FINA 6112 Investment and Portfolio Analysis

Lecture 5: Capital Market Efficiency &

Investor Behavior

LUO Dan
Recap of Portfolio allocation & CAPM
• Optimal portfolio
– Take 𝐸 𝑅! and 𝐶𝑜𝑣 𝑅! , 𝑅" as given, choose portfolio weights
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max $ 𝑥% 𝐸 𝑅% − ⋅ 𝐴 ⋅ $ $ 𝑥% 𝑥& 𝐶𝑜𝑣 𝑅% , 𝑅&
∑! "! #$ % 2 % &

• Tangent portfolio
– The risky portfolio with the highest Sharpe ratio

$%&'E%)*%#+,-.//#0.'1&2 #! $! "#!#%"
P4R&S.#0R'*%#=# #=#
$%&'E%)*%#7%)R'*)*'8 &DV $! :

• Investors allocate between the tangent portfolio and the risky-free asset
– Risk aversion determines the weight of the tangent portfolio
𝐸 𝑅' − 𝑟(
𝑥=
𝐴 ⋅ 𝑉𝑎𝑟 𝑅'

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Recap of Portfolio allocation & CAPM
• The tangent portfolio and any asset satisfy
𝐶𝑜𝑣 𝑅% , 𝑅'
𝐸 𝑅% − 𝑟( = 𝐸 𝑅' − 𝑟(
𝑉𝑎𝑟 𝑅'

• CAPM: The market portfolio is the tangent portfolio.

– The aggregate risky portfolio that investors want to hold is the tangent portfolio.
– The aggregate risky portfolio that investors can hold is the market portfolio.
– By market clearing, they must be the same.

• Asset pricing under CAPM

!"#$%&#&%'(") (!(%*$%(&+(,"--".(/&%*(%*0(-$120%
!""" "#"""" $
%C3 D! 4(5(()** 3 D! 6 D"#$ 4 ()+3 D! 6 D"#$ 4
!! (7 (7( (
%C3 D"#$ 4 ,-* 3 D"#$ 4

&0 '! 1%2%E! %2%E" %3% !! 4 "0 ##$% 1%!%$" R

!""#""$
!"#$%&'()"*)%+,'%#(-*'"./%!

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Many Things Not Considered in CAPM
• Many assets are not tradable
– Human capital, which generates labor income
– Implication: the true market is much broader than the financial
market, and a person’s asset allocation in the true market is
constrained.

• Liquidity
– Liquidity of an asset is the ease and speed with which it can be sold
at fair market value.
– Illiquidity can be measured in part by the discount from fair market
value a seller must accept if the asset is to be sold quickly.
– Transaction is not free.

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The Relationship Between Illiquidity and
Average Returns

• Source: Derived from Amihud, Y., & Mendelson, H. (1986). Asset pricing and the
bid–ask spread. Journal of Financial Economics, 17, 223–249.

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Liquidity
𝑇ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑦𝑜𝑢 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒𝑙𝑦 𝑒𝑎𝑟𝑛 = 𝑅' − 𝑅'((')*'+',-

• 𝑅'((')*'+',- is not fixed.

– In a financial crisis, liquidity can unexpectedly dry up
– When liquidity in one stock decreases, it commonly tends to
decrease in other stocks at the same time.

• “Liquidity betas”
– When the market-wide liquidity dries up, how much an asset’s
liquidity dries up
– A measure for liquidity risk
– Investors demand compensation for liquidity risk: firms with
greater liquidity risk having higher average returns.

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Stock’s Alpha
• A security’s required return from the security market line.

&! !=!&" !+!! ! " ! '" E#$% #!#!&" $

• A stock’s alpha: the difference between a stock’s expected

return and its required return according to the security
market line.
!! "="#! $! "!! %! "

• When the CAPM holds, all stocks are on the security market
line and have an alpha of zero.
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Non-zero Alpha
• Suppose that the CAPM captures stocks’ risks and should hold, but
does not hold exactly due to some frictions.

• Positive alphas
mean prices are
too low.
• Negative alphas
mean prices are
too high

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Non-zero Alpha
• Arbitrage
– The exploitation of security mispricing in such a way that risk-free
profits can be earned.

• Non-zero alphas imply arbitrage opportunities.

