Lecture 5

Investor Behavior and Capital Market Efficiency

(Chap. 13)

Riccardo Zago

ESCP Business School

2024 / 2025
Introduction

Is it possible to systematically “beat” the market?

Bill Miller, as a fund manager of Legg Mason Value Trust:
▶ Outperformed the market each year between 1991 and 2005.
▶ In 2007 and 2008, the fund lost almost 65% of its value.
According to the CAPM, it should be impossible to achieve a
performance (= Sharpe ratio) superior to the one of the market
in a persistent manner!

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Outline

A. Competition and capital markets (Chap 13.1)

B. Information and rational expectations (Chap 13.2)
C. The behavior of individual investors (Chap 13.3)
D. Systematic trading biases (Chap 13.4)
E. The efficiency of the market portfolio (Chap 13.5)
F. Style-based techniques and the market efficiency debate (Chap.
13.6)
G. Methods used in practice (Chap. 13.8)

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A. Competition and capital markets

Necessary condition to beat the market?

▶ The expected returns on some investments need to exceed their
required returns.
Difference between expected return and required return: alpha
of an asset

αi = E (Ri ) − ri = E (Ri ) − (rf + βi (E (RM ) − rf )) .

If the market portfolio is efficient, all the securities and all the
portfolios are on the Security Market Line.
⇒ Their alphas are zero.

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An inefficient market portfolio: example

Market becomes inefficient after news announcement which lowers (raises)

expected returns of McDonald & Tiffany (Nike & Walmart).
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Deviations from Security Market Line: example

You can improve upon market portfolio by buying (selling) stocks with positive
(negative) alpha. As you do so, prices change and alphas shrink toward zero.
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B. Information and rational expectations

Hypothesis of the CAPM ⇒ all investors have access to the

same information set
Unrealistic in practice!

VS.

But “naı̈ve” investors do not necessarily lose out:

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Example: how to avoid to be beaten by informed
investors?

Jérôme does not have access to any information regarding

stocks. Nevertheless, he knows that the other investors have a
great deal of information and use that information when they
construct their portfolio.
This information asymmetry is a concern to Jérôme, because he
thinks it will cause his portfolio to underperform the portfolio of
the other investors.

⇒ How can he guarantee that his portfolio will do as well as

that of the average investors?

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Rational expectations and the inefficiency of the
market portfolio
The market portfolio can be inefficient (so it is possible to beat the
market) only if a significant number of investors either

Do not have rational expectations so that they 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

returns and volatility, and so are willing to hold inefficient
portfolios of securities.

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C. The behavior of individual investors
Underdiversification
▶ In 2001, for households that held stocks, median number of
stocks held was 4, and 9 out of 10 held less then 10 stocks.
Possible explanations:
⋆ Familiarity bias
⋆ “Keeping up with the Joneses” (relative wealth concerns)
Overconfidence
▶ Leads to excessive trading
⇒ Reduces the performance due to transaction costs.

Underdiversification and excessive trading violate key predictions

of CAPM, but does this imply that remaining conclusions of
CAPM are also invalid?
Not necessarily, if departures from CAPM are random.
⇒ To have an impact, biases need to lead to systematic
deviations from rational behavior.
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D. Systematic trading biases
Disposition effect
▶ Tendency to sell winners too early and hang on to losers too
long.
Investor attention, mood, and experience
Herd behavior (imitate each other’s actions)
▶ Informational cascade effect: ignore own information and hope
to profit from information of others.
▶ Relative wealth and performance concerns.

⇒ Consequences: Biases will affect prices if:

Biases are sufficiently pervasive and persistent.
Competition to exploit these arbitrage opportunities is limited.

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E. The efficiency of the market portfolio
Example for trading on news: Takeover offers
If you could predict whether firm would ultimately be acquired or
not, you could earn trading profits.

Source: Adapted from M.

Bradley, A. Desai, and E. H.
Kim, “The Rationale Behind
Interfirm Tender Offers:
Information or Synergy?”
Journal of Financial
Economics 11 (1983)
183-206.

Returns to holding target stocks subsequent to takeover announcements

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Performance of fund managers

Fund Manager Value-Added

▶ Before fees and adjusting for assets under management, the
average mutual fund adds value.
▶ However, the median mutual fund destroys value.
▶ Most fund managers appear to trade so much that their trading
costs exceed the profits from any trading opportunities they
may find.
Return to Investors
▶ Numerous studies report that the actual alpha (net of fees) to
investors of the average mutual fund is negative.
▶ Superior past performance is not a good predictor of a fund’s
future ability to outperform the market.

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Performance of fund managers (con’t)
Manager Value Added and Investor Before and After Hiring Returns of
Returns for U.S. Mutual Funds Investment Managers

Sources: A. Goyal and S. Wahal, “The Selection

and Termination of Investment Management
Source: J. Berk and J. van Binsbergen,
Firms by Plan Sponsors,” Journal of Finance 63
“Measuring Managerial Skill in the Mutual Fund
(2008): 1805-1847 and with J. Busse,
Industry,” Journal of Financial Economics 118
“Performance and Persistence in Institutional
(2015): 1-20.
Investment Management,” Journal of Finance 63
(2008): 1805-1847.
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The winners and the losers

The average investor earns an alpha of zero, before including

trading costs.
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.

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F. Style-based techniques and the market efficiency
debate
Excess return and market capitalizations (Size effect)
▶ Small market capitalization stocks have historically earned higher
average returns than the market portfolio, even after accounting for
their higher betas.
Excess return and book-to-market ratio (B/M effect)
▶ High book-to-market (value) stocks have historically earned higher
average returns than low book-to-market (growth) stocks.
Momentum
▶ Strategy: buy stocks that have had past high returns and (short) sell
stocks that have had past low returns.
Empirical evidence:
▶ Possibility of a data snooping bias: given enough characteristics, it will
always be possible to find some characteristic that by pure chance
happens to be correlated with the estimation error of average returns.
▶ But Size, B/M and Momentum effects seem to be robust.

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Empirical evidence (con’t)

Excess Return of Size Excess Return of

Portfolios, 1926-2015 Book-to-Market Portfolios,
1926-2015
Data is from Ken French’s datalibrary: http://mba.tuck.dartmouth.
edu/pages/faculty/ken.french/data_library.html.

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Implications of positive-alpha trading strategies
The only way positive-alpha strategies can persist in a market is
if some barrier to entry restricts competition.
▶ However, the existence of these trading strategies has been
widely known for more than 20 yrs.
Another possibility is that the market portfolio is not efficient,
and therefore a stock’s beta with the market is not an adequate
measure of its systematic risk.
Proxy error: true market portfolio may be efficient, but our
proxy may be inaccurate.
Behavioral biases: may induce investors to hold inefficient
portfolios.
Alternative risk preferences and non-tradable wealth: may induce
investors to choose inefficient portfolios (in the mean-variance
sense).
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G. Methods used in practice

There is no clear answer to the question of which technique is

used in practice—it very much depends on the organization and
the sector.
In addition, all the techniques covered are imprecise.
A survey of CFOs found that
▶ 73.5% of the firms used the CAPM to calculate the cost of
capital.
▶ 40% used historical average returns.
▶ 16% used the dividend discount model.
▶ Larger firms were more likely to use the CAPM than were
smaller firms.

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Quiz

If investors buy a stock with a positive alpha, what is the likely

effect on its price and expected return?
How can uninformed investors guarantee themselves a
non-negative alpha?
Why is the high trading volume observed in markets inconsistent
with the CAPM equilibrium?
What are some of the systematic behavioral biases to which
individual investors fall prey?

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