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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?