Help from the finance gurus here!!

[dekster]

Hi guys! Crunch time ulit for thesis hehehe!!! :) Does anyone here know of any formal theory/model relating an investor's knowledge of people's preferences in investments and profitability? i.e. Is there a theory/model that says profit can be made by having knowledge on other investors inpreferences?

Thanks guys :)

[rabbaddal]

I'm not a finance guru, but off the top of my mind, I think most financial models make use of people's preferences in one way or another depending on how you define "preferences". By preferences, do you mean risk aversion? If so, you can use the capital allocation line where the expected return (a measure of risk aversion) on the portfolio is dependent on the investor's preferred level of risk aversion. You can also study the Black-Scholes Pricing Formula for options where expected return is built-into the theorem via the stock price - if you know how the stock price will turn out, then you can estimate the exercise price and eventually the option price (for which you will charge your option-buying client a fee). Take data over the last 10 years and use a tool like regression to show that there is a pattern.

If you want to study an economics model, try Game Theory.

Maybe other financial PEXers like Lek-Lek, Hannibal, Trinity and Utopia can help some more.

[dekster]

Tthe reason I'm asking is that I am doing a statistical research right now looking for trading patterns like herding etc... Basically I need to be able to justify my answers so for example, if in a given time period it turns out that people prefer investments into corps with larger growth (or size, or value per se and so on... ) I also need to be able to answer the question so what?

I just need a theory/model that says knowledge on investor preferences (in terms of size, value, growth, risk etc...) directly contributes to the profitability of his investments...

Thanks again for your input rab. Option's valuation does tackle the preference question but its not within my scope right now since I'm limited to the stock market here... oh and one more thing... my deadline is this friday na heheh ;)

Anyway... any other suggestions peeps? :)

[Hannibal]

I'm not sure I understood dekster's question above.

Are you looking for a theory that establishes a cause-effect relationship between investor preferences and profit?

There are many theories in finance that focus on the correlation of risk and return - eg capital asset pricing model, arbitrage pricing theory - to name a few. However, a correlation does not necessarily prove there's a cause-effect relationship.

Are you really looking for a cause-effect type of relationship, or would a correlation do it for you?

You may want to read "Investment Analysis and Portfolio Management" (by Frank Reilly).

I suggest the more up-to-speed academicians in Pex like Victory address your question.

I graduated over a decade ago and my field of specialization is equity derivatives (before) and private equity/venture capital (currently). I'm not current on portfolio theory.

Good luck!

[dekster]

hmmm... ok i'll try to rephrase again. Basically, the results of my study will show monthly trends in investors' preferences. I'm trying to answer the question: so what?

That's why I'm looking for some theory/model that says that knowledge on how investors (will) behave can be very profitable for an investor. I also want to base my recommendations on that theory.

Your suggestions: CAPM, APT etc. explain the factors affecting asset returns and also goes through things like risk aversion and temporal preferences and I have mentioned those things. However, they are still not the models I'm looking for because they do not link the importance of knowing how other investors will behave, to one's investment decisions and ultimately, whether he meets his profit goals.

Hope that shed's more light to what I'm trying to figure out here. Thanks for your post Hannibal :)

[rabbaddal]

Originally posted by dekster
hmmm... ok i'll try to rephrase again. Basically, the results of my study will show monthly trends in investors' preferences. I'm trying to answer the question: so what?

That's why I'm looking for some theory/model that says that knowledge on how investors (will) behave can be very profitable for an investor. I also want to base my recommendations on that theory.

Your suggestions: CAPM, APT etc. explain the factors affecting asset returns and also goes through things like risk aversion and temporal preferences and I have mentioned those things. However, they are still not the models I'm looking for because they do not link the importance of knowing how other investors will behave, to one's investment decisions and ultimately, whether he meets his profit goals.


From the way you describe it, it sounds more like you need a microeconomic model than a financial model. I think what Hannibal meant by the CAPM was that if you were the one estimating investor preference, then you would use the CAPM to estimate risk. I think risk-return is what motivates investors preference most of the time (eg. whether they want to invest in large corps). You are right in that on its own, it does not link knowledge of preference to making investment decisions. Hence, Hannibal's qualification - "...a correlation does not necessarily prove there's a cause-effect relationship." Thus, the CAPM is just a step in making that decision.

