Unit Ii: Conventional Finance, Prospect Theory and Market Efficiency

E L E C TI V E 8 – B E HA V I O R A L F I N A N C E
UNIT II: CONVENTIONAL FINANCE, PROSPECT THEORY AND

MARKET EFFICIENCY
Overview
The behavior of individuals, practitioners, markets, and managers is sometimes

characterized as “irrational,” but what exactly does that mean? To answer this
question, we must take several steps back and fully understand the foundations of
modern finance, which are based on rational decision-making. This unit will be
presenting the standard theory of how individuals make decisions when confronted
with uncertainty.
Learning Objectives_
At the end of the unit, I am able to:
1. understand individual behavior, financial decision-making and market
outcomes;
2. describe prospect theory as an alternative to expected utility theory;
3. describe how people use a framing approach known as mental accounting to
simplify, and sometimes distort, decision making;
4. explain how the frame or presentation of a problem impacts the decision a
person makes;
5. differentiate the following concepts:
a. prospect and probability distribution,
b. risk and uncertainty,
c. utility function and expected utility
d. risk aversion, risk seeking and risk neutrality,
e. momentum and reversal,
f. value and growth stocks and
g. fundamental and noise-trader risk;
6. discuss capital asset pricing model and agency model;
7. outline empirical literature on anomalies.
8. identify the implications of market efficiency and its misconceptions.
9. compute the expected rate of return and risk of a portfolio using capital asset
pricing model.
UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 1

Lesson Proper
Neoclassical Economics
Traditional finance models have a basis in economics, and neoclassical economics is the
dominant paradigm. In this representation, individuals and firms are self-interested agents
who attempt to optimize to the best of their ability in the face of constraints on resources.
The value (or price) of an asset is determined in a market, subject to the influences of supply
and demand. In this unit, we focus on individual decision-making, leaving markets to the
following chapter.
Neoclassical economics makes some fundamental assumptions about people:

1. People have rational preferences across possible outcomes or states of nature.
2. People maximize utility and firms maximize profits.
3. People make independent decisions based on all relevant information.
Rational Preferences
What does it mean for individuals to have rational preferences? Certain conditions are
commonly imposed on preferences. Suppose a person is confronted with the choice between
two outcomes, x and y. The symbol ≻ means that one choice is strictly preferred to another,
so that the relation x ≻ y means that x is always the preferred choice when x and y are offered
to some individual. The symbol * indicates indifference, so that x ~ y indicates that the
person values the two outcomes the same. Finally, the symbol ≽ indicates weak preference,
so that x ≽ y means that the person prefers x or is indifferent between x and y.
An important assumption is that people’s preferences are complete. This means that a
person can compare all possible choices and assess preference or indifference. Thus, for any
pair of choices, x ≽ y or y ≽ x or both, which would mean that x ~ y. This assumption does
not seem to cause too many problems. Surely most people know what they like and what
they do not like.
A second assumption, transitivity, does not seem to be too strong an assumption for
most people. Suppose now that a person is confronted with a choice among three outcomes:
x, y, and z. According to transitivity, if x ≻ y and y ≻ z, then x ≻ z. If you prefer vanilla ice
cream to chocolate, and chocolate to strawberry, you I should also prefer vanilla to
strawberry. If transitivity does not hold, we cannot determine an optimal or best choice. So,
rational choices are transitive.
Utility Maximization
Utility theory is used to describe preferences. With a utility function, we assign numbers
to possible outcomes so that preferred choices receive higher numbers. We can think of
utility as the satisfaction received from a particular outcome. Normally an outcome is
characterized by a “bundle” of goods.

For example, someone might have to choose between two slices of cake plus one cup of
milk tea and one slice of cake plus two cups of milk tea.
The utility function is ordinal (i.e., order-preserving) but not cardinal (which would
mean the exact utility value matters). To arrive at one’s optimal choice, an individual
considers all possible bundles of goods that satisfy the budget constraint (based on wealth
or income), and then chooses the bundle that maximizes the utility. If there is a single good
of interest, then ranking under certainty is trivial. This stems from the principle of non-
satiation, which simply means the more the better.
Table 1. Logarithmic Utility of Wealth
Wealth (in P 10,000s) u(ѡ) = ln(ѡ)

