Archive for the 'Security Selection' Category

How Many Stocks are Needed for Diversification?

Portfolio management theory asserts, based on the variance between a given asset and the rest of the portfolio, that as few as 8-20 stocks are sufficient to provide most of the benefits of diversification.

In the November 2007 Financial Review Domian, Louton and Racine challenge this assumption by proposing that long-term investors are likely to be more concerned with shortfall risk (failure to reach a target ending wealth) than with return variance.

Based on the returns of 1,000 stocks and a safety first criterion, they find that at least 164 stocks are necessary to reduce shortfall risk to no more than a 1% chance of underperforming Treasury bonds. Although smaller portfolios can be enhanced by diversifying across industries, the benefit is not as powerful as that provided by simply adding more stocks to the portfolio.

Posted on 9th July 2008
Under: Active Management, Asset Allocation, FInancial Planning, Institutional Investing, Investing in Stocks, Investment Returns, Passive Management, Performance Measurement, Portfolio Management, Research, Risk Management, Security Selection | No Comments »

Brokers versus Dealers

Brokers and dealers play different roles in securities markets.

The broker is an agent of the investor. He represents the order, finding opposite sides of the trade. Brokers also supply market information, provide discretion and secrecy, and sometimes provide other supporting services such as margin, record-keeping, custody, etc.)

Dealers are adversaries of the investor. They benefit from a higher bid/ask spread, where the investor covets a lower one. Since their profits are small on a given trade, they are unwilling to trade against informed investors (those who have specific information that the security is mispriced) or those with a reputation for finding mispriced securities. The informed investors want to maintain their ability to trade, and thus don’t want dealers to know they are behind the order.

Posted on 3rd July 2008
Under: Active Management, Investing in Stocks, Portfolio Management, Security Selection, Trading Execution | No Comments »

Where is the Value Premium?

The value premium refers to the well-documented outperformance of value stocks (those with high book value relative to market value) over gorwth stocks (those with high market-book ratios.) This outperformance is not explained by systematic Beta as defined in the CAPM, though it does represent one of the three/four factors used in the Fama-French model.

In the March/April 2008 Financial Analysts Journal, Phalippou finds that the value premium is driven by stocks with low institutional ownership – a group that represents just 7% of the total stock market capitalization. Since individual investors may be less sophisticated than institutional investors, such stocks may have a higher tendency to be mispriced. The low institutional ownership may also signal that the mispricing opportunities are difficult to arbitrage.

Posted on 3rd July 2008
Under: Active Management, Fundamental Analysis, Institutional Investing, Investing in Stocks, Investment Returns, Security Selection, Valuation | No Comments »

Dealing With Rising Correlations in Falling Markets

One of the major advantages of international diversification is to reduce overall portfolio risk because the returns on international portfolios have low correlations with the returns on domestic portfolios. However, several studies have shown that correlations across markets are higher when the U.S. market is falling than when it is rising – reducing the value of diversification just when it is needed most.

In the September 2007 Review of Financial Studies Hong, Tu and Zhou sort the CRSP database for monthly returns on 10 style portfolios and the value weighted market index. They find that the correlation asymmetry primarily exists within the four smallest size portfolios.

When considering the asymmetries from an investment decision-making perspective, the authors find that investors with disappointment aversion should reduce their exposure to risky assets, and in particular to the smallest-capitalization stocks.

Posted on 8th June 2008
Under: Active Management, International Investing, Investing in Stocks, Investment Returns, Risk Management, Security Selection | No Comments »

How Structural Changes Affect Industries

There are many factors that influence the investment performance of securities and industries. Only some of these are related to the general economy. Structural changes in a variety of categories can affect the prospects for companies and industries.


Changes in birth rates can have a profound impact on the overall economy. The “baby boom” in the US drove many trends as the needs of a large segment of the population evolved from diapers to education, from first homes to child-raising and finally to retirement. As the group retires, it may result in wage increases as the workers must be replaced from a smaller pool or in greater demand for financial services advice.


Are people living in cities or moving to suburbs? Is the divorce rate rising or falling? Are more people buying second homes or discretionary items? All of these can influence industry prospects.


Technology can make some products obsolete, and introduce entirely new products. It can also effect the efficiency of the overall economy.