Why not try the budget line ? Here's how it goes:

(1) Use the CAPM to estimate expected return (aka. establish correlation)

(2) Plot the indifference curves according to various levels of expected return vis-a-vis the volatility (aka. standard deviation) of these returns

(3) Draw the budget line using the same Cartesian plane (you need to calculate the slope of the budget line)

The investor's objective - find that utility-maximizing portfolio at the point where an indifference curve is tangent to the budget line.

If you can prove that this model works given the data that you have, then you've found your cause-effect relationship - the "link" you are looking for bec. you as an investor can find that right expected return w/c maximizes your portfolio utility in the indifference curve that is tangent w/ the budget line.

Look up the budget line and indifference curves in greater detail in the Microeconomics textbook by Robert Pindyck and Daniel Rubinfeld.

That's just my guess.

[wisenheimer]

Unless I misunderstood the question, this is simply technical analysis of stock prices. Looking at price and volume charts tell you exactly what investor preferences are. If you see prices moving up on heavy volume, then investors like that stock. Japanese candlestick charting takes it an extra step by allowing you to examine high-low-close on a daily basis. The overall theory behind technical analysis is that you can use investor sentiment and emotion to make money.

[victory]

Hi, dekster --

Am no finance guru by any stretch of the imagination, but here are my two cents worth.

First cent: You may want to examine two strands of literature, if you haven't done so yet:

1. Bidding behavior: The normative literature on bidding behavior, for example, assumes that bidders have a priori fixed preferences that are independent of other players. Game theoretic treatment then proceeds to derive optimal bidding behavior considering what other bidders might do, given that other bidders have fixed and independent preferences too ("given a first-price auction mechanism and uniformly distributed and independent preferences for n bidders, the optimal bid is characterized by blah-blah-blah"). The problem arises when preferences are not independent or fixed (i.e., "correlated preferences" -- if you see someone bidding a high price for a painting you really like you mentally adjust your own valuation because you were influenced by this show of desire, etc., hence the need for sealed bids, etc.). Have you taken a look at this?

2. The behavioral economics and finance literature on investor behavior: Attempts to link the effects of psychological factors to classical economic assumptions and derive explanations for observed systematic violations of the predictions of economic and financial theory. Check in particular the work on prospect theory by Daniel Kahneman and Amos Tversky, the stuff on and mental accounting rules by Richard Thaler. If your model requires a more normative approach, examine Quiggin's work on rank-dependent expected utility. For contemporary examples of empirical work based on this stuff, go visit Terrance Odean's website at Berkeley as he's written some interesting things about investor behavior:

Terrance Odean's CV at UC Berkeley (http://faculty.haas.berkeley.edu/odean/cv.html)

There's a bunch of interesting stuff on Terry's website, but do make sure you check out the following papers:

1. "Are Investors Reluctant to Realize Their Losses?", Journal of Finance, Vol. LIII, No. 5, October 1998, 1775-1798. (http://faculty.haas.berkeley.edu/odean/papers/disposition/disposition.html) -- this may give you some ideas of why stuff like "herding behavior" occurs, as well as ideas for empirical work.

2. And just for fun:"Boys will be Boys: Gender, Overconfidence, and Common Stock Investment" with Brad Barber, Quarterly Journal of Economics, February 2001, Vol. 116, No. 1, 261-292. (http://faculty.haas.berkeley.edu/odean/papers/gender/gender.html) An extremely interesting paper about why men in general trade more often than women -- and why portfolios held by men suffer as a result.

Did you take up any of these things in your classes?

Second cent: I may be wrong and totally off the mark, and if so, I apologize. And this may be the overwhelmingly popular approach to (undergraduate?) thesis writing, but I am not sure if it's very scientific. You seem to be data-driven, forcing your results to conform to your initial hypotheses. Are you sure that these are the equilibria that solid theory will predict? "Kitchen-sink regressions" will show some kind of correlation between any variable, but whether or not it makes sense or actually establishes causality is another matter (as Hannibal raised above). Are you going to use quotes from the references we provided and the thoughts we shared to bolster your own stuff or did you really derive your predictions from first principles?

