Models for Investors in Real World Markets

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A uniquely timely look at where modern financial economic theory has failed-and where we should go from here The collapse of the Scholes-Merton based Long Term Capital Management (LTCM) hedge fund should have sounded alarms or, at least, raised questions about investment strategies based on risk-neutral probabilities. More recently, the fallout of Enron, WorldCom, and similar fiascos must now give pause to those who take the efficient market-based formula for "fair prices" (especially in options and derivatives) as rigid laws. This provocative volume provides a new, antiefficient markets approach to investment theory and management. Questioning the assumption that markets clear neatly and quickly, Models for Investors in Real World Markets considers neoclassical models in light of what can go wrong with them, outlines basic institutional factors associated with how stock markets operate, and then offers ways to bring about better (though never correct) models. Providing a stinging critique of modern financial economic theory, this timely book: * Introduces basic concepts of utility theory, the cornerstone of portfolio theory * Illustrates why diversification is an important fundamental requirement of rational investment choice * Provides a detailed procedure for analyzing securities, borrowing the concepts of Benjamin Graham and David Dodd, and building a quantitative framework for them * Examines the importance of compound interest and observes that stock growth may be viewed as noisy compound interest * Demonstrates that options are themselves stochastic, risky entities and not magical devices for the elimination of risk * Develops a conceptualization of risk profiling based on their development of the simugram. As opposed to the Markowitz approach of maximizing growth subject to acceptable levels of volatility, the authors use the simugram, their computer intensive forecast of the time-indexed density function of portfolio value. Percentiles, rather than expectations, form the major bases for the criterion functions and constraints utilized for portfolio management. For anyone who has ever questioned-or should have questioned-the efficient market orthodoxy, this book will be a valuable reference on market analysis and investment strategy.