Politics and Regulation

Regulations affect many industries, and the political climate, lifestyles and social values can impact the future of those regulations. New regulations, changes to existing regulations, and deregulation can all have profound impacts on company and industry prospects.

Posted on 1st June 2008
Under: Economic Analysis, Industry Analysis, Investing in Stocks, Security Selection | No Comments »

Are Markets Semistrong Form Efficient?

If the semistrong form of the efficient market hypothesis holds, investors should not be able to earn excess risk-adjusted returns if their decisions are based on information that has already been made public. Neither technical analysis nor fundamental analysis would provide a predictable edge.

There are two types of studies frequently used to test the semistrong form of the EMH:

  1. Return prediction studies attempt to predict the future rates of returns for the market or individual stocks using public information such as valuation, dividend yield, or risk premium. Another type of return prediction study is event studies, which examine abnormal returns immediately following a major announcement to determine whether returns predictably persist or reverse.
  2. Cross-sectional return prediction studies test whether variables such as valuation to predict the relative returns of all stocks in a sample.

Return prediction studies have generally shown little success in predicting short-term returns. However, they have successfully been used to predict long-term returns. For example, high dividend yields, high default spreads and high term structure spreads all tend to predict higher long-term returns for stocks.

Studies have also demonstrated that markets do not rapidly process the information related to earnings surprise, or unanticipated changes in earnings. If markets are semistrong efficient such information should be reflected on the day of the earnings announcement. However, as much as half of the total change in stock price can occur in the 90 days following the day of the announcement.

Cross-sectional studies have demonstrated several anomalies that appear to contradict the efficient market hypothesis. On a risk adjusted basis: low P/E stocks tend to outperform high P/E stocks; small stocks tend to outperform large stocks; stocks with low price/book ratios outperform stocks with high price/book ratios.

Event studies of stock splits, IPOs (after issuance), accounting changes and corporate finance events generally support the efficient market hypothesis in that the news of such items is quickly and fully incorporated into the market price.

Posted on 28th May 2008
Under: Active Management, Behavioral Finance, Fundamental Analysis, Investing in Stocks, Investment Returns, Passive Management, Portfolio Management, Research, Security Selection | No Comments »

Types of Securities Markets

Global securities markets are organized into a number of different structures.

Quote Driven (Dealer) Markets

These markets rely on dealers to provide liquidity by establishing firm prices at which securities can be bought or sold. The dealers will buy securities for inventory at a specified offer price and sell securities from inventory (or short) at a specified ask price. The dealers’ benefit for providing liquidity is the difference between the bid and ask prices (the bid-ask spread).

Dealer bid and ask prices are subject to a limit on the number of shares offered (bid or ask size). In effect, the bid and ask are limit orders placed by the dealer. If multiple dealers are placing orders, it is not necessary for the same dealer to have the best bid and the best ask. Consider the following dealer order book:


Dealer C is offering the best bid for shares at $100.05. Any sell orders will go to dealer C. Dealer D is offering the best ask price at $100.15 and will fill any market buy orders. Although Dealer B is willing to accept the smallest spread, he is not offering the best price at either the bid or the ask and will only fill orders that exceed the bid and ask sizes offered by dealers C and D.

The inside quote is the best bid from any dealer and the best ask by any dealer. The spread for the inside quote will be less than or equal to the smallest bid-ask spread for a given dealer.

Order Driven Markets

In order driven markets, transaction prices are established by  public limit orders and there is no intermediation by designated dealers. The lack of dealers could have different types of impact on order prices:

  • Competition could be higher because there are more public participants than there would be dealers. This is often true of highly liquid securities.
  • Competition could be lower because there are no dealers who are required to fill orders by taking in or drawing down inventory. This can be the case for less liquid securities.

Current trends favor order-driven markets, including:

  • Electronic crossing networks that batch orders together and cross them at a specific time. The fulfillment price will be the price at which the most shares can be traded – all buy orders with prices above the trading price are matched with the sell orders below that trading price. When trading on such networks there is no price discovery – the price at execution is not known until there is execution.
  • Auction markets in which orders compete for execution. Since the orders are visible there is price discovery. Auction markets can be batch markets or continuous auction markets.
  • Automated auctions operate continuously and offer price discovery. Execution is based on a set of rules.

