Test #1 Review Comments for Fall 2005

Test #1 Review Comments
Finance 450
Fall 2005

General Format

Covers the following material:

General Introductory Comments
Historical Rates of Return and Risks (Ch. 3, Reilly & Brown, pp. 52-59)
Introduction to Finance 450 lectures (incl. Ch.1, Haugen)
Warren Buffett: Oracle of Omaha (videotape)
Value Investing – Graham vs. Buffett
Mauboussin – the Market as a Complex Adaptive System
Alpha and Active Investment Management
Efficient Capital Markets (Ch. 6, Reilly & Brown)

Structure:

Approx. 36 Multiple Choice questions.

General Comments:

Focus on lecture note topics, and make sure you have read the relevant sections of the textbooks
You are also responsible for any material that was covered in class that may or may not be covered in the textbooks or on the PowerPoint lecture notes

Please remember to bring a Scantron form, a #2 pencil, and a calculator to class

Comments on Specific Subject Areas:

Introductory Comments and Historical Rates of Return and Risks (Material from Ch. 3, R&B, pp. 90-98):

Know the general historical relationship between risk and return across different asset classes (pp. 90-98 of Reilly & Brown) – more specifically, what are the arithmetic and geometric mean rates of return and the standard deviations of returns for large-cap stocks and for small-cap stocks? How does the performance of small- and large-cap stocks compare to the performance of corporate bonds? Of government bonds?
What is the difference between the arithmetic mean return and the geometric mean return? What key factor drives the size of the difference between these two different measures of mean return?

Introduction to Finance 450 (See PowerPoint lecture notes; the material in these notes includes Haugen, Ch. 1):

What is the difference between financial analysis and security analysis?
Know the evolution of academic finance – who are Benjamin Graham, Warren Buffett, Harry Markowitz, William Sharpe, and Eugene Fama?
Who is the Father of Security Analysis? What else is he known as the father of?
Who was his most famous student, and how successful has he been?
What did Dr. Pete expect to be taught about in his MBA program? What was he taught instead?
What are the three pillars of Modern Finance?
When they tried to jointly study CAPM and the Efficient Market Hypothesis, what did Fama and French find? What variable did Fama and French find to be most significant? What variable did Fama and French find to be insignificant?
What are the implications of these results? What approach to investing did these results support?
What were the three categories of explanations for their results? Which of these explanations appears to be most reasonable in light of the evidence presented in class? Which of the three explanations did Fama and French espouse?
What are the three “risk” factors included in the Fama and French three-factor risk-adjustment model?
How do value investors’ (such as Graham’s) views differ from those of the EMH regarding the possible justifications behind the relative P/B ratios of high and low P/B stocks? What is the difference between a “growth” stock and a “value”? What is a “glamour” stock?
What is behavioral finance?
What is the paradox of the efficient markets hypothesis?
If investors are irrational and the markets are inefficient, does this mean that it is easy for professionals to beat the market?
Are investors generally better off investing through index funds?
If investors are increasingly investing more money through index funds rather than through other types of actively managed mutual funds, will this lead the markets to become more efficient or less efficient, in general?
If the markets are not efficient and if CAPM is flawed, what are some of the alternative perspectives on how the markets should be viewed and what the best way is for investors to act?
In what ways are Haugen’s (and Berghage’s) and Mauboussin’s approaches different? In what ways are they similar? Which approach places greater emphasis on the portfolio on the primary unit of analysis and which places greater emphasis on individual securities as the primary unit of analysis?
What are the two key effects or attributes that multifractal models of stock returns seek to describe?

