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FINM7007 Applied Corporate Finance
Lecture 5 Investor Behavior and Capital Market Efficiency BD Chapter 13
Learning Object ives
1. Compute a stocks alpha.
2. Explain how investors attempts to beat the market should keep the market
portfolio efficient.
3. Describe the effect of homogeneous expectations on a securitys alpha.
4. Explain why holding the market portfolio does not depend on the quality of an
investors information or tradingskills.
5. Understand what the CAPM requires about investors expectations.
6. Evaluate under what conditions the market portfolio would be inefficient.
7. Explain diversification bias and familiarity bias.
8. Discuss why uninformed investors trade too much.
9. Assess how uninformed investors behavior deviates from the CAPM insystematic ways.
10. Explain the disposition effect.
11. Review why investors, on average, earn negative alphas when they invest in
managed mutual funds.
12. Assess the strategy of an investor holding the market.
13. Discuss the size effect.
14. Describe the momentum trading strategy.
15. Explain how the choice of the market proxy may lead to non-zero alphas.
16. Discuss how systematic behavioral biases may affect the efficiency of the market
portfolio.
17. Assess how a preference for stocks with a positively skewed return distribution
would impact the market portfolios efficiency.
18. Describe the Arbitrage Pricing Theory.
19. Discuss the expected return on a self-financing portfolio.
20. Discuss the Fama-French-Carhart model.
Competi t ion and Capital Markets
Identifying a Stocks Alpha
To improve the performance of their portfolios, investors will compare theexpected return of a security with its required return from the security market
line.
Identifying a Stocks Alpha
The difference between a stocks expected return and its required return
according to the security market line is called the stocks alpha.
When the market portfolio is efficient, all stocks are on the security market
line and have an alpha of zero.
( [ ] )s f s Mkt fr r E R r
[ ]s s sE R r
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Figure 13.1An Inefficient Market Portfolio
Profiting from Non-Zero Alpha Stocks
Investors can improve the performance of their portfolios by buying stocks
with positive alphas and by selling stocks with negative alphas.
Figure 13.2Deviations from the Security Market Line
Information and Rational Expectat ions
Informed Versus Uninformed Investors
In the CAPM framework, investors should hold the market portfolio combined
with risk-free investments.
This investment strategy does not depend on the quality of an investors
information or trading skill.
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Example
The Behavior of Individual Investors
Underdiversification and Portfolio Biases
There is much evidence that individual investors fail to diversify their
portfolios adequately.
Familiarity Bias
Investors favor investments in companies they are familiar with
Relative Wealth Concerns
Investors care more about the performance of their portfolios relative to
their peers.
Excessive Trading and Overconfidence
According to the CAPM, investors should hold risk-free assets in combination
with the market portfolio of all risky securities.
In reality, a tremendous amount of trading occurs each day.
Overconfidence Bias Investors believe they can pick winners and losers when, in fact, they
cannot; this leads them to trade too much.
Sensation Seeking
An individuals desire for novel and intense risk-taking experiences.
Figure 13.3NYSE Annual ShareTurnover, 19702011
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Figure 13.4Individual Investor Returns Versus Portfolio Turnover
Source: B. Barber and T. Odean, Trading Is Hazardous to Your Wealth: The Common
Stock Investment Performance of Individual Investors, Journal of Finance 55 (2000)
773806.)
Individual Behavior and Market Prices If individuals depart from the CAPM in random ways, then these departures
will tend to cancel out.
Individuals will hold the market portfolio in aggregate, and there will be no
effect on market prices or returns.
Systematic Trading Biases
Hanging on to Losers and the Disposition Effect
Disposition Effect
When an investor holds on to stocks that have lost their value and sell
stocks that have risen in value since the time of purchase.
Investor Attention, Mood, and Experience
Studies show that individuals are more likely to buy stocks that have recently
been in the news, engaged in advertising, experienced exceptionally high
trading volume, or have had extreme returns.
Sunshine generally has a positive effect on mood, and studies have found
that stock returns tend to be higher when it is a sunny day at the location of
the stock exchange.
Investor Attention, Mood, and Experience
Investors appear to put too much weight on their own experience rather than
considering all the historical evidence.
As a result, people who grew up and lived during a time of high stock returns
are more likely to invest in stocks than people who experienced times when
stocks performed poorly.
