Lesson 8: Behavioral Finance and Multifactor Models

Question 1

Define behavior that is inconsistent with CAPM?

Answer 1

1. Portfolios are not diversified
   - Familiarity bias, certain stocks may be more familiar.
   - Relative wealth concerns, investors may want to have the same stocks as their friends or neighbors
2. Portfolios are excessively traded (CAPM suggests holding)
   - overconfidence in ones ability to choose stocks
   - sensation seeking. Investors who get more speeding tickets also trade more often

Question 2

Which behaviors contradict CAPM?

Answer 2

Not behaviors defined as “idiosyncratic”, meaning they are not followed in tandem by large groups of investors. Behaviors defined as systematic weaken CAPM, casing the market portfolio to not be efficient.

Question 3

Define behaviors seen as systematic

Answer 3

1. Disposition effect
2. Attention, mood, experience
3. Herd behavior

Question 4

What is the disposition effect?

Answer 4

Investors hang on to losers and sell winners

Question 5

What is the attention, mood, experience effect?

Answer 5

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.

Question 6

What is the herd behavior effect?

Answer 6

Investors buy the stocks that their friends or neighbors buy

Question 7

What the candidate methods for beating the stocks market?

Answer 7

1. Taking advantage of news
2. Stock recommendations
3. Professional investors

Question 8

How does one take advantage of news?

Answer 8

For example, when a company may be taken over at a premium, the stock price doesn’t rise all the way to the offer price. But this is because of uncertainty regarding the takeover. If someone could predict the future, they might beat the market.

Question 9

How does one beat the market with stock recommendations?

Answer 9

Stock recommendations usually lead to jumps in the prices of the recommended stocks. But these jumps usually are higher than justified. Professionals may be able to beat the market by shorting these stocks, but it is not always easy to short these stocks since they may not be easily available.

Question 10

How does one beat the market with professional investors?

Answer 10

Good fund managers may be able to beat the market. However, individual investors must pay a management fee to get services of a fund manager, and it’s rare that the alpha generated by a fund manager is higher than the management fee.

Question 11

Name three asset types with returns that seem to violate market efficiency and produce positive alpha

Answer 11

1. Small companies, firms with low market capitalization.
2. Value stocks, companies with high book to market ratios.
3. Momentum, companies with higher recent past returns.

Question 12

What is the size effect?

Answer 12

Small companies, firms with low market capitalization, tend to have positive alphas. They are more risky, but their returns are higher than suggested by CAPM even when that is taken into account. This is called a size effect.

Question 13

What is a value stock?

Answer 13

Value stocks, companies with high book to market ratios tend to have positive alphas. Companies with high book-to-market ratios are called value stocks.

Question 14

What is a momentum strategy?

Answer 14

Companies with higher recent past returns tend to generate positive alphas in the future. Investing in such stocks is called a momentum strategy.

Question 15

What are the implications of observed assets with positive alpha?

Answer 15

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

Question 16

Define proxy error

Answer 16

Perhaps the true market portfolio is efficient, but the proxy we use is not. The S&P 500, and index of equity in U.S. companies, does not represent the full market, which includes bonds, commodities, non-U.S. equity, and so on.

Question 17

Define alternative risk preferences and non tradable wealth

Answer 17

Investors may have alternative goals to maximizing return per unit of volatility. And they may have human wealth that has to factor in. For example, an employee of a financial firm is invested in the financial industry implicitly and may choose to diversify to other industries rather than holding a full market portfolio.

Question 18

What are three self financing factor portfolios?

Answer 18

1. Market capitalization
2. Book-to-market ratio
3. Past returns

Question 19

What is the market capitalization portfolio?

Answer 19

Small firms are below median market value and big firms are above median market value. The portfolio buys small firms and finances itself by selling big firms. This is the small-minus-big (SMB) portfolio.

Question 20

What is the book-to-market portfolio strategy?

Answer 20

Low firms have a book-to-market ratio below the 30th percentile. High firms have a book-to-market ratio greater than the 70th percentile. The high-minus-low (HML) portfolio longs the high firms and short the low firms.

Question 21

What is the past returns portfolio strategy?

Answer 21

The prior one-year momentum (PR1YR) portfolio longs stocks with the top 30% of returns in the prior year and shorts stocks with the bottom 30% of returns.

Question 22

What is a self-financing portfolio?

Answer 22

A portfolio in which we borrow the amount needed to invest in portfolio at the risk free rate.

Question 23

What is the Arbitrage Pricing Theory?

Answer 23

A multi factor model that is an alternative to CAPM

Question 24

What is the Fama-French-Cathcart factory specification (FFC)?

Answer 24

Uses the market portfolio plus the SMB, HML, and PR1YR self financing portfolios as its four factors. Since the market portfolio is not self financing, you must subtract r from its return.

Question 25

What is an advantage of APT over CAPM

Answer 25

APT doesn’t need a market portfolio. APT can use various factors.