Ingat lang and make sure your story is fairly sound, OK? Make sure your empirics control for reverse causality / endogeneity / simultaneity. Be careful about measurement error particularly in your independent variables. What kind of estimators are you using and are you sure they are appropriate for your study?

I guess my biggest concern for you is that at the end of the day even if your empirical work is solid, your thesis evaluators can slam you if you don't have sound underlying theory behind your regressions. I know my first questions would go something like this, even before I took a look at your empirics: How did you define your investor's objective function? How did you model the game that your investors are playing? What kind of (multiple?) equilibrium predictions did you derive? What assumptions underlie them? Did you consider off-equilibrium beliefs? If you used a limited number of players in your model, will it generalize to n players? How robust is your model if we perturb some of your maintained assumptions?

I may be asking for way too much but I've never believed in holding back in terms of standards. At the end of the day, always confer with your thesis adviser and coordinate expectations and deliverables. Good luck and hope this helps.

[dijkstra]

there are five PExers above: dekster,hannibal,wisenheimer and two humble ateneans.

[muchomuchacho]

Originally posted by dijkstra
there are five PExers above: dekster,hannibal,wisenheimer and two humble ateneans.

Hannibal is from Ateneo as well. "Helpful" is a better description.

[dijkstra]

Originally posted by muchomuchacho


Hannibal is from Ateneo as well. "Helpful" is a better description.

using this thread as a parameter, "humble" is a the best adjective. both started "im not a financial guru" but their knowledge says otherwise. they've just broken the stereotype for ateneans.

"helpful" is also another word that fits them.

thanks for introducing hannibal.

[btycangco]

Hi Dexter. I know it's already too late by now to help you out since your deadline was yesterday. I only saw this message board when I logged-on this morning. All I can do now is wish you the best of luck on your thesis. Good luck!

In hindsight, there's a dilemma when you try to interpret the relationship between somthing as simple as the stock market and something as complicated as your everyday investor. I'm saying because it's the investor that complicates markets, and just like markets are irrational, investors are irrational as well. There are just too many variables to consider, and not all investors act on the same variables or indicators to make their decision.

Sinking your feet into behavioral investing can help you gain knowledge of what events cause investors to act a certain way, but it's no sure-fire way that you'll make more money in the stock market. The general market (the investors) tends to be wrong most of the time. If the average investor had a batting average better than .500 then markets would never go down, and more than half the time someone was making money. Unfortunately, it's the opposite. The higher markets go, the more people are willing to invest -- it sets them up for a big loss that will likely wipe out all previous gains made in the market. And when markets are falling, the less people are willing to put in -- this sets them up for marginal gains when the markets do finally turn a corner. Perhaps knowing this is the key to successful investing...

A lot of contrarians capitalize on the unwavering failure of most investors... by going against the trend whenever the market's irrationalism takes center stage during market peaks and troughs where volume turnover is strongest.

[dijkstra]

Originally posted by btycangco
Hi Dexter. I know it's already too late by now to help you out since your deadline was yesterday. I only saw this message board when I logged-on this morning. All I can do now is wish you the best of luck on your thesis. Good luck!

In hindsight, there's a dilemma when you try to interpret the relationship between somthing as simple as the stock market and something as complicated as your everyday investor. I'm saying because it's the investor that complicates markets, and just like markets are irrational, investors are irrational as well. There are just too many variables to consider, and not all investors act on the same variables or indicators to make their decision.

Sinking your feet into behavioral investing can help you gain knowledge of what events cause investors to act a certain way, but it's no sure-fire way that you'll make more money in the stock market. The general market (the investors) tends to be wrong most of the time. If the average investor had a batting average better than .500 then markets would never go down, and more than half the time someone was making money. Unfortunately, it's the opposite. The higher markets go, the more people are willing to invest -- it sets them up for a big loss that will likely wipe out all previous gains made in the market. And when markets are falling, the less people are willing to put in -- this sets them up for marginal gains when the markets do finally turn a corner. Perhaps knowing this is the key to successful investing...

