Investor behavior C h A P Ter

and Capital
Market efficiency 13
aS FUND MaNaGer OF LeGG MaSON VaLUe trUSt, WIllIam h. MIller
had built a reputation as one of the world’s savviest investors. Miller’s fund outperformed
the overall market every year from 1991–2005, a winning streak no other fund manager
came close to matching. But in 2007–2008, Legg Mason Value Trust fell by nearly 65%,
N otat Ion
almost twice as much as the broader market. While Legg Mason Value Trust outperformed xi portfolio weight of
the market in 2009, it lagged again from 2010 until Miller ultimately stepped down as investment in i
manager and chief investment officer in 2012. As a result of this performance, investors in Rs return of stock or
the fund since 1991 effectively gave back all of the gains they had earned relative to the
portfolio s
market in the intervening years and Miller’s reputation lay in tatters.1 Was Miller’s perfor- rf risk-free rate of interest
mance prior to 2007 merely luck or was his performance in post-2007 the aberration? as alpha of stock s
According to the CAPM, the market portfolio is efficient, so it should be impos- b is beta of stock s with
sible to consistently do better than the market without taking on additional risk. In this portfolio i
chapter, we will take a close look at this prediction of the CAPM, and assess to what es residual risk of
extent the market portfolio is or is not efficient. We will begin by looking at the role stock s
of competition in driving the CAPM results, noting that for some investors to beat the
market, other investors must be willing to hold portfolios that underperform the mar-
ket. We then look at the behavior of individual investors, who tend to make a number of
mistakes that reduce their returns. But while some professional fund managers are able
to exploit these mistakes and profit from them, it does not appear that much, if any, of
these profits make it into the hands of the investors who hold their funds.
We will also consider evidence that certain investment “styles,” namely holding
small stocks, value stocks, and stocks with high recent returns, perform better than
predicted by the CAPM, indicating that the market portfolio may not be efficient. We
explore this evidence, and then consider how to calculate the cost of capital if indeed
the market portfolio is not efficient by deriving an alternative model of risk—the
multifactor asset pricing model.

1
T. Lauricella, “The Stock Picker’s Defeat,” Wall Street Journal, December 10, 2008. 477

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 478 Chapter 13╇ Investor Behavior and Capital Market Efficiency

13.1 Competition and Capital Markets

To understand the role of competition in the market, it is useful to consider how the
CAPM equilibrium we derived in Chapter€11 might arise based on the behavior of indi-
vidual investors. In this section, we explain how investors who care only about expected
return and variance react to new information and how their actions lead to the CAPM
equilibrium.

Identifying a Stock’s Alpha

Consider the equilibrium, as we depicted in Figure 11.12 on pages 422–423, where the
CAPM holds and the market portfolio is efficient. Now suppose new information arrives
such that, if market prices remain unchanged, this news would raise the expected return of
Walmart and Nike stocks by 2% and lower the expected return of McDonald’s and Tiffany
stocks by 2%, leaving the expected return of the market unchanged.2 Figure€13.1 illustrates
the effect of this change on the efficient frontier. With the new information, the market
portfolio is no longer efficient. Alternative portfolios offer a higher expected return and a
lower volatility than we can obtain by holding the market portfolio. Investors who are
aware of this fact will alter their investments in order to make their portfolios efficient.
To improve the performance of their portfolios, investors who are holding the market
portfolio will compare the expected return of each security s with its required return from
the CAPM (Eq. 12.1):
rs = rf + bs * (E [RMkt ] - rf ) (13.1)

Figure 13.1╇
15%
An Inefficient Market
Portfolio
If the market �portfolio is Efficient Portfolio
(after news announcement) GE Tiffany
not equal to the �efficient
portfolio, then the market 10%
Expected Return

is not in the CAPM equilib- Market Portfolio Apple

Nike
rium. The figure illustrates (efficient prior
this possibility if news is to news) Amazon
announced that raises
the expected return of IBM
Walmart and Nike stocks 5% Walmart Molson-Coors
and lowers the expected
return of McDonald’s and
Newmont Mining
Â�Tiffany stocks compared to McDonald’s
the situation depicted in
T-Bills = effect of news
Figure 11.12.
0%
0% 5% 10% 15% 20% 25% 30% 35% 40%

Volatility (standard deviation)

2
In general, news about individual stocks will affect the market’s expected return because these stocks are
part of the market portfolio. To keep things simple, we assume the individual stock effects cancel out so
that the market’s expected return remains unchanged.

