Class for bachelor students

Finance (10 ECTS)

Corporate Finance ( 5 ECTS)
Week 10: Investor Behavior and Capital Market Efficiency
(Chapter 13 in Berk/DeMarzo)

Steffen Meyer
stme@[Link]

1
 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 Techniques and the Market Efficiency Debate
13.7 Multifactor Models of Risk
13.8 Methods Used in Practice
Appendix

2
 Learning Objectives

1. Compute a stock’s 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 security’s alpha.
4. Explain why holding the market portfolio does not depend on the quality of an
investor’s information or trading skills.
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.

3
 Learning Objectives (cont’d)

9. Assess how uninformed investors’ behavior deviates from the CAPM in

systematic 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.

4
 Learning Objectives (cont’d)

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 portfolio’s efficiency.
18. Describe the Arbitrage Pricing Theory.
19. Discuss the expected return on a self-financing portfolio.
20. Discuss the Fama-French-Carhart model.

5
 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.

rs = rf +  s  (E[RMkt ] − rf )

6
 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.

 s = E[Rs ] − rs
▪ When the market portfolio is efficient, all stocks
are on the security market line and have an alpha of zero.

7
Figure 13.1 An Inefficient Market Portfolio

8
 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.

9
Figure 13.2 Deviations from the Security Market Line

10
 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.

11
Textbook Example 13.1

12
Textbook Example 13.1

13
 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.

14
 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.

15
 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.

16
 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.

17
 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 with which they are familiar.
▪ Relative Wealth Concerns
▪ Investors care more about the performance of their portfolios relative to
their peers.

18
 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.

19
 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

20
 Figure 13.3 NYSE Annual Share Turnover, 1970–2015

Source: [Link]

21
 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.)
22
 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.

23
 13.4 Systematic Trading Biases

▪ Hanging on to Losers and the Disposition Effect

▪ Disposition Effect
▪ An investor holds on to stocks that have lost their value and sell stocks
that have risen in value since the time of purchase.

24
 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.

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 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 are people who experienced times
when stocks performed poorly.

26
 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

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 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.

28
 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.

29
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.
30
 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.

31
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.
32
 13.5 The Efficiency of the Market Portfolio (cont’d)

▪ 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 fund’s future
ability to outperform the market.

33
Figure 13.7 Manager Value Added and Investor Returns for
U.S. Mutual Funds (1977–2011)

34
 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 63
(2008): 1805–1847.
35
 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.

36
 13.6 Style-Based Techniques 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.

37
 Figure 13.9 Excess Return of Size Portfolios, 1926–2015

Source: Data courtesy of Kenneth French.

38
 Figure 13.10 Excess Return of Book-to-Market Portfolios, 1926–
2015

Source: Data courtesy of Kenneth French.

39
 13.6 Style-Based Techniques 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.

40
Textbook Example 13.2

41
Textbook Example 13.2 (cont’d)

42
 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?

43
 Alternative Example 13.2A (cont’d)

▪ 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?

44
 Alternative Example 13.2A (cont’d)

▪ Solution
$2,200,000
Market ValueABC = = $18,333,333
0.12
$2,200,000
Market ValueXYZ = = $13, 750, 000
0.16

▪ ABC has an expected return of 12%.

▪ XYZ has an expected return of 16%.

45
 Alternative Example 13.2A (cont’d)

▪ Solution
▪ αABC = 12% - 15% = -3%
▪ αXYZ = 16% - 15% = 1%
▪ The firm with the lower market value has the
higher alpha.

46
 13.6 Style-Based Techniques 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.

47
 13.6 Style-Based Techniques 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.

48
 13.6 Style-Based Techniques and the Market Efficiency Debate
(cont’d)

▪ Implications of Positive-Alpha Trading Strategies

▪ 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.

49
 13.6 Style-Based Techniques and the Market Efficiency Debate
(cont’d)

▪ Implications of Positive-Alpha Trading Strategies

▪ 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.

50
 13.7 Multifactor Models of Risk

▪ The expected return of any marketable security is

E[Rs ] = rf =  seff  (E[Reff ] − rf )

▪ 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.

51
 13.7 Multifactor Models of Risk (cont’d)

▪ Using Factor Portfolios

▪ Given N factor portfolios with returns RF1, . . . , RFN, the expected return of asset s
is defined as follows:
E[Rs ] = rf +  sF 1 (E[RF 1 ] − rf ) +  sF 2 (E[RF 2 ] − rf ) + +  sFN (E[RFN ] − rf )
N
= rf + 
n =1
s
FN
(E[RFN ] − rf )

▪ β1…. βN are the factor betas.

52
 13.7 Multifactor Models of Risk (cont’d)

▪ 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.

53
 13.7 Multifactor Models of Risk (cont’d)

▪ Using Factor Portfolios

▪ A self-financing portfolio can 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.

54
 13.7 Multifactor Models of Risk (cont’d)

▪ Using Factor Portfolios

▪ If all factor portfolios are self-financing, then

E[Rs ] = rf +  sF 1E[RF 1 ] +  sF 2 E[RF 2 ] + +  sFN E[RFN ]

N
= rf +  s (E[RFN ])
 FN

n =1

55
 13.7 Multifactor Models of Risk (cont’d)

▪ 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.

56
 13.7 Multifactor Models of Risk (cont’d)

▪ Selecting the Portfolios

▪ 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.

57
 13.7 Multifactor Models of Risk (cont’d)

▪ Selecting the Portfolios

▪ 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 this
position 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.