Herd Behavior
When investors make similar trading errors because they are actively trying
to follow each others behavior
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Informational Cascade Effects
Where traders ignore their own information hoping to profit from the
information of others
Implications of Behavioral Biases
If individual investors are engaging in strategies that earn negative alphas, it
may be possible for more sophisticated investors to take advantage of this
behavior and earn positive alphas
The Effic iency o f the Market Portfol io
Trading on News or Recommendations
Takeover Offers
If you could predict whether the firm would ultimately be acquired or not,
you could earn profits trading on that information
Figure 13.5 Returns to Holding Target Stocks Subsequent to Takeover
Announcements
Source: Adapted from M. Bradley, A. Desai, and E. H. Kim, The Rationale Behind
Interfirm Tender Offers: Information or Synergy? Journal of Financial Economics 11
(1983) 183206
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Trading on News or Recommendations
Stock Recommendations
Jim Cramer makes numerous stock recommendations on his television
show, Mad Money
For stocks with news, it appears that the stock price correctly
reflects this information the next day, and stays flat (relative to the
market) subsequently
On the other hand, for the stocks without news, there appears to be
a significant jump in the stock price the next day, but the stock price
then tends to fall relative to the market, generating a negative alpha,
over the next several weeks
Figure 13.6 Stock Price Reactions to Recommendations on Mad Money
Source: Adapted from J. Engelberg, C. Sasseville, J. Williams, Market Madness?
The Case of Mad Money, SSRN working paper, 2009.
The Performance of Fund Managers
Fund Manager Value-Added The median mutual fund actually destroys value
Most fund managers appear to trade so much that their trading costs
exceed the profits from any trading opportunities they may find.
Return to Investors
Numerous studies report that the actual returns to investors of the
average mutual fund have a negative alpha
Superior past performance is not a good predictor of a funds future
ability to outperform the market
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Figure 13.7Estimated Alphas for U.S. Mutual Funds (19752002)
Source: Adapted from R. Kosowski, A. Timmermann, R. Wermers, H. White, Can
Mutual Fund Stars Really Pick Stocks? New Evidence from a Bootstrap Analysis,
Journal of Finance 61 (2006): 25512596.
Figure 13.8Before and After Hiring Returns of Investment Managers
Sources : A. Goyal and S. Wahal, The Selection and Termination of InvestmentManagement Firms by Plan Sponsors, Journal of Finance 63 (2008): 18051847 and
with J. Busse, Performance and Persistence in Institutional Investment Management,
Journal of Finance 63 (2008): 18051847.
The Winners and Losers
The average investor earns an alpha of zero, before including trading costs
Beating the market should require special skills or lower trading costs
Because individual investors are likely to be at a disadvantage on both
counts, the CAPM wisdom that investors should hold the market is
probably the best advice for most people
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Style-Based An omalies and the Market Eff ic iency Debate
Size Effect
Excess Return and Market Capitalizations
Small market capitalization stocks have historically earned higher
average returns than the market portfolio, even after accounting for their
higher betas
Excess Return and Book-to-Market Ratio
High book-to-market stocks have historically earned higher average
returns than low book-to-market stocks
Figure 13.9Excess Return of Size Portfolios, 19262011
Source: Data courtesy of Kenneth French.
Figure 13.10Excess Return of Book-to-Market Portfolios, 19262011
Source: Data courtesy of Kenneth French
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Size Effect
Size Effects and Empirical Evidence
Data Snooping Bias
Given enough characteristics, it will always be possible to find some
characteristic that by pure chance happens to be correlated with the
estimation error of average returns
Example
Problem
Suppose two firms, ABC and XYZ, are both expected to pay a dividend
stream of $2.2 million per year in perpetuity.
ABCs cost of capital is 12% per year and XYZs cost of capital is 16%.
Which firm has the higher market value?
Which firm has the higher expected return?
Solution
ABC has an expected return of 12%.
XYZ has an expected return of 16%.
Problem
Now assume both stocks have the same estimated beta, either because of
estimation error or because the market portfolio is not efficient.
Based on this beta, the CAPM would assign an expected return of 15% to
both stocks.
Which firm has the higher alpha?
How do the market values of the firms relate to their alphas?
Solution
ABC= 12% - 15% = -3% XYZ= 16% - 15% = 1%
The firm with the lower market value has the higher alpha.
Momentum
Momentum Strategy
Buying stocks that have had past high returns and (short) selling stocks
that have had past low returns
ABC
$2,200,000Market Value $18,333,333
.12
XYZ
$2,200,000Market Value $13,750,000
.16
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Implications of Positive-Alpha Trading Strategies
The only way positive-alpha strategies can persist in a market is if some
barrier to entry restricts competition
However, the existence of these trading strategies has been widely
known for more than 15 years
Another possibility is that the market portfolio is not efficient, and therefore a
stocks beta with the market is not an adequate measure of its systematic
risk.
