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MGT338H5 Chapter Notes - Chapter 13: Market Capitalization, Trading Strategy, Rational ExpectationsExam

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Gabor Virag
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Prof. Gabor Virag MGT338 Page 1 of 6
Chapter 13 Notes Investor Behaviour
Chapter 13 Notes Investor Behaviour
and Capital Market Efficiency
Stock’s Alpha; Information & Rational Expectations; Behaviour of Individual Investors;
Systematic Trading Biases; Efficiency of the Market Portfolio; Trading Strategies;
Multifactor Models
In the CAPM framework, investors should hold the market portfolio combined with risk-free
investments. This investment strategy does not depend on the quality of an investor’s information or
trading skill. At the equilibrium, nobody can beat the market. But Buffet did.
The Secret to Buffets Success
How did Buffet do it? Well, since mutual funds want to outperform the market, they use a strategy of
stock-picking; buy high-beta stocks, because investors generally look only at return, not risk-adjusted
return. This means that low beta stocks are ignored and are underpriced.
Factor 1:
Exploit Low-Beta Stocks
Buffet exploits the underpriced low-beta stocks and buys high-quality companies when they are
temporarily down on their luck. Ex: Coca-Cola in the 1980s after the New Coke debacle and GE during
the 2008 financial crisis.
Factor 2:
Leverage its capital by 60%. The firm has been able to borrow at a low cost; its debt was AAA rated
from 1989 to 2009. Berkshire’s borrowing costs 2.2% (three percentage points below the average
short-term financing cost of the American government over the same period).
Identifying a Stocks Alpha
To improve the performance of their portfolios, investors will compare the expected return of a
security with its required return from the security market line.
𝑠= 𝑟
𝑓+ 𝛽𝑠×(𝐸[𝑅𝑀𝑘𝑡]− 𝑟
The difference between a stock’s expected return and its required return according to the security
market line is called the stock’s alpha.
𝛼𝑠= 𝐸[𝑅𝑠]− 𝑟
When the market portfolio is efficient, all stocks are on the
security market line & have an alpha of 0. If the market
portfolio is not efficient, then stocks will not all lie on the
security market line. Buying stocks with positive alphas
and selling stocks with negative alphas will cause prices to
change and their alphas will shrink toward 0.

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Prof. Gabor Virag MGT338 Page 2 of 6
Chapter 13 Notes Investor Behaviour
Rational Expectations
All investors correctly interpret and use their own information, as well as information that can be
inferred from market prices or the trades of others.
Because the average portfolio of all investors is the market portfolio, the average alpha of all investors
is zero. If no investor earns a negative alpha, then no investor can earn a positive alpha, and the market
portfolio must be efficient.
The market portfolio can be inefficient only if a significant number of investors either:
o 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.
o Care about aspects of their portfolios other than expected return and volatility, and so are willing to hold inefficient
portfolios of securities.
These are violations of the CAPM assumptions.
Behavioural Finance
The “traditional view of finance” suggests that investors:
o Consider all available information
o Act rationally and do not make systematic errors, either in processing information or in implementing decisions
o Adhere to the basic tenets of modern portfolio theory, which implies they are risk averse, they diversify, and they
consider risk in the context of a well-diversified portfolio
Behavioural finance is a field of financial thought that suggests investor behaviour is not always
rational but is influenced by psychological biases that cause investors to make systematic errors in
Speculative Bubbles in Assets Prices
Bubbles are significant and generally unwarranted increases in asset prices that lead to unsustainably
high price levels. The U.S. real estate bubble that caused the sub-prime crisis in 2008 is an example.
In bubbles investors exhibit herd-like behaviour, overconfidence and fear of regret if they fail to
participate in the bubble.
Underdiversification and Portfolio Biases
o There is much evidence that individual investors fail to diversify their portfolios adequately.
o Familiarity Bias: Investors favor investments in companies they are familiar with.
o Relative Wealth Concerns: Investors care more about the performance of their portfolios relative to
their peers.
Excessive Trading
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.
o Overconfidence Bias: Investors believe they can pick winners and losers when, in fact, they
cannot; this leads them to trade too much.
o Sensation Seeking: An individuals desire for novel and intense risk-taking experiences.
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