a. What are the two complementary causes of stock market inefficiency? According

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a.       What are the two complementary causes of stock market inefficiency? According to Daniel Kahneman, what is the ultimate source of behavioral biases?

This is the data that is needed to answer this question.

The second column has the cash flows from clients. Assume such cash flows occur just before the end of each month. Note the fund is created on Dec 31 2011 with a cash inflow of 10,000. The last column has a Total Return Index for the Russell 3000.

e.       What is the CAPM alpha of the fund (monthly and annualized). Assume the risk-free rate is equal to zero throughout the entire period, and that the Russell 3000 index is the Market Portfolio.

f.       What is the Information Ratio of the fund? (Monthly and annualized). Assume the Russell 3000 is the benchmark.

g.        What is the Maximum Draw Down of the fund?

h.       Are fund managers doing a good job?

cash ($) stocks ($) total ($) Russell 3000 with div. Client flow 0 31-Dec-11 10000 412 9588 10000 3449.92 30-Jan-12 0 412 11852 12264 3571.83 28-Feb-12 0 412 17134 17546 3732.76 31-Mar-12 0 412 16904 17316 3866.13 30-Apr-12 0 412 15522 15934 3810.91 31-May-12 0 412 13842 14254 3638.04 30-Jun-12 0 412 16094 16506 3728.72 31-Jul-12 0 412 14276 14688 3769.23 31-Aug-12 0 412 15416 15828 3850.65 30-Sep-12 0 412 15552 15964 3955.86 31-Oct-12 0 412 17144 17556 3878.72 30-Nov-12 0 412 13434 13846 3874.14 31-Dec-12 10000 1854 22322 24176 3956.65 30-Jan-13 0 1854 24667 26521 4179.75 28-Feb-13 0 1854 24168 26022 4151.61 31-Mar-13 0 1854 25818 27672 4370.52 30-Apr-13 0 1854 26986 28840 4452.47 31-May-13 0 1854 27188 29042 4648.17 30-Jun-13 0 1854 25345 27199 4543.36 31-Jul-13 0 1854 26645 28499 4752.44 31-Aug-13 0 2945 25425 28370 4646.54 30-Sep-13 0 2945 31421 34366 4799.28 31-Oct-13 0 2945 31512 34457 5024.42 30-Nov-13 0 2965 33116 36081 5131.71 31-Dec-13 0 2965 28093 31058 5262.98 31-Jan-14 0 2965 22854 25819 5105.86 28-Feb-14 0 2990 26271 29261 5323.05 31-Mar-14 0 2990 27417 30407 5388.41 30-Apr-14 0 2990 30341 33331 5349.34 31-May-14 0 3015 29741 32756 5516.72 30-Jun-14 0 3015 28898 31913 5650.94 31-Jul-14 0 3015 27564 30579 5669.33 31-Aug-14 0 3040 26872 29912 5774.29 30-Sep-14 0 3040 23316 26356 5775.62

Explanation / Answer

a. Market inefficiency means that the price of a security is a biased estimate of its intrinsic value. In simple words, in an inefficient market a security is not accurately priced. The intrinsic value of a stock is determined by discounting its future cash flows.

Two complementary causes of market inefficiency are:

1. Human nature - Human nature perpetuates greed as well as fear. Now, many investors put their money in the stock market through agents like brokers or mutual fund houses who act on behalf of the investors. Now the agents have access to more information than the principal investors. Also, the motives and incentives of the agents may differ from those of the principal investors.

Often investors are fueled by their greed and they don't tend to maximize the outcome of their investment (which they should). Rather they end up trying to merely beat the market benchmark. This results in inefficiencies.

2. Price overreactions - People in the market tend to follow the decision of the majority i.e. when the mood in the stock market is enthusiastic, people tend to buy stocks on the basis of this mood and this results in the prices of various stocks being propelled upwards. But when the majority panics a bearish environment is created. This results in volumes as well as prices of various stocks falling down. The result of both the scenarios is that prices of various stocks overreact to market information. When mood in the stock market is enthusiastic price may overreact by increasing more than required. The reverse will also hold true.

These two causes are complementary as they support each other on the basis of greed and fear. Human nature wants to make decisions that will result in maximum benefits or will result in minimum losses.

According to Daniel Kahneman the ultimate source of behavioral bias is the intuitive approach being used by the brain of a human being. Kahneman divides human brain into system 1 and system 2. System 1 is the intuitive approach which is fast and System 2 is the rational approach which is slower. Now, system 1 is more influential than system 2 and by unduly influencing system 2 it often causes the system to make suboptimal and irrational decisions.

(only part "a" has been answered as mentioned in your comment).

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