </li></ul><ul><li>61 students and 57 federal investigators to identify mock confessions </li></ul><ul><li>Audio/Video </li></ul><ul><li>53% accuracy, just the same as chance </li></ul><ul><li>When it was told that 50% of them will be accurate, students had a better judgment rates then professionals </li></ul><ul><li>When training is given to ‘Students’ the number of false alarms increases </li></ul><ul><li>Catching a deception is not so easy </li></ul>
  37. 37. Overtrading: Myopia Of Short Termism <ul><li>Attention Deficit Hyperactivity Disorder </li></ul><ul><li>Incentives of Fund Managers </li></ul><ul><ul><li>Better to fail conventionally than to succeed unconventionally </li></ul></ul><ul><li>Reducing average holding periods of stocks </li></ul>
  38. 38. Fire The Fund Manager
  39. 39. Believing What You Read <ul><li>Stock brokers sell greed </li></ul><ul><li>The Allure of growth </li></ul><ul><li>Dangers of story view </li></ul><ul><li>Spurn The Spin </li></ul>
  40. 40. On Belief Systems <ul><li>Cartesian Vs Spinoza Belief Systems </li></ul><ul><li>Challenge or Upset beliefs </li></ul><ul><li>Avoid all beliefs </li></ul><ul><li>Go away from the noise </li></ul>
  41. 41. Conclusion <ul><li>There is no free lunch </li></ul><ul><li>That investment is not a casual game but alert frugal patient investor’s game of silent and continuous practice </li></ul><ul><li>Financial Markets are not a place to display you RISK TAKING ABILITY </li></ul><ul><li>They are a place to show your Minimum Risk Maximum Return Finding Ability </li></ul>