For instance: if a stock with a +ve [a] would not very likely be sold and hence increase instability.
Traders rely on their personal experiences instead of theoretical guides
Stock returns are said to be higher on sunny days
Traders fall prey to
ATTENTION, MOOD & EXPERIENCE
buying most advertised stocks and stocks with extreme returns
Information Efficiency
For a capital market to be efficient, all investors must have access to the same information. This is not possible however, due to information asymmetry. There are three different levels of information efficiency in a capital market.
Weak Form
This level has share prices that reflect all past information and it is impossible to make abnormal gains off past historical information.
Semi-Strong Form
At this level shares fully reflect all historical and present information and it is not possible for investors to make abnormal gains by studying commonly available information.
Strong Form
At this level, share prices reflect historical, present and private information and it is impossible for traders to make abnormal gains by studying any kind of information.
Because for the market to be impacted by the behaviour of uninformed investors, 3 conditions are to be met.
Conclusion
While it is possible to gain superior value to that of the market, it is very difficult for most investors as it requires lower transaction costs and high quality information.
INTERPRETATION: facts say that investors choose to remain unprotected by not holding a market portfolio implying that with respect to the CAPM, if investors engage in strategies resulting in -ve [a], sophisticated investors are very likely to take advantage of them and earn +ve [a].
(iii)Investors must have or share common motives
(ii) systematic uncertainties will show case significant impact on prices
(i) patterns must be available show casing investors behaviour straying from CAPM in systematic ways
Does not imply that CAPM conclusions are void.
For Instance inferences from market prices or other trades.:
Equilibrium rate of return occurs when any +ve or -ve price deviation forms a temporary occurrence of return of an asset being equal to its risks
As a result,
Investors ambition is to beat the market by earning +ve alpha[a]
CAPM assumption that a market is always efficient is false
Investor Behaviour and Capital Market efficieny
13.8: Methods used in practice
There's quite a variety in the number of methods available to firms in order to estimate the cost of capital. One of the most commonly used one is the CAPM model. The others are used by companies that prefer a different style of approach, that best curtails to their circumstances, conditions and needs. These methods are the previously mentioned 'Multifactor model'. Also, by using the historical average returns of the firm, and lastly, the dividend discount model, which is not that commonly used by many firms. All of these methods depend on the organization and its type, and the sector is operates in. i.e: The CAPM model is more commonly and likely to be used than smaller firms. In addition to that, the model is also quite simple to implement and tends to provide reliable results.
13.6: Style Based Techniques and the Market Efficiency Debate
Investors use different trading strategies based on the type of stocks they hold.
IMPLICATIONS OF THESE TRADING STRATEGIES
2. CAPM doesn’t correctly compute risk premium
The market porftfolio is inefficient such that the stock’s beta does not adequately measure the market risk, but the investors are bear risk unknowingly, thus the returns the earn are not excess (alpha) but merely the compensation for taking on additional risk
Why are some market portfolios not efficient?
Investors who care about characteristics other than the volatility of stocks, for example, the probability of extremely high dividends, may choose portfolios that are inefficient.
Investors who are biased towards large growth stock, who are attracted by news coverage alone, and don't maintain a balance between small, value and momentum stocks.
Proxies such as S&P 500 maybe inefficient in a true market scenario, because there are stocks which have nonzero alphas.
1. CAPM correctly computes required risk premiums
Investors are systematically ignoring positive NPV investment opportunities, because either there is lack of information or the cost of implementing strategies is higher than the returns to be earned
13.4:Systematic Trading Biases
Why do they occur?
(iii) Investors blinding follow eachothers behaviours: HERD BEHAVIOUR
(ii)Most traders are part-time traders and are affected by:
(i)DISPOSITION EFFECT: Investors hold on to stocks that have depreciated and sell stocks that have appreciated.
13.2: Information and Rational Expectations
Homogeneous Expectations
An increase in the price of a stock will result in a zero alpha [a] & restore equilibrium as in the example.
attribute similar expectations in all investors resulting from acquisition of same stock information.