A lot of contrarians capitalize on the unwavering failure of most investors... by going against the trend whenever the market's irrationalism takes center stage during market peaks and troughs where volume turnover is strongest.

aanhin pa ang damo kung patay na ang kabayo?

[eigenvector007]

Originally posted by dijkstra


aanhin pa ang damo kung patay na ang kabayo?

huli man daw at magaling maihahabol din. who knows? btycangco might be able to convince dekster to buy his laptop.

[dekster]

Phew! Can’t believe I made it over the first among the large hurdles!! When my group started working seriously on the thesis last week we all thought that we knew what we were doing already pero it turned out that I had misunderstood the framework we were using! Bwisit!! I can’t imagine how hard it would have been had we not had computers lols! Just imagine the gravity of mistaking a multivariate regression with multiple regression!! Can’t believe I missed that out heheh…

Anyway… I just wanna say thanks to everyone for trying to help by posting in this thread. I wasn’t able to incorporate most of the things you said because of lack of time (I was really panicing na kasi heheh) but nevertheless, you guys have given me much to think about in anticipation of my defense this coming Saturday.

In case I haven’t mentioned it already… my thesis is a replication of a foreign study on herding. The reason I chose the framework was because it is the first that empirically distinguishes between spurious and intentional herding from correlated trading. In short… we were able to discover that in the Philippines, herding occurred most during the year the Asian Financial Crisis began which was year of great market stress and uncertainty. If ever you are interested in the details of the study just let me know and I’ll post it next week. Gotta be careful in case my panelists are pexers as well heheh… wouldn’t want to give them too much time to think of more questions heheheh ;)

The reason I was asking for linkages between knowledge of investors preferences and profit success was so I could boost the importance of the study. Like I said before, people may say after the reading my paper “so what if herding occurs?” You suggestions didn’t quite hit the spot but nevertheless it had a big role in guiding me to my answer so again I say thanks to you all.

Victory: thanks again for your insights. I sent you an email last night and I’ll continue it later today but bottom line, I appreciate your concern especially on issues about ungrouded models. Rest assured however that this issue is the least of my concerns cos aside from being a replication of someone else’s study, I also have a very thick review of literature to back the study up. In preparation for my defense, I am seriously taking note of the questions you would ask if you were my panelist. Let me get back to you in a while.

Wisenhammier: In a sense yes, I was looking for an answer that extends from technical analysis. Let us say kasi that my results showed that people were spuriously herding towards value stocks. I have equated spurious herding to preferences and so I have been able to determine the preference of the majority at a certain time. Again let me get back to you after Saturday for my answers J

Bytangco: Even though I got to read your post after my deadline I just want to say thanks anyway for trying to help. Sa totoo lang your post is the closest to the conclusion of my study heheh :)
Sinking your feet into behavioral investing can help you gain knowledge of what events cause investors to act a certain way, but it's no sure-fire way that you'll make more money in the stock market. The general market (the investors) tends to be wrong most of the time.

Once again, thank you all for trying to help me!! Wish me luck on my defense this coming Saturday. I will surely keep you informed :)

[Count_Dooku]

AWWWWWW TOOO BAD
it is only now that I read this thread.

I have a complete book of this theory emanating from training and working with Citibank.

Well, just buzz me if you STILL need help

[dekster]

count: what is it that you have?

It's pretty much done but I'm still open to seeing anything you have cos I haven't submitted my revisions yet. :)

[dekster]

count: what is it that you have?

It's pretty much done but I'm still open to seeing anything you have cos I haven't submitted my revisions yet. :)

[Hash_Assassin]

I need to make a report in my economics class and I really need the grade badly....

If you guys can help me I think its quite simple to you guys....

I need to report on the Budget line and how to derive it...

I can't find a decent site were it's stated...

if its ok thanx!!


btw, my report's 2 dauys from now...

chill! peace!