Working Paper: NBER ID: w1958
Authors: Alex Kane; Alan J. Marcus
Abstract: Active portfolio management is commonly partitioned into two types of \nactivities: market timing, which requires forecasts of broad-based market \nmovements, and security analysis, which requires the selection of individual \nstocks that are perceived to be underpriced by the market. Merton (1981) has \nprovided an inciteful and easily-implemented means to place a value on market \ntiming skills. In contrast, while a normative theory of stock selection was \noutlined long ago in Treynor and Black's (1973) work, no convenient means of \nvaluing potential selection ability has yet been devised. \nWe present a framework in which the value of a security analyst can be \ncomputed. We also treat market timing ability in this framework, and \ntherefore can compare the relative values of each type of investment \nanalysts. We find that stock selection is potentially extremely valuable, but \nthat its value depends critically on the forecast interval, on the correlation \nstructure of residual stock returns, and on the ability to engage in short \nsales. Finally, we show how to modify the value of selection for the \nimportant case in which analysts' forecasts of stocks' alphas are subject to \nerror.
Keywords: Active Portfolio Management; Market Timing; Security Analysis; Stock Selection; Valuation Framework
JEL Codes: G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stock selection (G11) | value of stock selection (G11) |
| ability to engage in short sales (G19) | value of analysis (D46) |
| leverage (G24) | value of analysis (D46) |
| forecast interval (C53) | value of selection (C52) |
| correlation structure of residual stock returns (C10) | value of analysis (D46) |
| analysts' forecasts containing error (G17) | value of selection ability (C52) |