Category: Investment theory

Testing for investment skill: Benchmark or peers?

It is not possible to refute the existence of skilful investors, as explained in my previous post. So, can we test whether there are investment managers with skill by analysing their investment returns? Investment performance can only be judged on a relative basis. The two candidates to evaluate performance against are either a peer group or a defined benchmark. We consider the merits of both.

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Evidence for irrational traders

Irrational traders know the fundamental value of a security, but rather than basing their trading decisions on this, they base it on their expectations of how other market participants will behave. Here we discuss experimental evidence demonstrating this irrational behaviour. We consider bubbles and IPOs as real life examples.

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Who are the deluded investors? Probably you and me!

Deluded investors are foolish market participants who are uninformed but transact in financial markets with the delusion that they are informed. They would trade actively in an attempt to outperform when a security is mispriced according to their analysis. Deluded participants are, however, wrong in believing that they know the fair value of the security.

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Irrational investors trust in greater fools

We have classified market participants into five types. In this post we describe the irrational investors or traders in more detail. As explained before, the irrational traders are the market participants who are informed, but still transact although they understand that they are buying securities above fair value or are selling securities below fair value. Even so, they believe that their strategy will lead to outperformance.

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Five types of investors: Which one are you?

In previous posts we considered informed and uninformed market participants. We then introduced another type of participant which we called the foolish investor. In an attempt to outperform the market foolish market participants actively trade to their own detriment at inefficient prices. Here we refine our definition of foolish market participants by dividing them into three groups: the gamblers, the deluded traders and the irrational traders. Each group is foolish in a different way.

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