Study session 13 in the Level I CFA Program curriculum begins the material on equity investments with three readings (46-48). The material is almost completely conceptual and likely not worth a ton of points but still worth your time. Since it is all basic-level and conceptual, it is pretty easy to understand and you only need the basic idea to get any points on the exam. Make sure you understand the vocabulary and concepts, including any lists and advantages/limitations on comparisons given.
Market Organization and Structure
This is almost entirely a vocabulary lesson on the market and participants. It is important that you know the information for general knowledge but it is not as testable as some of the other readings. The key terms are good for flashcards with a quick rundown until you’ve got them.
Understand the difference between assets; i.e. fixed-income, equities and pooled investment vehicles. You likely won’t need much other than the brief definitional material for futures, options, swaps and commodities. Most of these assets are covered in much more detail in other parts of the curriculum.
Understand how to calculate returns on leveraged positions, maintenance margin requirement and the margin call price. If a buyer will receive a margin call when the value of equity drops below 25% of the maintenance margin requirement, with an initial stock price of $20 leveraged with 60% margin: the margin call price is ($8 +Price – $20) / Price = $16.
While the likelihood of seeing much of this one the exam is pretty low, make sure you have a basic grasp of the material. Understanding how the markets are organized and the primary players is an absolutely basic requirement to understanding how the markets operate. It should be repeat information for Finance students but will get you up to speed if you are from a different educational background.
Security Market Indices
The differences and calculations for the indices (price-weighted, equal-weighted, market cap, and fundamentally-weighted) are important information and have shown up on the exam. It’s really not difficult information, just understand how they are constructed and how to calculate returns.
Price-weighted indices are based on the price of each stock. This means that higher-priced stocks will have more influence on the index. It is simply calculated but biased to the higher-priced stocks and may involve a downward bias. Stock splits, spinoffs and constituent changes will all affect the divisor.
Equally-weighted indices are based on an equal-dollar amount in each stock. The advantage is that it is also easily calculated but it may bias towards small-cap firms because there are more of these in the market. It also requires frequent rebalancing (higher transaction costs) and contains potentially illiquid stocks.
Market-cap weighted indices are based on the value of each stock company in the index. Advantages include a better representation of each company’s value in the market though the index will be biased to larger firms. The index may overweight stocks that have seen their value increase (overvalued) against those that have decreased in value.
Understand the uses of indices; i.e. measuring market sentiment, as a proxy for asset classes, as benchmarks for managed portfolios and as the bases for new products.
They construction and limitations of alternative asset indices shows up several times in the curriculum, so spend some time on this section. Pay special attention to the possible biases within each index.
The efficient markets theory is a huge concept in the industry and for the exams. You do not necessarily need to know all the data and details that support it, but you should know the implications of each level of efficiency. Understand what it means for technical analysis and transaction costs in trading.
Know the difference between market value (the current price in the market) and intrinsic value (value based on investment characteristics). Depending on the efficiency of the market, these two values may differ widely.
The Institute does not ask you to take a position on the efficient market hypothesis but regardless of how you believe the markets behave, when you are taking the exam the curriculum is the ultimate truth. Know that there is considerable evidence supporting the semi-strong form of efficiency and some evidence to support the strong form. Understand the implication this has on active portfolio management, i.e. that gross performance will likely mirror the market but will underperform after fees.
Remember the factors contributing to or impeding efficiency in market prices:
- Greater number of participants should contribute to market efficiency through consensus
- Information availability and financial disclosure should promote fairness and efficiency
- Limits to trading like restrictions on short-selling and operational inefficiencies (high transaction costs, difficulties in execution) impede market efficiency
The list of market anomalies is testable vocabulary and can be fun to read through. Again, mostly a flashcard exercise until you can recognize the terms and their basic idea. Understand that most of these anomalies are limited due to market knowledge that they exist and front-running.
Understand the basic idea behind the eight behavioral biases, which will be even more important in your Level 3 exam.
- Loss aversion is bias that investors dislike losses much more than the want gains and will hold on to losers to avoid losses much longer than they should.
- Overconfidence is the tendency to overestimate your own ability to predict/forecast prices and other market indicators. Often leads to undiversified portfolios.
- Representativeness is the bias that investors give greater weight of probability to the current situation, i.e. investors overweight current information and trends and tend to neglect new information or trends.
- Gambler’s fallacy is the bias to project long-term reversion to the mean, i.e. that falling stocks will reverse direction based on no fundamental change
- Mental accounting is the bias to mentally track gains and losses for different investments within separate ‘buckets’ rather than as a whole portfolio view
- Conservatism is the bias to under-react to new information and tendency to stick to prior views
- Disposition effect is the tendency to avoid regret by selling winners too early and holding on to losers too long
- Narrow framing is the tendency to analyze a situation in isolation, ignoring the larger context and forces
Again, most of this stuff is perfect for flash cards and a quick understanding of basic ideas. Just make sure you have the concepts and move on to spend more time on more important study sessions.
‘til next time, happy studyin’
Joseph Hogue, CFA