Applied Investment Theory (eBook)

Les Coleman is a Senior Lecturer in Finance at the University of Melbourne, Australia. His main research interest is financial decision making by firms and investment funds, and his finance publications include three research monographs, four book chapters and nearly 30 journal articles. Les trained originally as an engineer, and spent almost 30 years in senior management positions with Anglo American and ExxonMobil Corporations in Australia and overseas.

Dedication 5
Preface 6
Contents 17
About the Author 19
List of Figures 21
List of Tables 22
1: Introduction 23
1.1 Developments in Financial Markets over Recent Decades 24
1.1.1 Transformation of the Equity Investor Base 25
1.1.2 Inflation in Scale and Scope of Markets 26
1.1.3 Importance of Non-economic Factors in  Investment Decisions 29
1.1.4 Systemic Weaknesses in Financial Systems Reliability 30
1.1.5 Difficulty of Transitioning MPT to Investment Practice 32
1.2 Motivation and Plan of This Book 32
Part I: Investment Theory and Practice 34
2: Current Paradigm: Neoclassical Investment Theory 35
2.1 The Building Blocks of Investment 37
2.2 Utility Theory and Investor Risk Propensity 40
2.3 Capital Asset Pricing Model 40
2.4 Factor Models and Arbitrage Pricing Theory 42
2.5 Other Valuation Models 44
2.6 Conclusion: Useable Hypotheses of Neoclassical Investment Theory 48
3: Behavioural Biases in Investor Decisions 49
3.1 The Catalogue of Cognitive Investment Biases 51
3.1.1 Affect Heuristic 57
3.1.2 Anchoring and Adjustment 57
3.1.3 Asset-Liability Management 58
3.1.4 Bounding 58
3.1.5 Disposition Effect 60
3.1.6 Framing 60
3.1.7 Herding 61
3.1.8 Hindsight Bias 62
3.1.9 Homogenizing of Probabilities 62
3.1.10 Hyperbolic Discounting 63
3.1.11 Mental Accounting 64
3.1.12 Overconfidence 64
3.1.13 Prospect Theory and Situational Attitudes Toward Uncertainty and Loss 65
3.1.14 Regret Aversion 66
3.1.15 Sentiment 67
3.2 Could There Be a Common Behavioural Denominator? 67
3.3 Conclusion 69
4: Uncertainty in Investor Wealth 73
4.1 Background 74
4.2 Risk in the Finance Literature 77
4.2.1 Relationship Between Security Return and Uncertainty 77
4.3 Unpacking the Notion of Uncertainty and Risk in Finance 82
4.3.1 Exogenous Influences on Equity Uncertainty or Risk 82
4.3.2 Endogenous (Non-human) Influences on Uncertainty in Firm Value 86
4.3.3 Human Influences on Uncertainty in Firm Value 86
4.3.4 Governance, Ethics and Sustainability 88
4.3.5 Proxies for Uncertainty in Firm Performance 90
4.4 Conclusion: The Return-Uncertainty Link for Equities 91
Part II: Structure, Conduct and Performance of Fund Manager Investment 93
5: Building Investment Theory Using the Structure-Conduct-Performance (SCP) Paradigm 94
5.1 What Is a ‘Good’ Investment Theory? 95
5.2 Does Investment Theory Have to Be Quantitative? 97
5.3 Structure-Conduct-Performance (SCP) Paradigm 98
5.4 Conclusion 100
6: Structure of Equity Prices 101
6.1 Compilations of Facts in Finance 102
6.2 Distribution of Equity Prices 104
6.2.1 Unexpectedly High Turnover and Volatility 105
6.2.2 Patterns in Markets 106
6.2.2.1 Seasonal Patterns in Markets 106
6.2.2.2 Cyclical Features of Equity Prices 107
6.2.2.3 Clustering in Returns and Volatility 111
6.2.2.4 Tendency of Prices to Trend 113
6.2.3 Macrodrivers of Equity Returns 117
6.2.4 Other Market Behaviours 119
6.3 Explanations of Equity Prices 122
6.3.1 Smart Beta: Systematic Influences on the Cross Section of Stock Returns 122
6.3.2 Influence on Returns of Firm and Security Traits 124
6.3.3 Can Lagged Variables Really Predict Returns? 125
6.4 Unpacking the Practical Value of Price-­Sensitive Information 130
6.5 Factor X: The Recurrence of Unknowable Events 133
6.6 Conclusion 135
7: The Mutual Fund Industry: Structure and Conduct 139
7.1 Exogenous Structural Forces on Mutual Funds 140
7.2 Structural Features of the Managed Investment Industry 141
7.3 Mutual Fund Conduct 144
7.4 Conclusion 147
8: Fund Managers’ Conduct: The Story of How They Invest 148
8.1 Fund Manager (FM) Decision Making 149
8.1.1 Fund Managers’ Valuation Paradigm 150
8.1.2 Fund Managers Share Common Information and Analytical Techniques 154
8.2 The Role of Prices in Investor Utility Functions 155
8.2.1 Using Proxies to Rank Relative Valuations of Equities 157
8.3 Socialisation of Investment Decisions 157
8.3.1 Sourcing Information from Social Networks 158
8.3.2 Impression Management 160
8.3.3 Herding 161
8.4 Investor Reflexivity and Market Evolution 162
8.5 Conclusion 164
9: Performance of Mutual Funds 167
9.1 Return of Managed Funds 168
9.1.1 Unpacking Funds’ Poor Return 169
9.2 Integrity of Mutual Funds’ Role as Agents 173
9.2.1 Is There an Ethical Crisis in Funds Management? 175
9.3 Conclusion 176
Part III: Towards an Enhanced Theory of Investment 179
10: Piecing Together the Jigsaw: Applied Investment Theory 180
10.1 Central Inputs to an Applied Investment Theory 181
10.1.1 Financial Performance of Mutual Funds Has Structural Determinants 183
10.1.2 Humans Have Significant Influence over Equity Prices 184
10.1.3 Investors Incorporate Price in Utility Functions Because of Market Inefficiencies 186
10.1.4 Investor Risk Incorporates Uncertainty and Downside Loss 187
10.1.5 Investors Lack Predictive Capability, and Develop Relative Rankings of Equity Value 187
10.1.6 Three-Component Model of Equity Value 188
10.2 Seemingly False Assumptions 193
10.3 Applied Investment Theory 194
10.3.1 A Structural Perspective on Applied Investment Theory 208
10.4 Puzzles Resolved by AIT 211
10.5 AIT and the Standard Investment Paradigm 214
10.6 Conclusion 217
11: Real World Application of Applied Investment Theory 218
11.1 A Research Agenda for Applied Investment Theory 219
11.2 How to Teach Applied Investment Theory 223
11.3 Investing with Applied Investment Theory 224
11.4 A Better Regulatory Framework 227
11.5 Conclusion 228
Bibliography 230
Index 257