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 13.1╇ Competition and Capital Markets 479

Figure 13.2╇
15% Security Market Line
Deviations from the
Security Market Line aTIF
If the market portfolio is
not efficient, then stocks Tiffany
will not all lie on the
10% Nike
security market line. The

Expected Return
distance of a stock above or
below the security market
line is the stock’s alpha.
We can improve upon the Walmart Market Portfolio
market portfolio by buying 5%
stocks with positive alphas
and selling stocks with
= effect of news
negative alphas, but as we
McDonald’s
do so, prices will change
T-Bills = effect of trade
and their alphas will shrink
toward zero.
0.50 0.00 0.50 1.00 1.50 2.00

Beta

Figure€13.2 shows this comparison. Note that the stocks whose returns have changed are
no longer on the security market line. The difference between a stock’s expected return and
its required return according to the security market line is the stock’s alpha:
as = E [R s ] - rs (13.2)
When the market portfolio is efficient, all stocks are on the security market line and
have an alpha of zero. When a stock’s alpha is not zero, investors can improve upon the
�performance of the market portfolio. As we saw in Chapter€11, the Sharpe ratio of a port-
folio will increase if we buy stocks whose expected return exceeds their required return—
that is, if we buy stocks with positive alphas. Similarly, we can improve the performance of
our portfolio by selling stocks with negative alphas.

Profiting from Non-Zero Alpha Stocks

Faced with the situation in Figure€13.2, savvy investors who are holding the market port-
folio will want to buy stock in Walmart and Nike, and sell stock in McDonald’s and
Tiffany. The surge of buy orders for Walmart and Nike will cause their stock prices
to rise, and the surge of sell orders for McDonald’s and Tiffany will cause their stock
prices to fall. As stock prices change, so do expected returns. Recall that a stock’s total
return is equal to its dividend yield plus the capital gain rate. All else equal, an increase
in€the current stock price will lower the stock’s dividend yield and future capital gain rate,
thereby lowering its expected return. Thus, as savvy investors attempt to trade to improve
their portfolios, they raise the price and lower the expected return of the positive-alpha
stocks, and they depress the price and raise the expected return of the negative-alpha
stocks, until the stocks are once again on the security market line and the market port�
folio is efficient.
Notice that the actions of investors have two important consequences. First, while the
CAPM conclusion that the market is always efficient may not literally be true, competition

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 480 Chapter 13╇ Investor Behavior and Capital Market Efficiency

among savvy investors who try to “beat the market” and earn a positive alpha should keep
the market portfolio close to efficient much of the time. In that sense, we can view the
CAPM as an approximate description of a competitive market.
Second, there may exist trading strategies that take advantage of non-zero alpha stocks,
and by doing so actually can beat the market. In the remainder of this chapter we will
explore both of these consequences, looking at evidence of the approximate efficiency of
the market, as well as identifying trading strategies that may actually do better than the
market.

Concept Check 1. If investors attempt to buy a stock with a positive alpha, what is likely to happen to its price and
expected return? How will this affect its alpha?
2. What is the consequence of investors exploiting non-zero alpha stocks for the efficiency of the
market portfolio?

