Unit 7 - Investor Behaviour and Capital Market Efficiency Flashcards
According to CAPM, what would it mean if the market portfolio is not equal to the efficient portfolio?
If the market portfolio is not equal to the efficient portfolio, then the market is not in the CAPM equilibrium.
Informed (sophisticated) vs Uninformed (naive) Investors
In the CAPM framework, investors should hold the market portfolio combined with risk-free investments. This investment strategy does not depend on the quality of an investor’s information or trading skill.
Rational expectations:
All investors correctly interpret and use their own information, as well as information that can be inferred from market prices or the trades of others.
Regardless of how much information an investor has access to, he can guarantee himself an alpha of zero by holding the market portfolio.
Because the average portfolio of all investors is the market portfolio, the average alpha of all investors is zero.
If no investor earns a negative alpha, then no investor can earn a positive alpha, and the market portfolio must be efficient.
The market portfolio can be inefficient only if a significant number of investors either:
Misinterpret information and believe they are earning a positive alpha when they are actually earning a negative alpha, or
Care about aspects of their portfolios other than expected return and volatility, and so are willing to hold inefficient portfolios or securities
In regards to behaviour of individual investors, explain under-diversification and portfolio biases (familiarity bias and relative wealth concerns)
There is much evidence that individual investors fail to diversify their portfolios adequately.
Familiarity bias - Investors favour investments in companies they are familiar with.
Relative wealth concerns - Investors care more about the performance of their portfolios relative to their peers (following what other people are doing)
Explain excessive trading and overconfidence (behaviour of individual investors):
According to the CAPM, investors should hold risk-free assets in combination with the market portfolio of all risky securities.
However in reality, a tremendous amount of trading occurs daily.
Overconfidence Bias - Uninformed individuals tend to overestimate the precision of their knowledge. Investors believe they can pick winners and losers when, in fact, they cannot, leading them to trade too much.
Sensation Seeking - An individual’s desire for novel and intense risk-taking experiences.
Individual behaviour and market prices (behaviour of individual investors):
If individuals depart from the CAPM in random ways, then these departures tend to cancel out.
Individuals will hold the market portfolio in aggregate and there will be no effect on market prices or returns.
In order for the behaviour of uninformed investors to have an impact on the market, there must be patterns to their behaviour that lead them to depart from the CAPM in systematic ways, thus imparting systematic uncertainty into prices -> common, and predictable, biases.
In regards to systematic trading biases, explain hang on the losers and the disposition effect:
Disposition effect - when an investor holds on stocks that have lost their value and sell stocks that have risen in value since the time of purchase.
Possible reasons:
increased willingness to take on risk when facing possible losses
a reluctance “to admit a mistake” by taking the loss
a belief that the losing stocks would bounce back and outperform the winners going forward <- not supported by the empirical evidence.
Investor Attention, Mood, and Experience (Systematic Trading Biases):
Investor attention - studies show that individuals are more likely to buy stocks that have recently been in the news, engaged in advertising, experienced exceptionally high trading volume, or have had extreme returns.
Mood: Sunshine generally has a positive effect on mood, and studies have found that stock returns tend to be higher when it is a sunny day at the location of the stock exchange.
Experience: Investors appear to put too much weight on their own experience rather than considering all the historical evidence. For instance, people who grew up and lived during a time of high stock returns are more likely to invest in stocks than people who experienced times when stocks performed poorly.
In regards to systematic trading biases, what is herd behaviour?
When investors make similar trading errors because they are actively trying to follow each other’s behaviour.
What are some possible reasons behind herd behaviour?
Informational Cascade Effects - where traders ignore their own information hoping to profit from the (superior) information of others.
Due to relative wealth concerns, to herd is to avoid the risk of underperforming their peers.
Professional fund managers may face reputational risk if they stray too far from the action of their peers.
Implications of behavioural biases:
If individual investors are (pervasively and persistently) engaging in strategies that earn negative alphas, and
if there are limited competition to exploit these non-zero alpha opportunities
It may be possible for more sophisticated investors to take advantage of this behaviour and earn positive alphas.
Trading on News or Recommendations:
Takeover offers: if you could predict whether the firm would ultimately be acquired or not, you could earn profits trading on that information (initial jump in after announcement, studies found that stocks that are subsequently taken over following the announcement tend to appreciate and have positive alphas, while those that are not acquired have negative alphas).
Stock Recommendations (E.g., Mad Money TV Show)
The Performance of Fund Managers:
Numerous studies report that the actual returns to investors of the average mutual fund have a negative alpha
Superior past performance is not a good predictor of a fund’s future ability to outperform the market.
Consistent with a competitive capital market: money chasing deals
Being able to consistently find profitable trading opportunities is a rare talent possessed by only the most skilled fund managers.
The winners and losers (efficiency of market portfolio):
The average investor earns an alpha of zero, before including trading
Beating the market should require special skills or lower trading costs
because individual investors are likely to be at a disadvantage on both counts, the CAPM wisdom that investors should “hold the market”
is probably the best advice for most people.
Implications: while professional managers may profit because of their talent, information, and superior trading infrastructure, little of those profits go to the investors.