1 0
2 0.6931
5 1.6094
7 1.9459
10 2.3026
20 2.9957
30 3.4012
50 3.9120
100 4.6052
As an example of a single good, utility functions are often defined in relation to wealth.
Though mathematically a utility function can be specified in different ways, we will use the
example of a logarithmic function. In this case, the utility derived from wealth level w is u(ѡ)
= ln(ѡ). In Table 1, wealth is defined in P 10,000s, so that a wealth level of “1” translates to
P10,000, a wealth level of 10 translates to P 100,000, and so on. Figure 1.1 graphs this utility
function. Notice that the slope gets flatter as wealth increases. For a person, added wealth at
low income levels increases utility more than added wealth at high income levels.
Figure 1. Utility Function

Expected Utility Theory
Expected utility theory was developed by John von Neumann and Oskar Morgenstern in
an attempt to define rational behavior when people face uncertainty. This theory contends
that individuals should act in a particular way when confronted with decision-making under
uncertainty. In this sense, the theory is “normative,” which means that it describes how
people should rationally behave. This is in contrast to a “positive” theory, which
characterizes how people actually behave.
Expected utility theory is really set up to deal with risk, not uncertainty. A risky situation
is one in which you know what the outcomes could be and can assign a probability to each
outcome. Uncertainty is when you cannot assign probabilities or even come up with a list of
possible outcomes. According to Frank Knight, the difference between risk and uncertainty
is risk is measurable using probability, but uncertainty is not. Whereas, conforming to that
common practice, we began by saying that we were going to address decision making under
uncertainty, the truth is that we will almost always focus on decision-making under risk.
For almost all purposes, when considering decision-making under risk, it is sufficient to
think in terms of just wealth. Let’s suppose, for simplicity, that there are only two states of
the world: low wealth and high wealth. When it is low, your wealth is P50,000, and when it
is high, your wealth is P1,000,000. And further assume that you can assign probabilities to
each of these outcomes. You are fairly optimistic about your future, so you assign a
probability of 40% to low wealth and 60% to high wealth. Formally, a prospect is a series of
wealth outcomes, each of which is associated with a probability. If we call the latter prospect
P1, we can represent this situation using the following convenient format:
Note that with two outcomes the first number is the probability of the first outcome, and
the next two numbers are the two outcomes. If only one peso figure is given, as in P(.3, P100),
the assumption is that the second outcome is “0.” It can be shown that if one makes the
assumptions previously discussed along with several others that most people consider to be
reasonable, a procedure allowing us to make appropriate choices under risk results. In a
nutshell, this procedure involves calculating the probability-weighted expected value of the
different possible utility levels (that is, the expected utility).
Let us use the notation U(P) for the expected utility of a prospect. For P1, the expected utility,
or U(P1), is:
U(P1) = 0.40u(50,000) + 0.60u(1,000,000)
Expected utility can be used to rank risky alternatives because it is order-preserving (i.e.,
ordinal). It can be shown that for a given individual it is also cardinal, in the sense that it is
unique up to a positive linear transformation.
Risk Attitude
There is abundant evidence that most people avoid risk in most circumstances. People
are, however, willing to assume risk if they are compensated for it. For example, when
choosing between two stocks with the same expected return, if you are like most people, you

would invest in the one with the lower risk. If you are going to take on a riskier investment,
you will demand a higher return to compensate for the risk.
The utility function is useful in defining risk preferences. Returning to P1, the expected
value of wealth is:
E(w) = 0.40(P 50,000) + 0.60(P 1,000,000) = P 620,000 = E(P1)
Note that the expected value of wealth is synonymous with the expected value of the
prospect. The utility of this expected value of wealth is:
u(E(w)) = ln(62) = 4.1271
On the other hand, as we saw before, the expected utility is 3.4069, so u(E(w)) > U(P1).
This means that a person, whose preferences can be described by a logarithmic utility
function, prefers the expected value of a prospect to the prospect itself. In other words, if
you have a logarithmic utility function, you would rather have wealth of P 620,000 than a
prospect in which you have a 40% chance of wealth of P 50,000 and a 60% chance of wealth
of P1,000,000. A person of this type dislikes risk, and we say this person is risk averse.
Figure 2 illustrates the situation. In the figure, we see that the utility of the expected
wealth (u(E(w)) = u(62) = 4.1271) is greater than the expected utility of the prospect (U(P1)
= 3.4069). Someone who is risk averse has a concave utility function, which means that:
u(E(P)) > U(P)
Such a person’s preferences imply that the utility of the expected value of a prospect is
greater than the expected utility of the prospect. This person would rather have the expected
value of the prospect with certainty than actually take a gamble on the uncertain outcome.
For our example, a risk-averse person would rather have wealth of P 620,000 with certainty
as compared to a prospect with a 40% chance of wealth of P 50,000 and a 60% chance of
wealth of P 1,000,000.
Figure 2. Utility Function for a Risk Averse

