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Chapter 13 - Investor Behavior and Capital Market Efficiency
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Chapter 13 - Investor Behavior and Capital Market Efficiency
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NCHAPTER 13 - INVESTOR BEHAVIORAND CAPITAL MARKET EFFICIENCY
The difference between a stock's expected return and its required return according to the security
market line is - the stock's alpha
alpha = E[R(s)] - r(s)
While the CAPM conclusion that the market is always efficient may not literally be true, - competition
among savvy investors who try to "beat the market" and earn a positive alpha should keep the market
portfolio close to efficient much of the time
If all investors have homogenous expectations (all investors have the same information), - all investors
would be aware that a stock had a positive alpha and none would be willing to sell
*The only way to restore equilibrium in this case is for the price to rise immediately so that the alpha is
zero
An important conclusion of the CAPM is that - investors should hold the market portfolio (combined with
risk-free investments)
and
this investment advice does not depend on the quality of an investor's information or trading skill
*By doing this, investors can avoid being taken advantage of by more sophisticated investors
The CAPM requires only that investors have - rational expectations
*Means that all investors correctly interpret and use their own information, as well as the information
that can be inferred from market prices or the trades of others
The market portfolio can be inefficient only if - a significant number of investors either
, -Do not have rational expectations
or
-Care about aspects of their portfolios other than expected return and volatility
There is evidence that individual investors fail to ____ and favor ____ - -diversify their portfolios
adequately (under diversification bias)
-investments in companies they are familiar with (familiarity bias)
Investors appear to trade too much which stems, at least in part, from - investor overconfidence
(tendency of uninformed individuals to overestimate the precision of their knowledge)
In order for the behavior of uninformed investors to have an impact on the market, there must be -
patterns to their behavior that lead them to depart from the CAPM in systematic ways, thus imparting
systematic uncertainty into prices
Examples of behavior that could be systematic across investors include - -Disposition effect (tendency to
hang on to losers and sell winners)
-Investor mood swings that result from common events like weather
-Putting too much weight on their own experience
-Herd (actively try to follow each other's behavior)
Stock prices appear to have more volatility than one would expect based on - the volatility of dividends
It is not easy to profit simply by - trading on news
*Professional investors might be able to do so by, for example, being better able to predict takeover
outcomes
**In equilibrium, investors should not expect to share any of the benefit of this skill by investing with
such professional investors
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