Lesson 8: Behavioral Finance and Multifactor Models

Question 1

Individuals engage in the following 2 behaviors that are inconsistent with CAPM

Answer 1

1. Portfolios are not diversified, reasons:
   - familiarity bias: certain stocks may be more familiar
   - relative wealth concerns: investors may want to have the same stock as their friends or neighbors
2. Portfolios are excessively traded, reasons:
   - Overconfident in ones ability to choose stocks
   - Sensation seeking: investors who get more speeding tickets also trade more often
   Note: these behaviors do not contradict CAPM if they are not followed = large groups of investors

Question 2

The systematic behaviors may weaken CAPM, causing the market portfolio to not be efficient:

Answer 2

1. Disposition effect: investors hang on to losers and sell winners
2. Attention, mood, experience: investors may buy stocks which grab their attention since they are in the news or advertise, they may buy more if they are in a good mood, they may be more willing to buy if they’ve experienced good results in the past
3. Herd behavior: investors buy stocks that their friends or neighbors buy

Question 3

Some candidate methods for beating the market

Answer 3

1. Taking advantage of news
2. Stock recommendations: shorting the stocks that are recommended
3. Professional investors

Question 4

3 types of assets with returns that seem to violate market efficiency and produce (+) alpha

Answer 4

1. Small companies -> size effect
2. Value stocks: companies with high book-to-market ratios tend to have (+) alpha
3. Momentum: companies with higher recent past returns tend to generate positive alphas in the future, investing in such stocks -> momentum stategy

Question 5

3 possible explanations of market portfolio is not efficient

Answer 5

1. Proxy error: S&P 500 and index of equity in U.S companies, does not represent the full market, which includes bods, commodities, non-U.S equity,…
2. Behavioral biases
3. Alternative risk preferences and non-tradable wealth

Question 6

Arbitrage Pricing Theory (APT)

Answer 6

an alternative to CAPM, this is a multifactor model
A set of N factor portfolios is selected, Rfi: rate of return of factore portfolio i, βfi: beta with respect to that portfolio, s: an investment
E[Rs] - rf = Σ βs,fi (E[Rfn] - rf)
Simplify the equation = replace factor portfolio with self-financing portfolios:
E[Rs] = Σ βs,fi E[Rfn] , a self-financing portfolio is a portfolio in which we borrow the amount needed to invest in the portfolio at a risk-free rate -> drop the -rf

Question 7

3 self-financing factor portfolios:

Answer 7

1. Market capitalization: small firms are below median market value and big firms are above median market value. The portfolio buys small firms and finances itself = selling big firms -> small-minus-big (SMB) portfolio
2. Book-to-market ratio: low firms have a book-to-market ratio below the 30th percentile, high firms have a book-to-market greater than 70th percentile. The high-minus-low (HML) portfolio longs the high firms and shorts the low firms
3. Past returns. The prior one-year momentum (PRIYR) portfolio long stocks with top 30% of returns in the prior year and shorts stocks with bottom 30% of returns

Question 8

Fama-French-Carhart factor specification (FFC)

Answer 8

use the market portfolio plus the 3 specified self financing factor portfolios as its 4 factor. As market portfolio is not self financing, you must substract rf from its return
E[Rs] - rf = βs,Mkt (E[RMkt] - rf) + βs,smbE[Rsmb] + βs,hmlE[Rhml] + βs,pr1yr*E[Rpr1yr]