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EMH and Portfolio ManagementProfessional Money Managers Often Fight an Uphill BattleShould a portfolio be managed passively or actively? What difference do superior analysts make in the investment decision process? How does behavioral finance fit in?
Empirical evidence collected in the study of the efficient market hypothesis (EMH) suggests that professional money managers typically do not outperform the good old “buy-and-hold” strategy when adjusted for risk. Why? Arguments supporting portfolio managers’ inferior performance can be found in factors such as lack of superior analysts, costs of information and trading, as well as limitations of arbitrage. Should a Portfolio Be Managed Passively or Actively?The answer to this question depends on whether a professional portfolio manager has access to superior analysts or not. If a portfolio manager has access to superior analysts, whose analytical skills as well as their unique abilities to “read” financial information, have consistently generated abnormal returns over a period of time, then the portfolio should be actively managed. The symbiotic relationship between a superior analyst and portfolio manager should go along the following lines:
In addition, portfolio managers should urge superior analysts to focus more on mid-cap and small-cap stocks. Remember that for a market to be informationally efficient, all new information must be fully absorbed in order for the prices to be promptly adjusted. Large-cap stocks typically have a huge following among analysts; hence, it stands to reason that markets are broadly efficient in that tier. In contrast, mid-cap and small-cap stocks are generally less visible and it might be expected that pockets of informational inefficiencies could potentially create profitable opportunities. Anecdotal evidence suggests that the less analyzed stocks, the so called “neglected stocks” by the “smart money,” could be from time to time temporarily undervalued. Furthermore, superior analysts making stock recommendations for actively managed portfolios should pay special attention to the book value/market value ratio, to stocks’ market capitalization, as well as to the overall monetary policy landscape. When a portfolio manager does not have access to superior analysts, then the portfolio should be passively managed. What must be done first is to gauge a particular client’s risk tolerance level, and based on that determination, invest a portion of the portfolio in risky assets and the rest in risk-free assets. (See the article Understanding the Concept of CAPM.) In addition to properly diversifying a client’s portfolio to eliminate all unsystematic risk, money managers have to take into account transaction costs and minimize them as much as possible. This can be accomplished by minimizing the client’s exposure to tax expenditures, as well as to various trading costs. What Observations Are Offered by Behavioral Finance?Behavioral finance is only a recently emerged branch of economic theory, yet the one that has offered a number of insightful explanations for certain anomalies of the efficient market hypothesis. For example, studies done in the field of behavioral finance support the idea that stocks of growth companies are rarely growth stocks themselves. This is because analysts often gain considerable confidence in their forecasting abilities, which even more frequently lead to the creation of the herd mentality. (Remember that superior analysts have to be consistently correct and contrary to the consensus.) Furthermore, investors are inherently risk averse, yet susceptible to escalation bias, which causes them to ignore far too often and for too long loser stocks, resulting in increased costs of averaging down. This is why constant reevaluation of assets comprising a portfolio is of paramount importance, as well as considering the benefits of fusion investing. (This is the last article in the series.) Sources:
The copyright of the article EMH and Portfolio Management in Investment is owned by Inya Ivkovic. Permission to republish EMH and Portfolio Management in print or online must be granted by the author in writing.
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