29-10-2007

SAPM

Samuelsons continuous equilibrium theory

Economists who have studied the intrinsic value random walk model have
accepted and/or modified it in varying degrees. The Nobel Prize winning
economist, Paul Samuelson, for eg, has theorized about how security prices
would behave if securities mkt where what economists called “perfectly
competitive” or “perfectly efficient”.
Samuelson supplemented the intrinsic value random walk model
describe earlier by defining perfectly efficient prices to be market prices that
reflect all information (Paul Samuelson, “ proof that properly discounted
present values of assets vibrate randomly”. Bell journal of economics and
mgt science, Autumn 1973). Samuelson suggests that a security with
perfectly efficient prices would be in “continuous equilibrium”. This
continuous equilibrium will not be static through time. Every time a new
piece of news is released, the securities intrinsic value will change and the
securities mkt price will adjust toward the new value. It is the speed of this
price adjustment process which gauges the efficiency of a price. A perfectly
efficient security price is in a continuous equilibrium such that the
intrinsic value of the security vibrates randomly and the mkt price
equals the fluctuating intrinsic value at every moment in time. If any
disequilibrium (of even a temporary nature) exists, then the securities price
is less than perfectly efficient. Of course, actual mkt prices are not perfectly
efficient bcoz different security analyst typically assigned different value
estimates to any given security.
 Actual mkt prices can only peruse a consencus estimate of any given
securities intrinsic value since security analysts value estimates differ. If
most security analyst value estimate happened to be similar at a point in
time, then the consensus value estimate may only vary within a small range.
In this case, the seurities price will be almost perfectly efficient as it
fluctuates in a narrow range around its changing equilibrium economic value
as shown in the figure (a) below,

Price

t t+n

Time
Dia.(a)

Dia.(b)
30-10-07
Tuesday

Both panels (a) & (b) depict two different securities that have the same
intrinsic values. Both securities intrinsic values decline immediately at time
“t+n”, when some bad news about the security emerges. However, the
security in (b) has fallen “indisfavour”. Meaning back few investors are
interested in the security. Since very few investors were studying and
analyzing the security, large divergences between the securities price and its
value could occur. As fig (b) shows the securities price decline more slowly
but fluctuated far below its value because not enough investors were
continuously estimating the securities value comparing value with price, and
making frequent rational buy- sell decisions about it.
Fig. (a) Describes an asset that is more efficiently priced than
the asset in fig. (b) because, variance (price (a)- value (a)) <variance(
price(b) –value(b)).
If security prices reacted to new information inefficiently, as
shown at (b) above, security analysts should be able to make a fortune. They
could make large profits by finding under priced securities, buying them and
holding them while their prices rise, or by finding over priced securities,
selling them to profit from their falling prices. The profitability of doing
good securities analysis will increase as securities prices become more
inefficient. So when the desirability of being an aggressive investment
manager.
PASSIVE vs. AGGRESSIVE INVESTMENT MGT.

Scientific evidence suggests that expert security analysts can profit from
finding under value and overvalue securities. The existence of these
lucrative opportunities encourages one to become an aggressive investment
manager who buys and sells securities in order to maximize trading profits.

AGGRESSIVE INVESTMENT MGT.

Securities analysis is at the heart of aggressive investment mgt. it is the

present value model which is used in determining the intrinsic value of a
share i.e. the discounted value of expected dividends plus the present value
of the estimated price of the share in the terminal year. As can be seen, the
difficulties (and therefore opportunities in making a trading profit) depend
on the accuracy in making these estimates.
It requires good education, as well as significant amount of
experience, as well as hard work to profit from aggressive investment mgt.

PASSIVE INVESTMENT MGT.

Because of the scientific evidence suggesting that the prices of securities

fluctuate in a random walk that approaches what Samuelson called a
continuous equilibrium, passive investment management as become popular
since the 1980’s. The passive investors reasoned that if most investors are
highly informed and some degree of consensus exists about most securities
intrinsic values, then doing securities analysis and trading aggressively is too
much trouble and involves too many risks. As a result, many of these
investors invest in special portfolios called Index Funds. Index funds by the
same stocks that are in some share mkt index they select. The NSE or the
BSE index is a popular index to emulate. The stated investment objective of
such an index fund is to perform exactly like the index. Several of these
funds manage crores of rupees for passive investments. The efficient mkts
research has made such passive investment mgt practices a respectable
alternative to estimating values comparing them with prices, and trading
aggressively.

DIVWERSIFICATION AND PORTFOIO ANALYSIS

Investment are made with the objective of earning some expected rate of
return. Investors seek to minimize inefficient deviation from this expected
rate of return. Diversification is essential to the creation of an efficient
investment because it can reduce the risk (the variability of returns) around
the expected return.
The portfolio manager seeking efficient investments works with 2
kinds of statistics- expected return statistics and risk statistics. The objective
of portfolio analysis is to develop a portfolio that has the maximum return at
whatever level of risk the investor deems appropriate.
Let us consider some different diversification techniques for reducing
a portfolios risk.
1) Simple diversification

It can be defined as not putting all the eggs in

one basket. Or spreading the risk.
The figure below shows how simple diversification works, the figure was
prepared during empirical data on 470 common stocks from the NYSE. The
figure shows

FIGURE
The level of undiversifiable risk in the market was estimated as.12 (sigma m
=.12) 60 different portfolio of each size were assemble from randomly
selected stocks to prepare the figure above. Each randomly selected security
was allocated and equal weight in its portfolio. From the figure we can see
that, on the average, randomly combining 10 to 50 stocks will reduce a
portfolios total risk to the undiversifiable level. Spreading the portfolios
assets randomly over 2 or 3 times as many stocks cannot be expected to
reduce risk any further.