13.2 Information and Rational Expectations

If a stock like Exxon Mobile has a Under what circumstances could an investor profit from trading a non-zero alpha stock?
positive alpha, it means it's expected Consider the situation in Figure€13.2 after the news announcement. Because Exxon Mobil
to perform better than the market.
When news comes out that makes
has a positive alpha before prices adjust, investors will anticipate that the price will rise and
Exxon Mobil look even better, will likely put in buy orders at the current prices. If the information that altered Exxon
investors expect the stock price to go Mobil’s expected return is publically announced, there are likely to be a large number of
up. investors who receive this news and act on it. Similarly, anybody who hears the news will
Many investors will try to buy the
stock at the current price because not want to sell at the old prices. That is, there will be a large order imbalance. The only
they think it will rise. Because so way to remove this imbalance is for the price to rise so that the alpha is zero. Note that in
many people want to buy and no this case it is quite possible for the new prices to come about without trade. That is, the
one wants to sell at the old price, the
stock price will quickly rise. competition between investors may be so intense that prices move before any investor can
The price might rise so fast that it actually trade at the old prices, so no investor can profit from the news.3
reaches the new, higher level before
anyone can actually buy at the old,
lower price. This means no one can
Informed Versus Uninformed Investors
profit from the news because the As the above discussion makes clear, in order to profit by buying a positive-alpha stock, there
price adjusts too quickly. must be someone willing to sell it. Under the CAPM assumption of homogeneous expecta-
In short, investors can't profit from tions, which states that all investors have the same information, it would seem that all inves-
the news if the stock price adjusts tors would be aware that the stock had a positive alpha and none would be willing to sell.
too quickly due to high demand. Of course, the assumption of homogeneous expectations is not necessarily a good
description of the real world. In reality, investors have different information and spend
varying amounts of effort researching stocks. Consequently, we might expect that sophisti-
cated investors would learn that Exxon Mobil has a positive alpha, and that they would be
able to purchase shares from more naïve investors.
However, even differences in the quality of investors’ information will not necessarily
be enough to generate trade in this situation. An important conclusion of the CAPM is
that investors should hold the market portfolio (combined with risk-free investments), and
this investment advice does not depend on the quality of an investor’s information or trading
skill. Even naïve investors with no information can follow this investment advice, and as

3
The idea that prices will adjust to information without trade is sometimes referred to as the no-trade
theorem. (P. Milgrom and N. Stokey, “Information, Trade and Common Knowledge,” Journal of Economic
Theory 26 (1982): 17–27.)

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 13.2╇ Information and Rational Expectations 481

the following example shows, by doing so they can avoid being taken advantage of by more
sophisticated investors.

Example 13.1 How to Avoid Being Outsmarted in Financial Markets

Problem
Suppose you are an investor without access to any information regarding stocks. You know that
other investors in the market possess a great deal of information and are actively using that
information to select an efficient portfolio. You are concerned that because you are less informed
than the average investor, your portfolio will underperform the portfolio of the average investor.
How can you prevent that outcome and guarantee that your portfolio will do as well as that of
the average investor?

Solution
Even though you are not as well informed, you can guarantee yourself the same return as the
average investor simply by holding the market portfolio. Because the aggregate of all investors’
portfolios must equal the market portfolio (i.e., demand must equal supply), if you hold the
market portfolio then you must make the same return as the average investor.
On the other hand, suppose you don’t hold the market portfolio, but instead hold less of
some stock, such as Google, than its market weight. This must mean that in aggregate all other
investors have over-weighted Google relative to the market. But because other investors are more
informed than you are, they must realize Google is a good deal, and so are happy to profit at
your expense.