Rational Expections
If a significant number of investors do not operate on rational expectation and carefree of other aspects of their portfolios besides E[R] & Volatility, the market portfolio will be INEFFICIENT.
attributes to investors interpreting their own collated information being a CAPM assumption
13.7: Multifactor Models of Risk
Selecting the Portfolios
The first portfolio should consist of a long position in the market portfolio and be financed by a short position in a risk-free security.The remaining portfolios should use the trading strategies of market capitalization, book-to-market ratios, and past returns as they tend to produce high positive alphas.This means they capture risk not covered by the market portfolio.
Past Returns Strategy
A second name for this strategy would be the 'Prior one-year momentum' portfolio. (PR1YR) It's an assortment of stock returns of the past year, and requires taking into account the portfolios which ranks top 30% and those, ranking bottom 30% and holding them for one year.
Book-to-Market Ratio Strategy
Another risk adjustment technique is through analyzing book-to-market ratios of selected stocks of various firms. Those with ratios less than the 30th percentile of the NYSE firms' equally weighted portfolio are taken into account as the low portfolio and the ones with ratios higher than the 70th percentile are considered the high portfolio. With the use of a long position of low portfolios and their short sales enables to ability to buy high portfolios. This self-financing portfolio is known as the high-minus-low portfolio. (HML)
Fama-French-Carhart Specification
The compilation of the above four portfolios into one formula to derive the not only the collective expected return, but also the sensitivity of the stock to each portfolio. The formula is stated as follows:E(Rs)= rf + βmkt [E(R mkt ) – rf] + E(ri)= rf + βsmb [E(R smb ) – rf] + E(ri)= rf + βhml [E(Rhml ) – rf] + E(ri)= rf + βpr1yr [E(R pr1yr ) – rf]
Market Capitalization Strategy
A technique in which risk is adjusted is simply by organizing a collective set of firms with market values below the median of the NYSE firms' equally weighted portfolio and those firms above the median. Through the buying and short selling bits of the small firms' stocks, the big stocks are purchased. This self financing technique proves to be a very effective strategy. This is also known as the 'Small-minus-Big' portfolio (SMB)
Excess Return of the Market
-Market Portfolio is used first because it covers a lot of systematic risk even when inefficiend and tends to have large premiums over short-term risk-free investments such as low risk money market funds and treasury bills because they have short maturities. Risk-free assets are ones with certain returns.
-This is what makes it the best portfoilio to use as a starting point in the multifactor model when identify collections containing the efficient portfolio.
-Given by: Mkt -rf
Using Factor Portfolios
A collection of well-diversified portfolios to bring about ONE efficient portfolio. These factor portfolios' risk and return is altogether estimated through a formula known as the Multifactor Model of Risk. This model requires taking the sum E(Ri)= rf + βi [E(Rf ) – rf] of each of the factor portfolios. With the help of this model, we are able to cover all systematic risk for the efficient portfolio.
13.5: The Efficiency of the Market Portfolio
An investigation into whether individual investors can outperform the market without taking on additional risk. Essentially, how efficient is the market portfolio? One of the ways to profit is through information on non-zero alpha securities.
Trading on News or Recommendation
The Performance of Fund Managers
Talented mutual fund managers, while able to generate more gains than the market average, do not bring superior value to individual investors. This is because the excess gain over the market, will be captured by the mutual charge fees.
Recommendations
When investors who have an overconfidence-bias invest in the shares that have been recommended by expert authorities with no accompanying news, the share price rises rapidly and later falls over time below the market. Investors could obtain abnormal gains by shorting these stocks while the price is high.
Takeover Offers
Takeover bids are offers by a company to buy the shares of another company. This raises the share price of the company being bid for, as the shares will be purchased at a premium. Investors could profit of this information, if they knew for certain which bids would be successful as companies that have been taken over earn abnormal gains over time.
13.3: The Behavior of Individual Investors
WHY DO INVESTORS HOLD INEFFICIENT PORTFOLIOS?
2. Investor over-confidence - uninformed individuals overestimate precision of knowledge
1. Under-diversification due to familiarity bias towards familiar companies
13.1 Competition and Capital Markets
Alpha (a) = E[R]s - Rs
+ve [a] implies stock performance is better than CAPM predictions
-ve [a] implies stock expected returns are below the Security Market Line.
