Chapter 13

1. Chapter 13 Investor Behavior and Capital Market Efficiency

2. Chapter Outline 13.1 Competition and Capital Markets 13.2 Information and Rational Expectations 13.3 The Behavior of Individual Investors 13.4 Systematic Trading Biases 13.5 The Efficiency of the Market Portfolio 13.6 Style-Based Anomalies and the Market Efficiency Debate

3. Chapter Outline (cont’d) 13.7 Multifactor Models of Risk 13.8 Methods Used in Practice Appendix

4. Learning Objectives Compute a stock’s alpha. Explain how investors’ attempts to “beat the market” should keep the market portfolio efficient. Describe the effect of homogeneous expectations on a security’s alpha. Explain why holding the market portfolio does not depend on the quality of an investor’s information or trading skills. Understand what the CAPM requires about investors’ expectations.

5. Learning Objectives (cont’d) Evaluate under what conditions the market portfolio would be inefficient. Explain diversification bias and familiarity bias. Discuss why uninformed investors trade too much. Assess how uninformed investors’ behavior deviates from the CAPM in systematic ways. Explain the disposition effect.

6. Learning Objectives (cont’d) Review why investors, on average, earn negative alphas when they invest in managed mutual funds. Assess the strategy of an investor “holding the market.” Discuss the size effect. Describe the momentum trading strategy. Explain how the choice of the market proxy may lead to non-zero alphas.

7. Learning Objectives (cont’d) Discuss how systematic behavioral biases may affect the efficiency of the market portfolio. Assess how a preference for stocks with a positively skewed return distribution would impact the market portfolio’s efficiency. Describe the Arbitrage Pricing Theory. Discuss the expected return on a self-financing portfolio. Discuss the Fama-French-Carhart model.

8. 13.1 Competition and Capital Markets Identifying a Stock’s Alpha To improve the performance of their portfolios, investors will compare the expected return of a security with its required return from the security market line.

9. 13.1 Competition and Capital Markets (cont'd) Identifying a Stock’s Alpha The difference between a stock’s expected return and its required return according to the security market line is called the stock’s alpha. When the market portfolio is efficient, all stocks are on the security market line and have an alpha of zero.

10. Figure 13.1 An Inefficient Market Portfolio

11. 13.1 Competition and Capital Markets (cont'd) 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.

12. Figure 13.2 Deviations from the Security Market Line

13. 13.2 Information and Rational Expectations 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 investor’s information or trading skill.

14. Textbook Example 13.1

15. Textbook Example 13.1

16. 13.2 Information and Rational Expectations (cont’d) Rational Expectations All investors correctly interpret and use their own information, as well as information that can be inferred from market prices or the trades of others.

17. 13.2 Information and Rational Expectations (cont’d) Regardless of how much information an investor has access to, he can guarantee himself an alpha of zero by holding the market portfolio.

18. 13.2 Information and Rational Expectations (cont’d) Because the average portfolio of all investors is the market portfolio, the average alpha of all investors is zero. If no investor earns a negative alpha, then no investor can earn a positive alpha, and the market portfolio must be efficient.

19. 13.2 Information and Rational Expectations (cont’d) The market portfolio can be inefficient only if a significant number of investors either: Misinterpret information and believe they are earning a positive alpha when they are actually earning a negative alpha, or Care about aspects of their portfolios other than expected return and volatility, and so are willing to hold inefficient portfolios of securities.

20. 13.3 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.

21. 13.3 The Behavior of Individual Investors (cont’d) 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.

22. 13.3 The Behavior of Individual Investors (cont’d) Excessive Trading and Overconfidence 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 individual’s desire for novel and intense risk-taking experiences.

23. Figure 13.3 NYSE Annual ShareTurnover, 1970–2008 Source: www.nyxdata.com

24. Figure 13.4 Individual 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) 773–806.)

25. 13.3 The Behavior of Individual Investors (cont’d) 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.

26. 13.4 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.

27. 13.4 Systematic Trading Biases (cont’d) 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.

28. 13.4 Systematic Trading Biases (cont’d) 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.

29. 13.4 Systematic Trading Biases (cont’d) Herd Behavior When investors make similar trading errors because they are actively trying to follow each other’s behavior Informational Cascade Effects Where traders ignore their own information hoping to profit from the information of others

30. 13.4 Systematic Trading Biases (cont’d) 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

31. 13.5 The Efficiency of the Market Portfolio 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

32. 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) 183–206.

33. 13.5 The Efficiency of the Market Portfolio (cont’d) 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

34. Figure 13.6 Stock Price Reactionsto Recommendations on Mad Money Source: Adapted from J. Engelberg, C. Sasseville, J. Williams, “Market Madness? The Case of Mad Money,” SSRN working paper, 2009.

35. 13.5 The Efficiency of the Market Portfolio (cont’d) The Performance of Fund Managers 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 fund’s future ability to outperform the market

36. Figure 13.7 Estimated Alphas for U.S. Mutual Funds (1975–2002) 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): 2551–2596.

37. Figure 13.8 Before and After Hiring Returns of Investment Managers Sources: A. Goyal and S. Wahal, “The Selection and Termination of Investment Management Firms by Plan Sponsors,” Journal of Finance 63 (2008): 1805–1847 and with J. Busse, “Performance and Persistence in Institutional Investment Management,” Journal of Finance, forthcoming.

38. 13.5 The Efficiency of the Market Portfolio (cont’d) 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

39. 13.6 Style-Based Anomalies and the Market Efficiency 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

40. Figure 13.9 Excess Return of Size Portfolios, 1926–2008 Source: Data courtesy of Kenneth French.

41. Figure 13.10 Excess Return of Book-to-Market Portfolios, 1926–2008 Source: Data courtesy of Kenneth French.

42. 13.6 Style-Based Anomalies and the Market Efficiency Debate (cont’d) 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

43. Textbook Example 13.2

44. Textbook Example 13.2

45. Alternative Example 13.2A Problem Suppose two firms, ABC and XYZ, are both expected to pay a dividend stream of $2.2 million per year in perpetuity. ABC’s cost of capital is 12% per year and XYZ’s cost of capital is 16%. Which firm has the higher market value? Which firm has the higher expected return?

46. Alternative Example 13.2A Solution ABC has an expected return of 12%. XYZ has an expected return of 16%.

47. Alternative Example 13.2B 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?

48. Alternative Example 13.2B Solution αABC = 12% - 15% = -3% αXYZ = 16% - 15% = 1% The firm with the lower market value has the higher alpha.

49. 13.6 Style-Based Anomalies and the Market Efficiency Debate (cont’d) Momentum Momentum Strategy Buying stocks that have had past high returns and (short) selling stocks that have had past low returns

50. 13.6 Style-Based Anomalies and the Market Efficiency Debate (cont’d) 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 stock’s beta with the market is not an adequate measure of its systematic risk.