– Investors buy stocks with positive alphas and sell stocks with negative
alphas such that the average beta of the portfolio does not change.

• Arbitrage trading will largely eliminate non-zero alphas.

– Push up the price of stocks with positive alphas, decrease their
expected returns.
– Push down the price of stocks with negative alphas, increase
their expected returns.

• If CAPM correctly captures risk, non-zero alpha cannot

exist systematically.
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Positive-alpha Trading Strategies
• Size Effects
– Small market capitalization stocks have historically earned higher
average returns than the market portfolio, even after accounting
for their higher betas.

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Positive-alpha Trading Strategies
• Value Premium:
– Book-to-Market Ratio: the ratio of the book value of equity to the
market value of equity.

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• Amazon @ Dec 31, 2021
– Market value: 1691b
– Book value: 138b

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Positive-alpha Trading Strategies
• Value Premium:
– Book-to-Market Ratio: the ratio of the book value of equity to the
market value of equity.
– High book-to-market stocks have historically earned higher
average returns than low book-to-market stocks.

Value stocks: high

book-to-market
ratio

Growth stocks: low

book-to-market
ratio

Who are value or

growth stocks?
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Sentence CAPM To Death?
• Persistent existence of sizeable nonzero alphas indicates
violation of the CAPM.
• Is alpha correctly calculated?
– Cannot observe all tradable assets, impossible to pin down the true
market portfolio.
– Most tests focus on an observed, but perhaps inefficient, stock
index portfolio.
– Parameters like beta are likely time varying.

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Sentence CAPM To Death?
• The implications of positive-alpha trading strategies
1. The CAPM correctly computes required risk premiums, but
investors are ignoring opportunities to earn extra returns, either
because they are unaware of them or because the costs to
implement the strategies are too large.

2. Investors make mistakes-- misinterpret information and believe

they are earning a positive alpha when they are actually earning
a negative alpha.

3. The CAPM is not exactly correct-- investors care about aspects

of their portfolios other than expected return and volatility, and so
are willing to hold inefficient portfolios of securities.

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Sentence CAPM To Death?
• The first hypothesis is deemed to be unlikely
– The strategies has been widely known for several decades.
– Not only is the information required to form the portfolios readily
available, but many mutual funds try to follow the strategies.

• Any test of a model like the CAPM is essentially a joint test

of the model and investors’ rationality.
– Under rationality assumption, we know exactly how investors
behave.
– If investors can make mistakes, what mistake do they make?

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Systematic Trading Biases
• Underdiversification and Portfolio Biases
– Observation: individual investors fail to diversify their portfolios
adequately.
– Familiarity Bias
§ Investors favor investments in companies with which they are
familiar
§ This could also be justified by that investors have limited
capacity to process information and thus focus on a subset.
– Relative Wealth Concerns
§ Investors care more about the performance of their portfolios
relative to their peers

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Systematic Trading Biases
• Excessive Trading and Overconfidence
– Observation: according to the CAPM, investors should hold risk-
free assets in combination with the market portfolio of all risky
securities. In reality, a tremendous amount of trading occurs each
day.
– Overconfidence Bias
§ Investors believe they can pick winners and losers when, in
fact, they cannot; this leads them to trade too much
– Sensation Seeking
§ An individual’s desire for novel and intense risk-taking
experiences

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Systematic Trading Biases
• Individual Investor Returns Versus Portfolio Turnover

Source: B. Barber and T. Odean, “Trading Is Hazardous to Your Wealth: The Common
Stock Investment Performance of Individual Investors,” Journal of Finance 55 (2000) 773–
806.

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Systematic Trading Biases
• Hanging on to Losers and the Disposition Effect
– Disposition Effect: an investor holds on to stocks that have lost
their value and sell stocks that have risen in value since the time
of purchase

• Herd Behavior
– Investors tend to follow each other’s behavior
– Informational Cascade: traders ignore their own information and
rely on the information inferred from others’ behavior.

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Systematic Trading Biases
• Investor Experience
– Investors appear to put too much weight on their own experience
rather than considering all the historical evidence.
– As a result, people who grew up and lived during a time of high
stock returns are more likely to invest in stocks than are people
who experienced times when stocks performed poorly.

