LESSON 4 BAPT.pptxBehavioural portfolio theory
- 1. Behavioral Asset Pricing Model • all asset pricing models are versions of the old reliable supply-and-demand model of Introductory economics. The benefits that determine demand vary from product to product, but they can be classified into three groups: utilitarian, expressive, and emotional.
- 2. • The utilitarian benefits of a car include good gas mileage and reliability. Expressive benefits are those thatenable us to signal to ourselves or others our values, social class, and tastes. Expressive characteristics include style (e.g., the style of a Jaguar) and social responsibility (e.g., the environmental responsibility of a Prius). Emotional benefits include pride (e.g., “having arrived” with a Rolls Royce) and exhilaration (e.g., BMW as the “ultimate driving machine”).
- 3. • In the investment context, utilitarian benefits are often labeled “fundamental,” and expressive and emotional benefits are often labeled “sentiment.” High expected returns and low risk are utilitarian benefits of a stock, and those who restrict the demand function to it are considered rational
- 4. • The rubric of rationality is not so easily extended to expressive and emotional benefits, such as the display of social responsibility in a socially responsible mutual fund, the display of wealth in a hedge fund, or the excitement of an initial public offering
- 5. • What characteristics do stock buyers like? Investors like stocks with low volatility in prices and earnings. They also like stocks with large capitalization, high price-to-book ratios, high price-to-earnings ratios, low leverage, and more. Stocks with desirable characteristics fetch higher prices, and higher prices
- 6. • correspond to lower expected returns. Stocks with low book-to-market ratios (growth stocks) and large-cap stocks have low Expected returns. In the behavioral asset pricing model (BAPM) (Shefrin and Statman 1994, Statman 1999), stocks with desirable characteristics have low expected returns.
- 7. • The asset pricing model of standard finance is moving away from the capital asset pricing model (CAPM)—in which beta is the only characteristic that determines expected stock returns—toward a model that is similar to the BAPM.
- 8. • In standard finance, market capitalization and book-to-market ratios are interpreted as measures of risk; small-cap stocks and stocks with high book-to-market ratios (value stocks) are considered highrisk stocks, and the high risk justifies high expected returns
- 9. • In contrast, in behavioral asset pricing theory, the same characteristics are interpreted as reflections of affect, an emotion, and Representativeness, a cognitive bias. Both lead investors to identify good stocks as stocks of good companies.
- 10. • Small-cap stocks and stocks with high book-to- market ratios (value stocks) are stocks of “bad” companies (e.g., bank stocks in 2008). These companies have negative affect, so investors shun them, depressing their prices • and pushing up their expected returns.
- 11. • Statman, Fisher, and Anginer (2008) find that respondents in the Fortune surveys of admired companies consider stocks of small-cap, high book-to-market companies as unattractive investments, yet stocks of admired companies yielded lower returns, on average, than stocks of spurned companies.
- 12. • Still, the road from the preferences of normal investors to security returns is not straightforward, as explained by Shefrin and Statman (1994) and more recently by Pontiff (2006). Suppose that most investors are indeed normal investors who believe, erroneously, that good stocks are stocks of good companies.
- 13. • But surely not all investors commit that error. Some investors are rational, investors aware of the biases of normal investors and seeking to capitalize on them favoring stocks of “bad” companies. Would rational investors not nullify any effect of normal investors on security prices through arbitrage?
- 14. • If the effects of normal investors on stock returns are nullified, risk-adjusted expected returns to stocks of good companies will be no different from risk-adjusted expected returns to stocks of bad companies. However, if arbitrage is incomplete, risk adjusted expected returns to stocks of bad companies will exceed risk-adjusted expected returns to stocks of good companies.
- 15. • As we consider arbitrage and the likelihood that it would nullify the effects of the preferences of normal investors on stock price, note that no perfect (riskfree) arbitrage is possible here.
- 16. • To see the implications of imperfect arbitrage, • imagine rational investors who receive reliable, but not perfect, information about the expected return of a particular stock. Imagine also that the nature of the information is such that the expected return of the stock as assessed by rational investors is higher than the expected return as reflected in the current price of the stock.
- 17. • It is optimal for rational investors to increase their holdings of the particular stock, but as the amount devoted to the stock increases, their portfolios become less diversified as they take on more idiosyncratic risk
- 18. • The increase in risk leads rational investors to limit the amount allocated to the stock, and with it, limit their effect on its price. So, what does the BAPM look like? The CAPM is expressed as an equation where: Expected return of a stock = f (market factor). The three-factor model is expressed as an equation where: • Expected return of a stock = f (market factor, book-to- market factor, market cap factor).