58
 13.7 Multifactor Models of Risk (cont’d)

▪ Selecting the Portfolios

▪ Fama-French-Carhart (FFC) Factor Specifications

E[Rs ] = rf +  sMkt (E[RMkt ] − rf ) +  sSMB E[RSMB ]

+  sHML E[RHML ] +  sPR1YR E[RPR1YR ]

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Table 13.1 FFC Portfolio Average Monthly Returns, 1927–2015

60
Textbook Example 13.3

61
Textbook Example 13.3 (cont'd)

62
 Alternative Example 13.3A

▪ Problem
▪ You are considering making an investment in a project in the semiconductor
industry.
▪ The project has the same level of non-diversifiable risk as investing in Intel
stock.

63
 Alternative Example 13.3A (cont’d)

▪ Problem (continued)
▪ Assume you have calculated the following factor betas for Intel stock:

 INTC
Mkt
= 0.171
 INTC
SMB
= 0.432
 INTC
HML
= 0.419
 INTC
PR1YR
= 0.121
▪ Determine the cost of capital by using the FFC factor specification if the
monthly risk-free rate
is 0.5%.

64
 Alternative Example 13.3A (cont’d)

▪ Solution
E[Rs ] = rf +  sMkt (E[RMkt ] − rf ) +  sSMB E[RSMB ]
+  sHML E[RHML ] +  sPR1YR E[RPR1YR ]
E[Rs ] = 0.5% + (0.171)(.61%) + (0.432)(0.25%)
+(0.419)(0.38%) + (0.121)(0.70%)
E[Rs ] = 0.005 + 0.001043 + 0.001080 + 0.001592 + 0.000847
E[Rs ] = 0.009562
▪ The annual cost of capital is 0.009562 × 12 = 11.47%

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 Alternative Example 13.3B

▪ Problem
▪ You are considering making an investment in a project in the financial
services industry.
▪ The project has the same level of non-diversifiable risk as investing in Bank
of America stock.

66
 Alternative Example 13.3B (cont’d)

▪ Problem
▪ Assume you have calculated the following factor betas for Bank of
America stock:
 BAC
Mkt
= 0.186
 BAC
SMB
= 0.514
 BAC
HML
= 0.382
 BAC
PR1YR
= 0.211
▪ Determine the cost of capital by using the FFC factor specification if the
monthly risk-free rate
is 0.1%.

67
 Alternative Example 13.3B (cont’d)

▪ Solution
E[Rs ] = rf +  sMkt (E[RMkt ] − rf ) +  sSMB E[RSMB ]
+  sHML E[RHML ] +  sPR1YR E[RPR1YR ]
E[Rs ] = 0.1% + (0.186)(.61%) + (0.514)(0.25%)
+(0.382)(0.38%) + (0.211)(0.70%)
E[Rs ] = 0.001 + 0.001135 + 0.001285 + 0.001452 + 0.001477
E[Rs ] = 0.006348
▪ The annual cost of capital is 0.006348 × 12 = 7.62%

68
 13.7 Multifactor Models of Risk (cont’d)

▪ 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.

69
 13.7 Multifactor Models of Risk (cont’d)

▪ 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.

70
 13.8 Methods Used In Practice

▪ Financial Managers
▪ A survey of CFOs found that 73.5% of the firms used the CAPM to calculate the
cost of capital.
▪ 40% used historical average returns
▪ 16% used the dividend discount model
▪ Larger firms were more likely to use the CAPM than were smaller firms.

71
 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): 187–243.

72
 13.8 Methods Used in Practice

▪ Investors
▪ In a recent study of the different risk models examined, investor behavior
was found to be most consistent with the CAPM.

73
 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?

74
 Chapter Quiz (cont’d)

4. What are some of the systematic behavioral biases to which individual

investors fall prey?
5. If fund managers are so smart, why do the returns on their funds not have
positive alphas?
6. What does the existence of a positive-alpha trading strategy imply about
market efficiency?

75
 Chapter Quiz (cont’d)

7. What is the advantage of a multifactor model over a single factor model?

8. What is the most popular method used by corporations to calculate the cost
of capital?
9. What other techniques do corporations use to calculate the cost of capital?

76
Appendix

Chapter 13

77
 Appendix

▪ Building a Multifactor Model

▪ Assume that there are two portfolios that can be combined to form an
efficient portfolio.
▪ These are called factor portfolios, and their returns are denoted as
RF1 and RF2. The efficient portfolio consists of some (unknown)
combination of these two factor portfolios, represented by portfolio
weights x1 and x2:

78
 Appendix (cont’d)

▪ Building a Multifactor Model

▪ To see if these factor portfolios measure risk, regress the excess returns of
some stock s on the excess returns of both factors:

▪ This statistical technique is known as a multiple regression.

79
 Appendix (cont’d)

▪ Building a Multifactor Model

▪ A portfolio, P, consisting of the two factor portfolios has a return of

which simplifies to

80
 Appendix (cont’d)

▪ Building a Multifactor Model

▪ Since εi is uncorrelated with each factor, it must be uncorrelated with the
efficient portfolio:

81
 Appendix (cont’d)

▪ Building a Multifactor Model

▪ Recall that risk that is uncorrelated with the efficient portfolio is diversifiable
risk that does not command a risk premium. Therefore, the expected return
of portfolio P is rf , which means αs must equal zero.
▪ Setting αs equal to zero and taking expectations of both sides, the result
is the following two-factor model of expected returns:

82