• Investor Attention
– 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.

• Investor 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.
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Individual Behavior and Market Prices
• Does this observation imply that the conclusions of the
CAPM are invalid?

• Not necessarily
– If individuals’ departure from the CAPM is idiosyncratic, then these
departures will tend to cancel out.
– Even if individuals’ departure is somewhat systematic, arbitrage
trading may largely limit the effect on market prices.

• Then the question hinges on

– how systematic and strong are individuals’ biases.
– how strong sophisticated arbitrageurs are.
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Multifactor Models of Risk
• The CAPM a single factor model
– has only one risk that is priced – the market risk
– uses only one portfolio – the market portfolio

• More generally, 𝑁 risks can be captured by 𝑁 factor

portfolios
– The exposure to one risk is captured by the beta w.r.t. the
corresponding factor portfolio.

• Generalize the CAPM to multifactor models

– Given N factor portfolios with returns RF1, . . . , RFN, the expected
return of asset s is defined as follows:
&# '# $!=!E$ !+!! #! ! % &# '! ! $!"!E$ &!+!! #! " % &# '! " $!"!E$ &!+!!!+!! #!" % &# '!" $!"!E$ &
"
=!E$ !+!# ! #!" % &# '!" $!"!E$ &
%!=!!
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Selecting the Portfolios
• If a portfolio can persistently generate positive alphas,
certainly uncaptured systematic risk is attached to it.
• We should select these portfolios to capture the risks.
• Market portfolio
– buy the market and finances this position by borrowing at a risk-
free rate

• Small-minus-big (SMB) portfolio

– buy a set of small stocks and finances this position by short selling
a set of of big stocks

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Selecting the Portfolios
• High-minus-low (HML) portfolio
– buys a set of stocks with high book-to-market and finances this
position by short selling a set of stocks with low book-to-market
ratios

• Prior one-year momentum portfolio

– After ranking stocks by their return over the last one year, buy top
set of stocks and finances this position by short selling the bottom
set of stocks.

• Fama-French-Carhart (FFC) Factor Specifications

-" H! #!=!.& !+!! '!"# $ -" H!"# # "!.& %!!+!! '$!B -" H$!B #
!!!!!!!!!!!!!!+!! 'E!) -" HE!) # +!! '*H!,H -" H*H!,H #

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Exercise: Required Returns
Problem
– You are considering making an investment in a project in the
semiconductor industry.
– The returns of factor portfolios and the factor betas are

Average Monthly
Factor Portfolio Return (%) Factor Betas
Mkt 1.11 0.171
SMB 0.25 0.432
HML 0.38 0.419
PR1YR 0.70 0.121

– Determine the required return by using the FFC factor

specification if the monthly risk-free rate is 0.5%.

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Exercise: Required Returns
Solution
-" H& # = .' + ! &!"# $ -" H!"# # " .' % + ! &$!B -" H$!B #
+ ! &E!) -" HE!) # + ! &*H!,H -" H*H!,H #
-" H& # = &'() + $&'!*!%$'+!)% + $&',-.%$&'.()%
+$&',!/%$&'-0)% + $&'!.!%$&'*&)%
-" H& # = &'&&( + &'&&!&,- + &'&&!&0& + &'&&!(/. + &'&&&0,*
-" H& # = &'&&/(+.

– The annual required return is 0.009562 × 12 = 11.47%

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The Model Used In Practice

Source: J. R. Graham and C. R. Harvey, “The Theory and Practice of Corporate Finance:
Evidence from the Field,” Journal of Financial Economics 60 (2001): 187–243.

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The Model Used In Practice
• How do investors pick funds?
– Most consistent with the CAPM

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Evaluating Fund Performances
• The FFC factor specification is useful in measuring the risk
of actively managed mutual funds.
– Researchers have found that funds with high returns in the past
have positive alphas under the CAPM, but do not under the FFC.

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Efficient Market Hypothesis (EMH)

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Efficient Market Hypothesis
• EMH
– Prices of securities fully reflect available information.
– Investors buying securities in an efficient market should expect to
obtain a fair rate of return.

• Rationale
– Intelligent investors compete to discover relevant information on
which stocks to buy or sell before the rest of the market becomes
aware of that information.
– Strong competition assures prices quickly and thoroughly reflect
information.