- 19. • Similarly, the BAPM is expressed as: Expected return of a stock = f (market factor, book-to-market factor, market cap factor, momentum, affect factor, social responsibility factor, status factor, and more).
- 20. Market Efficiency The definition of “market efficiency” says that a market for a stock is efficient if the price of a stock is always equal to its fundamental value. A stock’s fundamental value is the present value of cash flows the stock can reasonably be expected to generate, such as dividends.
- 21. Logically, a market that is efficient in terms of the price equals-fundamental value definition is also a market that cannot be beaten, but a market that cannot be beaten is not necessarily efficient.
- 22. • We have much evidence that stock prices regularly deviate from fundamental value, so we know that markets for stocks are not always efficient. Richard • Roll (1988) found that only 20 percent of changes in stock prices can be attributed to changes in fundamental value, and Ray Fair (2002) found that many changes in the S&P 500 Index occur with no change in fundamental value.
- 23. • The stock market crash of 1987 stands out as an example of deviation from market efficiency. The U.S. stock market dropped more than 20 percent in one day, October 19, 1987 (popularly referred to as “Black Monday”). No one has been able to identify any change in the fundamental value of U.S. stocks that day that might come close to 20 percent.
- 24. • The problem of joint testing makes much of the debate on market efficiency futile. Proponents of standard finance regard market efficiency as fact and challenge anomalies that are inconsistent with it. For their part, investment • professionals who claim that they can beat the market regard market efficiency as false and delight in anomalies that are inconsistent with it.
- 25. • Standard finance proponents were happy with the CAPM as its asset pricing model as long as it served to show that markets are efficient, but they abandoned the CAPM in favor of the three-factor model when the CAPM produced anomalies inconsistent with market efficiency.
- 26. • The problem of jointly testing market efficiency and asset pricing models dooms us to attempt to determine two variables with Only one equation. Instead, we can assume market efficiency and explore the Characteristics that make an asset pricing model, or we can assume an asset pricing model and test market efficiency.
- 27. • I am inclined toward the former. When we see a Toyota automobile in a showroom with one price tag side by side with a Lexus with a higher price tag, we are inclined to look to the automobile asset pricing model for reasons for the price difference rather than conclude that the automobile market is inefficient.
- 28. • Does the Lexus have leather seats while the Toyota’s seats are upholstered in cloth? Does the Lexus nameplate convey higher status than the Toyota nameplate? The same is true when we see Stock A with an expected return of 8 percent and Stock B with an expected return of 6 percent.
- 29. Elegant Theories and Testable Hypotheses • The statement that behavioral finance is an interesting collection of stories but does not offer the equivalent of the comprehensive theory and rigorous tests of standard finance is as common as it is wrong
- 30. • When people think about standard finance, they usually think about the CAPM and mean- variance portfolio theory. These two models are elegant, but few use them in their elegant form. The elegant CAPM has been replaced as standard finance’s asset pricing model
- 31. • by the messy three-factor model, which claims that expected return is a function of equity market capitalization and the ratio of book value to market value in addition to beta
- 32. • In turn, the three-factor model has become the four-factor model with the addition of momentum and the five-factor model with the addition of liquidity. The list is likely to grow. Similarly, few apply mean=variance theory or its optimizer in their elegant forms.
- 33. • Instead, it is mostly constraints on the optimizer that determine mean-variance optimal portfolios, and these constraints are often rooted in Behavioral consideration. A constraint on the proportion allocated to foreign stocks is one example, driven by “home bias.” But we don’t need elegant models; we need models that describe real people in real markets. These are the models of behavioral finance.
- 34. • Behavioral finance offers behavioral asset pricing theory and behavioral portfolio theory, which are no less elegant than the models of standard finance and are much closer to reality. Moreover, behavioral finance offers testable hypotheses and empirical assessments that can reject these hypotheses if they deserve to be rejected.
- 35. • For example, Shefrin and Statman (1985) offered the testable “disposition” hypothesis that investors are disposed to hold on to losing stocks. This hypothesis can be rejected by empirical evidence that investors are quick to realize losses. But the evidence Among many types of investors in many countries supports the hypothesis. THUS B’F IS NOT A COLLECTION OF STORRIES