Behavioral Finance and Multifactor Models

Question 1

What are the three assumptions on which the CAPM is based?

Answer 1

1. Efficient transactions
2. Rationality
3. Homogenous expectations

Question 2

Why is it enough to assume “rational expectation” instead of “homogenous expectations” for the CAPM to hold? (alpha)

Answer 2

If an investor is rational, he will hold the mkt ptf with an alpha = 0 rather than investing in something with a negative alpha.

Question 3

What two behaviors are inconsistent with CAPM ?

Do they contradict CAPM?

Answer 3

1. Portfolios are not diversified
2. Portfolios are excessively traded
   No they do not if they are idiosyncratic

Question 4

What are two reasons to explain that portfolios are not diversified?

Answer 4

1. Familiarity bias

2. Relative wealth concerns (wanting to hold the same stocks as friends/family)

Question 5

What are two reasons to explain that portfolios are excessively traded?

Answer 5

1. Overconfidence

2. Sensation seeking

Question 6

What are the systematic behaviors that may weaken CAPM, causing the market portfolio to be inefficient?

Answer 6

1. Disposition effect
2. Attention, mood and experience
3. Herd behavior (buying the stocks that friends buy)

Question 7

What is the disposition effect?

Answer 7

Selling of winners and holding on to losers.

Question 8

Why is it not profitable to hire a fund manager?

Answer 8

The alpha they generate is not high enough to cover the management fees.

Question 9

What are three types of assets with returns that seem to violate market efficiency (produce positive alphas)?

Answer 9

1. Small companies (low market cap)
2. Value stocks (high book to market ratio)
3. Momentum

Question 10

What are three possible explanation why the market portfolio is not efficient?

Answer 10

1. Proxy error
2. Systematic behavioral biases
3. Alternative risk preferences and non-tradable wealth

Question 11

What is the Arbitrage Pricing Theory (ADT)?

Answer 11

An alternative to the CAPM.

The ADT is a multi factor model.

Question 12

What is a self financing portfolio?

Answer 12

Portfolio for which we borrow the amount needed at the risk-free rate.

Question 13

Is the market portfolio self-financing?

Answer 13

No.

Question 14

What are the 4 factors in the FFC model, and which are self-financing (SF)?

Answer 14

1. SMB (SF)
2. HML (SF)
3. PR1YR (SF)
4. Market portfolio

Question 15

What is the prior one year (PR1YR) portfolio?

Answer 15

Buy the top 30% stocks of the prior year, finance it by shorting the bottom 30% stocks of the prior year.