Rational Expectations
Example 13.1 is very powerful. It implies that every investor, regardless of how little infor-
mation he has access to, can guarantee himself the average return and earn an alpha of zero
simply by holding the market portfolio. Thus, no investor should choose a portfolio with a
negative alpha. However, because the average portfolio of all investors is the market port-
folio, the average alpha of all investors is zero. If no investor earns a negative alpha, then no
investor can earn a positive alpha, implying that the market portfolio must be efficient. As
a result, the CAPM does not depend on the assumption of homogeneous expectations.
Rather it requires only that investors have rational expectations, which means that 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.4
For an investor to earn a positive alpha and beat the market, some investors must hold
portfolios with negative alphas. Because these investors could have earned a zero alpha by
holding the market portfolio, we reach the following important conclusion:
The market portfolio can be inefficient (so it is possible to beat the market) only if a significant
number of investors either
1. Do not have rational expectations so that they misinterpret information and believe they
are earning a positive alpha when they are actually earning a negative alpha, or
2. Care about aspects of their portfolios other than expected return and volatility, and so are
willing to hold inefficient portfolios of securities.

4
See P. DeMarzo and C. Skiadas, “Aggregation, Determinacy, and Informational Efficiency for a Class of
Economies with Asymmetric Information,” Journal of Economic Theory 80 (1998): 123–152.

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 482 Chapter 13╇ Investor Behavior and Capital Market Efficiency

How do investors actually behave? Do uninformed investors follow the CAPM advice
and hold the market portfolio? To shed light on these questions, in the next section we
review the evidence on individual investor behavior.

Concept Check 1. How can an uninformed or unskilled investor guarantee herself a non-negative alpha?
2. Under what conditions will it be possible to earn a positive alpha and beat the market?

13.3 The Behavior of Individual Investors

In this section, we examine whether small, individual investors heed the advice of the
CAPM and hold the market portfolio. As we will see, many investors do not appear to hold
an efficient portfolio, but instead fail to diversify and trade too much. We then consider
whether these departures from the market create an opportunity for more sophisticated
investors to profit at individual investors’ expense.

Underdiversification and Portfolio Biases

One of the most important implications of our discussion of risk and return is the benefit
of diversification. By appropriately diversifying their portfolios, investors can reduce risk
without reducing their expected return. In that sense, diversification is a “free lunch” that
all investors should take advantage of.
Despite this benefit, there is much evidence that individual investors fail to diversify
their portfolios adequately. Evidence from the U.S. Survey of Consumer Finances shows
that, for households that held stocks, the median number of stocks held by investors in
2001 was four, and 90% of investors held fewer than ten different stocks.5 Moreover, these
investments are often concentrated in stocks of companies that are in the same industry or
are geographically close, further limiting the degree of diversification attained. A related
finding comes from studying how individuals allocate their retirement savings accounts
(401K plans). A study of large plans found that employees invested close to a third of their
assets in their employer’s own stock.6 These underdiversification results are not unique to
U.S. investors: A comprehensive study of Swedish investors documents that approximately
one-half of the volatility in investors’ portfolios is due to firm-specific risk.7
There are a number of potential explanations for this behavior. One is that investors
suffer from a familiarity bias, so that they favor investments in companies they are familiar
with.8 Another is that investors have relative wealth concerns and care most about the
performance of their portfolio relative to that of their peers. This desire to “keep up with
the Joneses” can lead investors to choose undiversified portfolios that match those of their
colleagues or neighbors.9 In any case, this underdiversification is one important piece of
evidence that individual investors may choose sub-optimal portfolios.

5
V. Polkovnichenko, “Household Portfolio Diversification: A Case for Rank Dependent Preferences,
Review of Financial Studies 18 (2005): 1467–1502.
6
S. Benartzi, “Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock,” Journal
of Finance 56 (2001): 1747–1764.
7
J. Campbell, “Household Finance,” Journal of Finance 61 (2006): 1553–1604.
8
G. Huberman, “Familiarity Breeds Investment,” Review of Financial Studies 14 (2001): 659–680.
9
P. DeMarzo, R. Kaniel, and I. Kremer, “Diversification as a Public Good: Community Effects in Â�Portfolio
Choice,” Journal of Finance 59 (2004): 1677–1715.