Brokered Markets

The broker is an agent of the buy side trader who collects a commission in exchange for skillful execution of the trade. Particularly when a trade involves blocks of illiquid securities, a broker may be useful for finding a natural counterparty. In some cases the broker may put its own capital at risk and take the other side of the order, hoping to find various parties willing to accept parts of the order at a later time. Brokers may also be useful in providing a reputational screen – offering the trade only to parties that will not try to trade in front of it.

Hybrid Markets

Many markets operate as a combination of the types listed above. For example, the New York Stock Exchange batches orders for market-on-open and market-on-close execution using a batch auction process. During the day, trading is accommodated using a continuous auction process. This consists of both order-driven quotes that do not reach a dealer and dealer-driven quotes offered by the specialists.

Posted on 3rd May 2008
Under: Active Management, Institutional Investing, Investing in Stocks, Portfolio Management, Security Selection, Trading Execution | No Comments »

The Top Down Approach to Security Selection

The top down approach to security selection is described in Investment Analysis and Portfolio Management (with Thomson ONE – Business School Edition) as a three-step process.

  1. Analysis of alternative economies and securities markets to decide how to allocate investments among countries, and within countries to asset classes such as stocks, bonds or cash.
  2. Analysis of alternative industries, based on the results of the market analysis. Which industries are likely to prosper or do poorly, both globally and on a country by country basis?
  3. Analysis of individual companies and stocks, based on the results of the first two steps. The final objective is to select the best securities in the industries most likely to benefit from economic trends.

Studies have shown significant relationships between a stock’s earnings and aggregate industry or market earnings. Other studies have demonstrated relationships between stock performance and economic data series. Significant portions of total return can be attributed to industry and market effects as well. These findings offer support for the top-down approach to security selection.

Posted on 1st May 2008
Under: Security Selection | No Comments »

Margin Transactions

Investors have the option to invest borrowed money, leveraging the return on their transactions. Brokers provide margin funds for this purpose.

In a margin transaction, the investor posts a portion of the cash needed to buy a security and borrows the rest. The stock or security purchased serves as collateral on the loan.

The Federal Reserve Board determines the margin requirement, or maximum portion of any transaction that can be made using margin. A lower margin requirement permits higher borrowing levels. Currently the margin requirement is 50%, meaning investors can borrow up to half the funds for a transaction.

Using margins exaggerates the return on an investment. For example, buying 100 shares of stock for $100 per share at 50% margin, the investor uses only $5,000 cash. The investor’s cash is also called the “equity” in the transaction.

If the stock rises to $110, the shares are worth $11,000 but the investor would still only owe $5,000 (plus some interest.) The equity has increased to $6,000 – which is a 20% gain even though the stock itself rose only 10%.

Of course, the same phenomenon works in reverse. If the stock falls 10% to $90, there is only $4,000 of equity and the investor loses 20% when the stock has lost just 10%.

Posted on 1st May 2008
Under: Investing in Stocks, Securities Regulation, Security Selection, Trading Execution | No Comments »

Are Markets Weak-Form Efficient?

If the weak form of the efficient market hypothesis holds, security market information should have no relationship with future returns. Technical analysis and trading rules should not allow investors to earn excess returns.

Researchers testing weak form market efficiency generally use one of two groups of tests when studying weak-form market efficiency.

  1. Statistical tests of independence measure either the significance of positive or negative correlation over time (autocorrelation) or by comparing the number of runs (consecutive moves in the same direction) with that expected in a normal sample. In general, statistical tests of independence have shown no relationship between current and future price movements.
  2. Tests of trading rules seek to mechanically simulate various trading strategies. For example, testing whether a strategy of buying when the stock price closes above the 50 day moving average and selling when the price closes below the moving average. In general, these tests have supported the weak-form efficient market hypothesis by showing no excess returns (after trading costs, compared to a buy-and-hold strategy) from following such rules. However, the results are not unanimous – some rules have been shown to offer superior returns.

Technical analysts criticize the existing tests as being too naive or simplistic to capture the

Posted on 28th April 2008
Under: Active Management, Behavioral Finance, Investing in Stocks, Investment Returns, Momentum Strategies, Portfolio Management, Research, Security Selection, Technical Analysis | No Comments »