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Efficient Market Hypothesis

• Stock price changes are random and

unpredictable
– Follows a martingale
– Because new information is unpredictable.
– Loosely correct.

• Strictly speaking, the expected price

change can be positive.
– Follows a submartingale
– compensation for TVM and systematic risk.

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Efficient Market Hypothesis

Figure Cumulative abnormal returns before takeover attempts: target companies.

Source: This is an update of a figure that appeared in Keown, A., & Pinkerton, J. (1981,
September). Merger announcements and insider trading activity. Journal of Finance, 36.
Updates courtesy of Jinghua Yan. 33
Versions of the EMH
1. Weak-form asserts that stock prices already reflect all
information contained in the history of past prices.
2. Semi strong-form asserts that stock prices already
reflect all publicly available information.
3. Strong-form asserts that stock prices reflect all relevant
information, including insider information.

• All versions assert that prices should reflect available

information but differ in what information is available to the
market.

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Technical Analysis
• Technical analysis
– Research to identify mispriced securities that focuses on recurrent
and predictable stock price patterns and on proxies for buy or sell
pressure in the market.

• Typical ideas of technical analysis

– Prices move in trends
– History tends to repeat itself

• If the EMH holds, is technical analysis is fruitful?

• All versions imply that it is fruitless.

• Key to success is a sluggish response of stock prices to

fundamental supply-and-demand factors.

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Fundamental Analysis
• Fundamental analysis
– Assessment of firm value that focuses on such determinants as
earnings and dividends prospects, expectations for future interest
rates, and risk evaluation

• Seeks to find firms that are mispriced compared to their

fundamental
• Attempt to find firms that are better than everyone else’s estimate
or troubled firms that may be great bargains

• Semi strong-form EMH predicts that most fundamental

analysis should be fruitless.
– It is possible that some fundamental analysis uncovers unique
information, but that should be very rare.

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Active Versus Passive Portfolio Management

Active Management Passive Management.

• Attempts to beat the market • Accept EMH: no attempt to
by timing the market or outsmart the market.
through superior security
selection.
• Take risk and enjoy
• Intend to earn positive
required returns.
alpha.
• Low-cost strategy: index
• An expensive strategy: hire
Funds and ETFs.
talents

• Under the EMH, passive management is favored

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Evaluating Fund Performances
• If fund managers really have skills, their performance should be
persistently high to some extent.
• Little persistence in relative performance across managers

• Figure Risk-adjusted performance in ranking quarter and following quarter.

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So, Are Markets Efficient?
• The picture is blurred.
• Enough anomalies exist in the empirical evidence to justify
the search for underpriced securities that clearly takes
place.
• However, the market is competitive enough that only
differentially superior information or insight will earn money.
• Margin of superiority that any professional manager can add
is so slight that the statistician will not easily be able to
detect it.

• Smart and hard-working people can make excess money.

For others, probably impossible.

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What Should Ordinary People Do？
• Investors’ abilities to collect and analyze information
determine the returns in excess of the average.

• Secondary markets are zero-sum games

– When someone makes money, there must be others losing money.

• How can you avoid being outsmarted in financial markets if

you are less informed than other investors?

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What Should Ordinary People Do？
• Hold the market portfolio!
• By holding the market portfolio, you guarantee the same
return as the average investor
– Math: the aggregate of all investors’ portfolio must equal the
market portfolio.

• On the other hand, if you don’t hold the market portfolio,

– Suppose hold less of Google. This must mean that in aggregate all
other investors have over-weighted Google relative to the market.
Because other investors are more informed than you are, they
must realize Google is a good deal, and so are happy to profit at
your expense.

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What Should Ordinary People Do？
• Active management seems not a good idea.
– The average alpha of all investors is zero.
– The average alpha of passive investors is zero.
– The average alpha of active investors is zero.

• Active management cannot beat the market on average.

– Active investors need to pay more money to hire talents than
passive investors

• Why would some people choose active management?

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Caveat on EMH

• EMH does not rely on any particular model about asset

prices.
– Rejection of a model, e.g., the CAPM, does not imply rejection of
EMH

• Efficient market ≠ perfect foresight market.

– In efficient markets, prices fully reflect only available information.

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