Chapter 13 - Investor behavior and Capital Market Efficiency Flashcards
what is a stocks alpha?
Alpha of a stock is the difference between its expected return and required return according to the security market line.
When are all stock located along the security market line?
When the portfolio of them is efficient. This corresponds to an alpha of 0, because there is not difference between expected return and required return.
We buy stocks with positive alpha, because this will improve the Sharpe ratio.
We short/sell stocks with negative alpha, because this will also improve the Sharpe ratio.
What two important consequences comes from the CAPM n regards to the actions of “savvy” investors?
1) while the market is not necessarily always efficient, competition between investors will make the market portfolio close to efficient much of the time.
2) there may exist trading strategies that take advantage of stock with non-zero alphas and by doing this can beat the market.
If investors identify a stock with positive alpha, what happens?
As they buy the stock, the stock price will rise, which will lower the expected return, which will decrease the alpha.
Recall that alpha is the difference between expected returns and required returns. Therefore, is alpha is positive, the expected returns is bigger than required return. Therefore it will be added to portoflios. As this happens, demand increas,e and price increase. Since expected return is about dividends and capital gain rate, decreasing the capital gain rate will decrease the expected returns, and it will move close to the required return.
If some important news of a stock is publicly announced and all ivnestors receive it at the same time, and are fierce in competition, wht is the result?
We can get price movement before any transacations occur. If the news is favorable to the stock, investors are not willing to sell at the old price. Therefore, they sell at the new price that reflect the news change. Because of this, the alpha actually remains 0 throughout the sequence of events.
This lead to an important result: in order to profit by buying a positive alpha stock, there must be someone willing to sell it.
In a perfect world, no one would sell a positive alpha stock.
how does CAPM place itself in regards to the transactions of positive alpha stocks?
First of all, we assume that in a perfect scenario, no one would sell a positive alpha stock. Therefore, the idea is that skillful investors with better and more research can take advantage of naive investors and thereby making such transactions occur.
However, according to the CAPM, every investor should hold the market portfolio along with risk-level of risk-free investment. This is sound advice that requires absolutely no research. The outcome of this is that “naive” investors are not taken advantage of by “better” investors.
Elaborate on CAPM and rational expectations
Every investor can earn average return and earn an alpha of 0 by holding the market portfolio.
Thus, because investors can earn an alpha of 0 by simply holding the market portfolio, no one would earn a negative alpha.
In order for someone to earn a positive alpha, someone would have to earn a negative alpha. Therefore, everyone must hold the market portoflio, and it is efficent.
Because of this, CAPM does not depend on homogenuous expectation assumptions, meaning that CAPM doesnt require the assumption that everyone knows the same things. Rather, it requires that all investors have rational expectaitons, in the sense that they understand their position, their informaiton.
From all this, we reach the following conclusions:
For the market portfolio to be ineffcient (and allow for someone to beat the market average), one of the following must hold:
1) Investors dont have rational expectations so they believe they are earning positive alpha when they actually earn negative alpha.
2) Investors care about aspects of their portfolio more than expected return and volatility.
Why is holding the market portfolio the same as getting average returns/0 alpha?
The market portfolio is the aggregate of all investors portfolio. Therefore, by holding the aggregate of all investors, you will get the average return of all investors as well.
name two reasons why people may not diversify as much as they should
familiarity bias
relative wealth concern
If investors violate the assumptions of CAPM and trade too much and are not diversified, will it mean that CAPM conclusions are invalid?
Not necessarily. If the deviations from CAPM is idiosynctratic, random, then it is still fine, because all of these deviations will cancel out each other.
In order for individual investors to have an impact on the market, there must be patterns to their actions that lead them to deviate from CAPM. There must be some systematic ways that they deviate from CAPM. For investors to act like this, there must be a common motivation that they share.
Let us consider the errors investors make that can give room for better investors to earn more money. Name some usual suspects
The disposition effect. This is about hanging on to losers and selling winners.
Selling winners is costly because of tax purposes. We essentially reduce present value by selling the winner early.
investor attention, mood and experience. People are generally not full time investors, and are likely to be influenced by things like news and stories etc. Fair of missing out is certainly here as well. Experience is also important: People value their own experiences a lot more than other data, and will therefore often completely rely on their own experience rather than collecting objective data.
herd behavior. For instance following the actions of a known great investor.
What is the prospect theory?
work by Kahneman and Tversky.
It is about how people make decisions when faced with uncertainty. It is about predicting the choices people actually “do” rather then the ones they “should” do.
What implications might systematic behavioral biases have for the CAPM?
iF people engage in bad strategies, there is opportunities to earn positive alpha for savvy investors.
Generally speaking, what must happen for there to be opportunities in terms of earning above average returns?
The behavioral biases that are systematic must push prices so that non-zero alpha trading opprtunities become apparent.
Recall that alpha is the difference between expected return and required return.
Then, there must also be limited competition among these non-zero alpha opportunities so that the prices are not immediately adjusted.
Remember: The idea we explore is to beat the market without taking on additional risk.
What usually happens to the stock price of a firm that is subject to a takeover offer?
The price will usually move close to the offer price. The reason why it is not at the offer price, is because there might still be some uncertainty regarding whether the takeover will actually happen or not etc.