Proxy Error
The true market portfolio may be efficient, but the proxy we have used for
it may be inaccurate
Behavioral Biases
By falling prey to behavioral biases, investors may hold inefficient
portfolios
Alternative Risk Preferences and Non-Tradable Wealth Investors may choose inefficient portfolios because they care about
risk characteristics other than the volatility of their traded portfolio
Mult i factor Models of Risk
The expected return of any marketable security is:
When the market portfolio is not efficient, we have to find a method to identify
an efficient portfolio before we can use the above equation. However, it is
not actually necessary to identify the efficient portfolio itself.
All that is required is to identify a collection of portfolios from which the
efficient portfolio can be constructed.
Using Factor Portfolios
Given N factor portfolios with returns RF1, . . . , RFN, the expected return of
asset sis defined as:
1. Nare the factor betas.
Using Factor Portfolios
Single-Factor Model
A model that uses one portfolio
Multi-Factor Model
A model that uses more than one portfolio in the model
The CAPM is an example of a single-factor model while the Arbitrage
Pricing Theory (APT)is an example of a multifactor model
[ ] ( [ ] ) effs f s eff fE R r E R r
1 2
1 2
1
[ ] ( [ ] ) ( [ ] ) ( [ ] )
( [ ] )
F F FN
s f s F f s F f s FN f
NFN
f s FN f
n
E R r E R r E R r E R r
r E R r
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Using Factor Portfolios
A self-financing portfoliocan be constructed by going long in some stocks
and going short in other stocks with equal market value
In general, a self-financing portfolio is any portfolio with portfolio weights that
sum to zero rather than one
Using Factor Portfolios
If all factor portfolios are self-financing then:
Selecting the Portfolios
Market Capitalization Strategy A trading strategy that each year buys a portfolio of small stocks and
finances this position by short selling a portfolio of big stocks has
historically produced positive risk-adjusted returns.
This self-financing portfolio is widely known as the small-minus-big
(SMB) portfolio.
Book-to-market Ratio Strategy
A trading strategy that each year buys an equally-weighted portfolio of
stocks with a book-to-market ratio less than the 30th percentile of NYSE
firms and finances this position by short selling an equally-weighted
portfolio of stocks with a book-to-market ratio greater than the 70th
percentile of NYSE stocks has historically produced positive
risk-adjusted returns.
This self-financing portfolio is widely known as the high-minus-low
(HML) portfolio.
Past Returns Strategy
Each year, after ranking stocks by their return over the last one year, a
trading strategy that buys the top 30% of stocks and finances thisposition by short selling bottom 30% of stocks has historically produced
positive risk-adjusted returns.
This self-financing portfolio is widely known as the prior one-year
momentum (PR1YR) portfolio.
This trading strategy requires holding the portfolio for a year and
the process is repeated annually.
Fama-French-Carhart (FFC) Factor Specifications
1 2
1 2
1
[ ] [ ] [ ] [ ]
( [ ])
F F FN
s f s F s F s FN
NFN
f s FN
n
E R r E R E R E R
r E R
1
1
[ ] ( [ ] ) [ ]
[ ] [ ]
Mkt SMBs f s Mkt f s SMB
HML PR YR
s HML s PR YR
E R r E R r E R
E R E R
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Table 13.1FFC Portfolio Average Monthly Returns, 19272012
Textbook Example 13.3
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The Cost of Capital Using the Fama-French-Carhart Factor Specification
Although it is widely used in research to measure risk, there is much debate
about whether the FFC factor specification is really a significant improvement
over the CAPM
The Cost of Capital Using the Fama-French-Carhart Factor Specification
One area where researchers have found that the FFC factor specification
does appear to do better than the CAPM is measuring the risk of actively
managed mutual funds
Researchers have found that funds with high returns in the past have
positive alphas under the CAPM. When the same tests were repeated
using the FFC factor specification to compute alphas, no evidence was
found that mutual funds with high past returns had future positive alphas.
Methods Used In Pract ice
There is no clear answer to the question of which technique is used to measure
risk in practiceit very much depends on the organization and the sector.
There is little consensus in practice in which technique to use because all the
techniques covered are imprecise.
Figure 13.11 How Firms Calculate the Cost of Capital
Source: J. R. Graham and C. R. Harvey, The Theory and Practice of Corporate
Finance: Evidence from the Field, Journal of Financial Economics 60 (2001):187243
Chapter Quiz
1. If investors buy a stock with a positive alpha, what is the likely effect on its price
and expected return?
2. How can an uninformed investor guarantee themselves a non-negative alpha?
3. Why is the high trading volume observed in markets inconsistent with the CAPM
equilibrium?
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