AFM 273 Textbook Notes & Economic Indicators (Some)

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13.1 Competition and Capital Markets
Figure 13.1 (p.445) -> if market portfolio =/= efficient portfolio, market not in CAPM
equilibrium
-
Possibility news is announced that some stocks' expected return & some stocks' expected
returns
With new information, market portfolio no longer efficient
Alternative portfolios offer a expected return & volatility than we can obtain by holding the
market portfolio
-
Investors alter their investments in order to make their portfolios efficient
To improve performance of portfolios, investors who are holding the market portfolio will
compare the expected return of each security s w/ its required return from CAPM:
-
rs= rf+ βs× (E[RMkt] - rf)
-
Improve upon market portfolio by buying stocks with +α& selling stocks with -α
Result: prices chg & αshrink towards 0 (move toward SML)
Alpha: difference b/w stock's expected return & its required return according to SML
-
αs= E[Rs] - rs
Market portfolio is efficient = all stocks on SML & α= 0
-
Identifying a Stock's Alpha
As stock prices change, so do expected returns (stock's total return = dividend yield + capital
gain rate).
-
All else being equal, in current stock price stock's div yield & future capital gain rate ->
expected return
Investors trade to improve their portfolios: price & expected return of +αstocks & price
& expected return of -αstocks, until the stocks are once again on the SML & the market
portfolio is efficient.
-
Actions of investors have 2 important consequences:
-
CAPM conclusion that market is always efficient not true -> competition among investors who
try to "beat the market" & earn a +αshould keep the market portfolio close to efficient much
of the time
1.
CAPM = approximate description of competitive market
May exist trading strategies that take advantage of non-zero αstocks -> can beat the market
2.
Profiting from Non-Zero Alpha Stocks
Info that altered +αstock is publicly announced -> large # of investors who receive news &
act -> nobody wants to sell at old prices -> large order imbalance -> only way to remove
imbalance is for price to & α= 0
-
Possible for new prices to occur w/o trade -> intense competition b/w investors -> prices move
before any investor can actually trade at old prices -> no investor profits from news
-
13.2 Information and Rational Expectations
In order to profit by buying a +αstock, there must be someone willing to sell it.
-
Homogeneous expectations -> investors have same info -> investors know about +αstock but
no desire to sell
-
Merely CAPM assumption, reality: investors have different info
Quality of investors' info not necessarily enough to generate trade in situation
-
Conclusion of CAPM: investors hold market portfolio (w/ risk-free investments) & investment
advice does not depend on quality of an investor's info or trading skill (sophisticated investors
have an adv over naïve investors)
-
Example 13.1 (p.447) -> hold market portfolio to make same return as avg investor OR hold
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Informed Versus Uninformed Investors
Chapter 13: Investor Behaviour and Capital Market
Efficiency
November 19, 2013
11:30 AM
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Example 13.1 (p.447) -> hold market portfolio to make same return as avg investor OR hold
less of +αstock than its market weight (result: all other investors have over-weighted the
stock to market -> traders won't profit)
-
What if all uninformed investors hold the market?
-
Supply & demand -> informed investors must hold the market & so informed investors cannot
exploit their informational advantage
Regardless of info, investors must make the same return
Only way informed investors can take advantage of less informed investors is if less informed
investors choose to depart from strategy of holding market portfolio (uninformed investor can
just hold market portfolio)
No investor should choose a portfolio with a -α
-
B/c avg portfolio of all investors = market portfolio -> avg αof all investors = 0
-
No investor earns -α& no investor earns +α-> market portfolio must be efficient
Result: CAPM does not depend on assumption of homogeneous expectations -> requires only
that investors have rational expectations: all investors correctly interpret & use own info &
info that can be inferred from market prices/trades of others
Investor to earn +α& beat market, some investors must hold portfolios w/ -α-> investors
could have earned 0 αby holding market portfolio -> conclusion:
-
The market portfolio can be inefficient (possible to beat the market) only if a significant # of
investors either
Do not have rational expectations so that they misinterpret info & believe they are earning a
+αwhen they are actually earning a -α, OR
1.
Care about aspects of their portfolios other than expected return & volatility, & so are willing
to hold inefficient portfolios of securities
2.