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 13.3╇ The Behavior of Individual Investors 483

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 Chapter€12, we demonstrated that because the
market portfolio is a value-weighted portfolio, it is also a passive portfolio in the sense that
an investor does not need to trade in response to daily price changes in order to maintain
it. Thus, if all investors held the market, we would see relatively little trading volume in
financial markets. Consequently
In reality, a tremendous amount of trading occurs each day. At its peak in 2008, for
example, annual turnover on the NYSE was nearly 140%, implying that each share of each
stock was traded 1.4 times on average. While average turnover has declined dramatically in
the wake of the financial crisis, as shown in Figure€13.3, it is still at levels far in excess of that
predicted by the CAPM. Moreover, in a study of trading in individual accounts at a dis-
count brokerage, Professors Brad Barber and Terrance Odean found that individual inves-
tors tend to trade very actively, with average turnover almost one and a half times the
overall rates reported in Figure€13.3 during the time period of their study.10
What might explain this trading behavior? Psychologists have known since the 1960s
that uninformed individuals tend to overestimate the precision of their knowledge. For
example, many sports fans sitting in the stands confidently second guess the coaching
decisions on the field, truly believing that they can do a better job. In finance we call
this presumptuousness the overconfidence bias. Barber and Odean hypothesized that this
kind of behavior also characterizes individual investment decision making: Like sports fans,
individual investors believe they can pick winners and losers when, in fact, they cannot;
this overconfidence leads them to trade too much.
An implication of this overconfidence bias is that, assuming they have no true ability,
investors who trade more will not earn higher returns. Instead, their performance will be

Figure 13.3╇
140%

NYSE Annual Share

Turnover, 1970–2015 120%
The plot shows the
annual share turnover 100%
NYSE Annual Turnover

(number of shares traded

in the year/total number
80%
of shares). Such high
turnover is difficult to
reconcile with the CAPM, 60%
which implies that investors
should hold passive market
40%
portfolios. Note also the
rapid increase in turnover
up through 2008, followed 20%
by a dramatic decline
post-crisis.
0%
Source: [Link] 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Year

10
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.

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 484 Chapter 13╇ Investor Behavior and Capital Market Efficiency

worse once we take into account the costs of trading (due to both commissions and bid-ask
spreads). Figure€13.4 documents precisely this result, showing that much investor trading
appears not to be based on rational assessments of performance.
As additional evidence, Barber and Odean contrasted the behavior and performance of
men versus women.11 Psychological studies have shown that, in areas such as finance, men
tend to be more overconfident than women. Consistent with the overconfidence hypoth-
esis, they documented that men tend to trade more than women, and that their portfolios
have lower returns as a result. These differences are even more pronounced for single men
and women.
Researchers have obtained similar results in an international context. Using an extraordi�
narily detailed database on Finnish investors, Professors Mark Grinblatt and Matti Keloharju
find that trading activity increases with psychological measures of �overconfidence.
�Interestingly, they also find that trading activity increases with the number of speeding tickets
an individual receives, which they interpret as a measure of sensation seeking, or the
Â�individual’s desire for novel and intense risk-taking experiences. In both cases, the increased
trading does not appear to be profitable for investors.12

Figure 13.4╇ Individual Investor Returns Versus Portfolio Turnover

20%

15%
Annual Return

10%

5%

0%
Q1 Q2 Q3 Q4 Q5 S&P 500
(lowest turnover) (highest turnover)

The plot shows average annual return (net of commissions and trading costs) for individual
investors at a large discount brokerage from 1991–1997. Investors are grouped into quintiles
based on their average annual turnover. While the least-active investors had slightly (but not
significantly) better performance than the S&P 500, performance declined with the rate of
turnover.
Source: B. Barber and T. Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Indi-
vidual Investors,” Journal of Finance 55 (2000): 773–806.

11
B. Barber and â•›T. Odean, “Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment,”
Quarterly Journal of Economics 116 (2001): 261–292.
12
M. Grinblatt and M. Keloharju, “Sensation Seeking, Overconfidence, and Trading Activity,” Journal of
Finance 64 (2009): 549–578.

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