Investment Philosophies, Second Edition

Investment Philosophies, Second Edition

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Successful Strategies and the Investors Who Made Them Work


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Book Details
 609 p
 File Size 
 8,128 KB
 File Type
 PDF format
 978-1-118-01151-5 (cloth)
 978-1-118-22192-1 (ebk)
 978-1-118-23561-4 (ebk)
 978-1-118-26049-4 (ebk)
 2012 by Aswath Damodaran 

Who wants to be an average investor? We all dream of beating the market
and being super investors, and we spend an inordinate amount of time
and resources in this endeavor. Consequently, we are easy prey for the magic
bullets and the secret formulas offered by salespeople pushing their wares.
In spite of our best efforts, though, most of us fail in our attempts to be
more than average. Nonetheless, we keep trying, hoping that we can be
more like the investing legends—another Warren Buffett, George Soros, or
Peter Lynch. We read the words written by and about successful investors,
hoping to find in them the key to their stock-picking abilities, so that we can
replicate them and become like them.

In our search, though, we are whipsawed by contradictions and anomalies.
On one corner of the investment town square stands an adviser, yelling
to us to buy businesses with solid cash flows and liquid assets because that’s
what worked for Buffett. On another corner, another investment expert
cautions us that this approach worked only in the old world, and that in the
new world of technology we have to bet on companies with great growth
prospects. On yet another corner stands a silver-tongued salesperson with
vivid charts who presents you with evidence of the charts’ capacity to get
you in and out of markets at exactly the right times. It is not surprising that
facing this cacophony of claims and counterclaims we end up more confused than ever.

In this chapter, we present the argument that to be successful with any
investment strategy, you have to begin with an investment philosophy that is
consistent at its core and matches not only the markets you choose to invest
in but your individual characteristics. In other words, the key to success in
investing may lie not in knowing what makes others successful but in finding
out more about yourself.

Table of Contents
Introduction 1
What Is an Investment Philosophy? 2
Why Do You Need an Investment Philosophy? 3
The Big Picture of Investing 4
Categorizing Investment Philosophies 7
Developing an Investment Philosophy 10
Conclusion 12
Exercises 13

Upside, Downside: Understanding Risk 15
What Is Risk? 16
Equity Risk: Theory-Based Models 16
Assessing Conventional Risk and Return Models 32
Equity Risk: Alternative Measures 34
Equity Risk: Assessing the Field 45
Default Risk 46
Conclusion 50
Exercises 51

Numbers Don’t Lie—Or Do They? 53
The Basic Accounting Statements 53
Asset Measurement and Valuation 55
Measuring Financing Mix 62
Measuring Earnings and Profitability 69
Measuring Risk 75
Differences in Accounting Standards and Practices 82
Conclusion 82
Exercises 85

Show Me the Money: The Basics of Valuation 87
Intrinsic Value 87
Relative Valuation 110
Valuing an Asset with Contingent Cash Flows (Options) 119
Conclusion 121
Exercises 122

Many a Slip: Trading, Execution, and Taxes 125
The Trading Cost Drag 125
The Components of Trading Costs: Traded Financial Assets 127
Trading Costs with Nontraded Assets 146
Management of Trading Costs 148
Taxes 150
Conclusion 159
Exercises 160

Too Good to Be True? Testing Investment Strategies 163
Why Does Market Efficiency Matter? 163
Efficient Markets: Definition and Implications 164
Behavioral Finance: The Challenge to Efficient Markets 170
A Skeptic’s Guide to Investment Strategies 204
Conclusion 206
Exercises 207

Smoke and Mirrors? Price Patterns, Volume Charts, and
Technical Analysis 209
Random Walks and Price Patterns 209
Empirical Evidence 211
The Foundations of Technical Analysis 239
Technical Indicators and Charting Patterns 240
Conclusion 255
Exercises 256

Graham’s Disciples: Value Investing 259
Who Is a Value Investor? 259
The Passive Screener 260
Contents vii
The Contrarian Value Investor 284
Activist Value Investing 293
Conclusion 326
Exercises 326

The Allure of Growth: Small Cap and Growth Investing 329
Who Is a Growth Investor? 329
Passive Growth Investing 330
Activist Growth Investing 365
Conclusion 372
Exercises 373

Information Pays: Trading on News 375
Information and Prices 376
Trading on Private Information 378
Trading on Public Information 398
Implementing an Information-Based Investment Strategy 421
Conclusion 422
Exercises 423

A Sure Profit: The Essence of Arbitrage 425
Pure Arbitrage 425
Near Arbitrage 450
Speculative Arbitrage 460
Long/Short Strategies—Hedge Funds 465
Conclusion 469
Exercises 470

The Impossible Dream? Timing the Market 473
Market Timing: Payoffs and Costs 473
Market Timing Approaches 477
The Evidence on Market Timing 506
Market Timing Strategies 514
Market Timing Instruments 518
Connecting Market Timing to Security Selection 521
Conclusion 521
Exercises 522

Ready to Give Up? The Allure of Indexing 525
The Mechanics of Indexing 525
A History of Indexing 527
The Case for Indexing 530
Why Do Active Investors Not Perform Better? 554
Alternative Paths to Indexing 562
Conclusion 571
Exercises 572

A Road Map to Choosing an Investment Philosophy 575
A Self-Assessment 575
Finding an Investment Philosophy 579
The Right Investment Philosophy 581
Conclusion 583
Exercises 584
Index 585

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An investment philosophy is a coherent way of thinking about markets,
how they work (and sometimes do not), and the types of mistakes that you
believe consistently underlie investor behavior. Why do we need to make
assumptions about investor mistakes? As we will argue, most investment
strategies are designed to take advantage of errors made by some or all
investors in pricing stocks. Those mistakes themselves are driven by far
more basic assumptions about human behavior. To provide an illustration,
the rational or irrational tendency of human beings to join crowds can result
in price momentum: stocks that have gone up the most in the recent past
are more likely to go up in the near future. Let us consider, therefore, the
ingredients of an investment philosophy.