Warren Buffett: Oracle of Omaha, and Benjamin Graham vs. Warren Buffett:

What are two key issues with which value investors are concerned? (A: how good the company is, and how good the price is)
What is the key determinant of an investor’s return on a given stock? (A: the price originally paid)
What is a key concept in which value investors believe? (A: reversion to the mean) Is this view consistent with that of the Efficient Markets Hypothesis?
How does Benjamin Graham view the long term versus the short term movements of the stock market? (“In the short run, the market is a ______ machine; in the long run, the market is a ________ machine.”)
In terms of price and quality of company, what types of investments did Benjamin Graham like to make? What type does Warren Buffett like to make? Between the two, who wass more selective in terms of the types of companies in which they would invest? Between the two, who diversified their holdings much more broadly, and who focused their portfolio holdings more narrowly?
What does the acronym “G.A.R.P.” stand for?
How frequently does Buffett require stock quotes on his investments?
What was Benjamin Graham’s typical holding period? What is Buffett’s desired holding period? Why are they different?
What is meant by, and what is the importance of “margin of safety”? How does this concept dffer from Buffett’s “margin of protection”?
What types of characteristics does Warren Buffett look for in a company in which he would consider investing? What types of stocks does he stay away from? What one word describes a key characteristic of companies that Warren Buffett and Peter Lynch both look for?
What was Ben Graham’s long-run rate of return on his investments?
What has Buffett’s long-run rate of return been?
What are the major similarities between Graham’s and Buffett’s approaches? What are the key differences? Whose approach is more profitable over the long run? Whose approach is more easily replicable by a typical investor?
What is Buffett’s annual salary earned for managing Berkshire Hathaway? When did he originally buy his house in Omaha, and how much did he pay for it? Why was he unwilling to pay more for his house or to spend a lot for consumer items such as cars?
To whom will Buffett leave his fortune? Does Peter Buffett like the idea of being able to make a living off of other people’s decisions?
Where did Buffett earn his masters’ degree, and who was his favorite professor there?
What are Buffett’s eating habits?

Mauboussin’s Shift Happens and Revisiting Market Efficiency: the Market as a Complex Adaptive System:

What is a paradigm, and what is meant by a paradigm shift?
What paradigm does Mauboussin propose to supplant the random walk model of stock returns?
What four key features of actual stock returns can the model of the market as a complex adaptive system capture that the random walk model cannot?

Generating Alpha:

What is “alpha”?
What is the weighted average alpha across the portfolios of all the investors in the market (i.e., what is the alpha for the market as a whole)?
If everyone throughout the market invested the same way as Warren Buffett, would everyone be able to beat the way that he does?
If Warren Buffett’s portfolio continues to beat the market, then what does that imply about the average performance of all other investors’ portfolios?
Is Warren Buffett always able to consistently beat the market (and generate positive alpha)?
What are three categories of stocks that tend to outperform the market on average? Do these categories of stocks consistently beat the market?
What is a key question that all investors need to ask themselves if they want to generate positive alphas?

Efficient Capital Markets (Ch. 6, R&B):

How are “the capital markets” defined, and what are the three functions of the capital markets?
What are the two types of market efficiency? What does it mean to say that the market is operationally efficient? What does it mean to say that the market is informationally efficient?
What are the three forms or levels of market efficiency? What is the relationship between them?
Know supporting and contradicting evidence for each of the three forms of the EMH
What does the weak-form EMH say?
Which type of analysis is rendered irrelevant under the weak-form EMH?
What does it mean to say that stock returns follow a “random walk?”
What does the semi-strong-form EMH say?
Which type of analysis is rendered irrelevant under the semi-strong-form EMH?
How is the semi-strong form tested? What are the implications of these tests?
How do you measure abnormal return for a stock?
What does the strong-form EMH say?
How has the strong form been tested? What do these tests imply?
What is an “anomaly?” What are some examples of stock market anomalies (i.e., what are some examples of test results that seem to contradict market efficiency)?
What is “information”?
If the markets are efficient, how would portfolio managers be expected to perform?
What are the implications of market efficiency for individual investors?

Miscellaneous:

Who are Jack Bogle, Ned and Abby Johnson, and J. Leonard Replogle?

Good luck!!