A risk-averse person is willing to sacrifice for certainty. The certainty equivalent is

defined as that wealth level that leads the decision-maker to be indifferent between a
particular prospect and a certain wealth level. In the case of P1 and logarithmic utility, the
certainty equivalent is P 301,700. This is because, as Figure 2 shows, wealth of 30.17 (in P
10,000s) leads to a utility level equal to the expected utility of the prospect.
The utility of the certainty equivalent is equal to the expected utility of the prospect or:
u(30.17) = u(w) = U(P1) = 0.40(1.6094) + 0.60(4.6052) = 3.4069
You would give up P 318,300 in expected value in order to exchange the prospect for
certainty.
We often assume that people are risk averse, but some people actually seem to prefer, at
least at times, to take on risk. Such a person is called a risk seeker and has a convex utility
function, as in:
u(E(P)) < U(P)
For such an individual, the utility of the expected value of a prospect is less than the
expected utility of the prospect. This person would rather gamble on the uncertain outcome
than take the expected value of the prospect with certainty. Figure 3 shows the relationship
between the utility of expected wealth and the expected utility of wealth for a risk seeker.
For a risk seeker, the certainty equivalent level of wealth is greater than the expected value.
Returning to our previous example, a risk seeker would rather have a prospect with a 40%
chance of wealth of $50,000 and a 60% chance of wealth of P 1,000,000 versus wealth of
P620,000 with certainty.
Figure 3. Utility Function for a Risk Seeker

Finally, people who are risk neutral lie between risk averters and risk seekers. These
people only care about expected values and risk does not matter at all. For someone who is
risk neutral we have:
u(E(P)) = U(P)
Thus the utility of the expected value of a prospect is equal to the expected utility of the
prospect, as illustrated in Figure 4. Again, returning to our previous example, a risk-neutral
individual would be indifferent between a prospect with a 40% chance of wealth of P 50,000
and a 60% chance of wealth of P 1,000,000 and wealth of P 620,000 with certainty. For a
risk-neutral person, the certainty equivalent level of wealth is equal to the expected value of
the prospect.
Figure 4. Utility Function for a Risk-neutral Individual
Allais Paradox
Throughout this module, we will consider a number of observed behaviors that appear
to be contrary to predictions generated by conventional finance models. Now, we will look
at one persistently documented contradiction of expected utility theory, the so-called Allais
paradox. Alternative approaches to decision-making under uncertainty have been
developed because researchers have detected this and other departures from expected
utility theory. The most famous is the prospect theory of Daniel Kahneman and Amos
Tversky, which will later on be discussed.
Consider the prospect choices in Table 2. In the case of Question 1, people can choose
between A and A*, while in the case of Question 2, people can choose between B and B*.
Questions 1 and 2 have been presented to many people. Take a moment now and answer
each question. For Question 1, would you prefer Prospect A or Prospect A*? For Question 2,
would you prefer Prospect B or Prospect B*?

Table 2. Prospect Choices
Question 1
Prospect A Prospect A*
P 1,000,000 100% 0 1%
P 1,000,000 89%
P 5,000,000 10%
Question 2
Prospect B Prospect B*
0 89% 0 90%
P 1,000,000 11% P 5,000,000 10%
Are you like many people? A large number of people choose A over A* and B* over B. We
now show that this violates expected utility theory. If expected utility theory can be used to
rank outcomes, a preference for A over A*, that is, U(A) > U(A*), implies:
U(A) = u(P 1,000,000) > .89u(P 1,000,000) + .1u(P 5,000,000) = U(A*)
Simplifying, we have:
11u(P 1,000,000) > .1u(P 5,000,000)
Again, if expected utility theory holds, a preference for B* over B, that is, U(B*) > U(B),
implies:
.1u(P 5,000,000) > .11u(P 1,000,000)
Since .11u(P1,000,000) > .1u(P5,000,000) and .1u(P5,000,000) > .11u(P1,000,000)