Rational Expectations
13.3 The Behaviour of Individual Investors
Diversifying risk w/o expected return
-
Evidence individual investors fail to diversify portfolios adequately -> concentrated in same
industry, geographically close, & employer's own stock
-
1/2 of volatility in investors' portfolios due to firm-specific risk
-
Explanations for behaviour:
-
Familiarity bias: tendency of investors to favour investments in companies w/ which they are
familiar
Relative wealth concerns: when investors are concerned about performance of their portfolio
relative to that of their peers, rather than its absolute performance
Underdiversification and Portfolio Biases
Market portfolio = value-weighted & passive portfolio (investor does not need to trade in
response to daily price chgs in order to maintain it) -> if all investors held market = relatively
little trading volume in financial markets
-
Explanations of behaviour:
-
Overconfidence hypothesis: tendency of individual investors to trade too much based on the
mistaken belief that they can pick winners & losers better than investment professionals
Implication: assuming investors have no true ability -> trade more = will not earn returns ->
performance is worse once taken into account of costs of trading (due to commissions & bid-
ask spreads)
Sensation seeking: in trading activity due to an individual's desire for novel or intense risk-
taking experiences
Men more overconfident, trade more & portfolios have lower returns
-
Excessive Trading and Overconfidence
Underdiversifying & trading too much -> violates key prediction of CAPM but does not imply
CAPM is invalid
-
If individuals depart from the CAPM in random, idiosyncratic ways, then despite the fact that
-
Individual Behaviour and Market Prices
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If individuals depart from the CAPM in random, idiosyncratic ways, then despite the fact that
each individual doesn't hold the market, when we combine their portfolios together these
departures will tend to cancel out just like any other idiosyncratic risk. Individuals will hold the
market portfolio in aggregate, & there will be no effect on market prices or returns.
Uninformed investors may be trading w/ themselves, generating trading commissions for their
brokers but w/o impacting the efficiency of the market.
-
In order for the behaviour of uninformed investors to have an impact on the market, there
must be patterns to their behaviour that will lead them to depart from the CAPM in systematic
ways, imparting systematic uncertainty into prices.
-
13.4 Systematic Trading Biases
Disposition effect: tendency to hold on to stocks that have lost value & sell stocks that have
risen in value since the time of purchase
-
Costly from a tax perspective
Capital gains taxed only when asset is sold -> optimal to postpone taxable gains by continuing
to hold profitable investments; delaying tax payment PV
Logical if losing stocks believe to "bounce back" & outperform winners (but normally
underperform)
Capture tax losses by selling losing investments, especially near year's end, to accelerate tax
write-off
-
Hanging on to Losers and the Disposition Effect
Investors more likely to buy stocks that have been recently in the news, engaged in
advertising, experienced exceptionally high trading volume, or had extreme (+/-) returns
-
Sunshine = + effect on mood -> stock returns
-
Investors put too much weight on own exp rather than considering all historical evidence ->
people who grow up & live during time of high stock returns more likely to invest
-
Investor Attention, Mood, and Experience
Herd behaviour: tendency of investors to make similar trading errors by actively imitating
other investors' actions
-
Reasons why traders might herd in portfolio choices:
-
Might believe others have superior info -> can take adv by copying trades -> cascade effect:
traders ignore own info hoping to profit from info of others
1.
Due to relative wealth concerns -> avoid risk of underperforming their peers
2.
Professional fund managers may face reputational risk if they stray too far from actions of
their peers.
3.
Herd Behaviour
Easy way to avoid mistakes: buying & holding market portfolio
-
Even though investors may not hold market portfolio -> no potential implications for CAPM
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Implications of Behavioural Biases
In order for sophisticated investors to profit from investor mistakes, 2 conditions must hold:
-
Mistakes must be sufficiently pervasive & persistent to affect stock prices.
1.
Investor behaviour must push prices so that non-zero αtrading opp become apparent
There must be limited competition to exploit these non-zero αopportunities
2.
Competition too intense -> opp quickly eliminated before any trader can take adv of them in a
significant way
13.5 The Efficiency of the Market Portfolio
Profitable trading opp -> reaction to big news announcements or analysts' recommendations
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Enough investors not paying attention -> one can profit from these public sources of info
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Trading on News or Recommendations
Offer is for significant premium to target's current stock price, & while target's stock price
typically jumps on announcement -> often does not jump completely to the offer price
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Seems different may create profitable trading opp BUT most cases: remaining uncertainty
-
Takeover Offer
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