Chapter 13 - Investor behaviour and capital market efficiency

Question 1

To improve the performance of their portfolios, what will investors do?

Answer 1

They will compare the expected return of hte stocks against the required return from the CAPM. If there is a deviaiton, they will act upon it.

For instance, if they have gained an understanding of some stock having 10% expected return, but hte required return from its level of risk is smaller, then this is a good bet, and the investor will increase his share in this firm. By how much? I suppose this is answered later

Question 2

If we have information that some stock has a different expected return than the CAPM’s reuqired return indicate, where is it placed on SML?

Answer 2

Above or below the line. Above it the expected return is higher than the required return.
Below if the expeccted return is lower than the required return.

Question 3

E[R_s] - r_s = ..?

Answer 3

This is the expected return of secruity s less the required return of security s. We define this to be the alpha of security s.

Question 4

What happens if a stocks alpha is not 0?

Answer 4

Inveestors can imrpove their portfolios so that they beat the market

Question 5

How do we act if some stock has negative alpha?

Answer 5

We sell it or short it

Question 6

elaborate on SML convergence

Answer 6

Stocks, even with non-zero alpha will converge towards the SML because as investors act upon opportunities with non-zero alpha, their additional supply and demand will increase and decrease prices, which will affect the capital gain rate of the investment, which will affect the expected return of the investment. This happens, and the expected return of the investment will converge towards the required return given by the capital asset pricing model.

Question 7

What is the real outcome of the SML convergence?

Answer 7

In competitive markets, the CAPM assumption, while not 100% true, is highly accurate.

Investors who actively try to seek non-zero alpha to profit on will drive stock convergence towards SML

Question 8

If we assume that all investors have access to the same information at hte same time, what is the main outcome in regards to alpha?

Answer 8

We will adjust prices and alpha without trade.

This is because if news come out that bump the alpha of stock X, then holders of X would obviously not want to sell at the old price. In fact, they want to sell at the new price that accounts for the news. Thus, the price is immediately driven up, and the expected return of the stock decrease, which also decrease alpha. Now, we have converged at SML without trade.

Question 9

Which assumption of CAPM must be wrong if someone are to profit in the market?

Answer 9

the assumption of homogeneous information.

Question 10

Answer 10

Question 11

Does CAPM depend on homogeneous expectations?

Answer 11

No. CAPM depends on RATIONAL expectations.

Every investor can guarantee himself average returns by holding the market portfolio. Therefore, as long as you understand that other people know more than you, and therefore can take advantage of this, you would be better of earning zero alpha returns. Since every noob does this, there are no one for the better investors to profit from. Therefore, since the better investors understand that everyone holds the market, they should do the same, because if no investor earns negative alpha, no one can earn positive alpha.

For an investor to gain positive alpha, someone must hold negative alpha. Since it is possible to earn 0 alpha, we’d expect no one to earn negative alpha. THere are 2 important outcomes to this

Question 12

What are the outcomes of the assumption of RATIONAL EXPECTATIONS?

Answer 12

The market portfolio can be inefficient only if a significant number of investors either:
1) Do not have rational expectations. Meaning, they misinterpret shit, or believe they are better than they actually are, so they think they will earn positive alpha while they actually earn negative alpha.

2) Care about certain aspects of their portfolios more than risk vs return, and therefore willingly hold a portfolio that will return negative alpha.

Question 13

median number of stock held by investors

Answer 13

4

Question 14

percentage of investors holding less than 10 stocks

Answer 14

90%

Question 15

relationship between your funds and your employers stock

Answer 15

approx 1/3 of your funds is typically allocated there

Question 16

what is familiarity bias

Answer 16

Investing in shit you have a close connection to

Question 17

what are relative wealth concerns?

Answer 17

Wish to keep your returns higher or at par with other relatives and people you know

Question 18

what is the outcome of relative wealth concerns, and familiarrity bias?

Answer 18

People are generally not diversified

Question 19

what can we say about excessive trading?

Answer 19

If people followed CAPM, we’d expect very little trading volume. However, the volume is actually insane, so this is good indication that CAPM is not exactly strict religion.

Recall that the reason why we expect low volume is that the market portfolio is value weighted, which also means that it is a passive portfolio. Since it is a passive portfolio, there is no need to actively trade while holding it.

Question 20

Why do people trade so much?

Answer 20

Overconfidence bias. Same reason why people believe they can pick winners and losers in sports betting.

Apparently, it is a risk seeking thing, like sensation seeking. It is actually correlated with speeding tickets.

Question 21

So, we know that most poeple deviate from CAPM. Does this invalidate capm?

Answer 21

Not necessarily. If the deviations are idiosyncratic, then it is still valid. So the question becomes: What cause people to deviate? is it common things, or independentthings?

In other words, in order for the deviations to affect market prices, we’d have to see some systematic deviations

Question 22

elaborate on the disposition effect

Answer 22

Hanging on to losers and selling winners. systematic trading bias.

Apparently, there is a tendency to do so.

Kahneman and Tversky alleged that this is a result of people being willing to bear more risk in the present of facing losses.

Question 23

herd behavior

Answer 23

systematic trading bias. Follow other people.

Question 24

What is outcome of the various systematic trading biases that occur?

Answer 24

Many investors earn negative alpha. therefore, there might be opportunities for better investors.

Question 25

what needs to happen for there to exist positive alpha opportunities?

Answer 25

the mistakes made by shit investors must be of a certain magnitude that makes prices move. Move enough to be recognized.

Secondly, there must be only a few who notice it. Low competition.

Question 26

what usually happns if there are news of a takeover happening?

Answer 26

The share price will move towards the offer price. The offer price will typically be a significant premium compared to the current price. However, it will likely not go all the way to the offer price. This is because there are still ikely some uncertainty regardging teh deal.

Question 27

elaborate on public stock recommandations from analysts etc

Answer 27

For smaller stocks, the recommendation may have a tendency to push the price too high. This actually makes the case that the stock will have negative alpha for a duration of time afterwards.

However, whne the recommendation came with the addition of a news of the firm, the stock price change typically lasted (was correct).

The conclusion here is that low liquidity firms typically see the negative alpha after recommendaitons. it is too easy to influence the share price.
larger firms does nto have this problem.

Question 28

What is the value added by a fund manager?

Answer 28

Alpha before fees. Also known as gross alpha.

Or to be more specific, the value added by a fund manager is equal to the gross alpha multiplied by the total assets under his control. In other words, the additional value of the fund manager (as compared to the situation without a fund manager, which is basically just holding the market portfolio passively) is the value he adds by beating the market by the alpha (gross alpha).

Question 29

what can we say about hte median fund manager+

Answer 29

Destroys value

Question 30

What can we say about hte mututal fund industry as a whole?

Answer 30

It adds value because skilled fund managers typically sit on the largest money pools, and therefore add more value than the shitty fund managers loose.

Question 31

So, some skilled fund managers generate positive gross alpha. Elaborate on how this relates to return to investors

Answer 31

Short answer: Investors gain nothing.

The average net alpha is negative. this is because of fees. Gross alpha is positive on average, but net alpha is negative.

Question 32

Some funds generate positive alpha for their investors. Is it possible to find htem?

Answer 32

No.

Past performance is not indicative of the future. if a dude generate shit loads of cash, people will notice it, and invest in his fund. The more money the fund has, the harder it is to find good investments. In fact, it will converge towards the market portfolio. At this point, you’d get market returns but receive negative net alpha because of the fees.

Question 33

When will the inflow of cash to the fund cease?

Answer 33

Whenever the net alpha becomes 0.