cannot both hold, such choices are clearly contradictory.
John Conlisk carefully investigated the robustness of the Allais paradox. He gave several
variations of the questions in Table 2 to the student participants in his research study. He
found that when the questions were presented in a form that better allowed the students to
see how the choice between A and B is similar to the choice between A* and B*, violations of
expected utility declined significantly.
As an example, refer to Table 3. This table presents the same questions as Table 2, but
the format is changed to illustrate the problem. Would you still make the same choices you
made when you first considered Table 2? For Question 1, would you now prefer Prospect A
or Prospect A*? For Question 2, would you now prefer Prospect B or Prospect B*?
For Question 1, both prospects offer an 89% chance to win P 1,000,000, so this does not
provide a basis for preference of A or A*. For Question 2, both prospects offer an 89% chance
of “0,” which again should provide no basis for choice because it is identical for both
prospects. Notice that after removing commonalities, now the choices between prospects A
and A* or B and B* are exactly the same. Thus, people should choose A and B or A* and B*.
Without such aids, many people do not seem to understand the structure of the decision and
choose A and B*.

Table 3. Reconsidering the Prospect Choices
Question 1
Prospect A Prospect A*
P 1,000,000 89% P 1,000,000 89%
P 1,000,000 11% 0 1%
P 5,000,000 10%
Question 2
Prospect B Prospect B*
0 89% 0 89%
P 1,000,000 11% 0 11%
P 5,000,000 10%
The Allais paradox is not the only documented violation of expected utility theory.
Sometimes researchers demonstrate that people do not make choices in accordance with
certain axioms on which expected utility theory rests. For example, failures in the ability to
order outcomes on a consistent basis and lack of transitivity have been reported. One can
also show that an axiom known as “context independence” is contradicted by the Allais
paradox.
To understand this contradiction, consider the following. Suppose a person is indifferent

between two prospects, A and B. If we consider another prospect, C, independence implies
that this person should also be indifferent between one gamble that combines A with C and
another that combines B with C with fixed probability.
We can illustrate this idea as follows. Suppose you are looking for a new car and you are
trying to decide between a Toyota and a BMW. The latter is a better car, but it is also more
expensive. Two charities are selling lottery tickets with identical ticket prices. The prize for
the first lottery is the BMW, and the prize for the second lottery is the Toyota. Now assume
you believe you have a better chance of winning the Toyota, so that you are actually
indifferent between these two lotteries.
Suppose now you consider a third lottery with a prize of a new television. The
consolation prize is a ticket for one of the car lotteries. Since you were indifferent between
the two car lotteries, you should also be indifferent between the BMW lottery plus the
television lottery and the Toyota lottery plus the television lottery.
Framing
Decision problems can be presented in many different ways, and some evidence
suggests that people’s decisions are not the same across various presentations. If I ask you
if you’d rather have a glass that is half empty or a glass that is half full, virtually everyone
would see through this transparent difference in decision frames and say that it doesn’t
matter. A decision frame is defined to be a decision-maker’s view of the problem and
possible outcomes. A frame is affected by the presentation mode and the individual’s
perception of the question, as well as personal characteristics.

Sometimes frames are opaque, which means that they are trickier to see through. For
this reason, when we present a choice problem to a person, a change in frame can lead to a
change in decision, as we saw with the choices in Tables 2 and 3. This is a violation of
expected utility theory, which rests on the assumption that people should have consistent
choices, regardless of presentation.
Psychologists and economists have documented that the frame has significant effects on
the decisions people make, including decisions of a financial nature. Framing has been
shown to have important implications in many areas of behavioral finance.
The Pricing of Risk
In the previous section we reviewed expected utility theory, which says that individuals
faced with uncertainty maximize the utility expected across possible states of the world. For
a financial asset with potentially innumerable possible future outcomes, this is not a
manageable task. Fortunately, asset pricing theory provides a way to quantify the trade-off
between risk and return. Before formally considering how assets should be priced, we will
examine how the trade-off between risk and return can be measured.
Risk and Return for Individual Assets
Modern portfolio theory provides a practical framework that assumes that

investors are risk averse and preferences are defined in terms of the mean and variance
of returns. This theory is based on statistics, so it is empirically based and the variables
are measurable. We can think of the return on an asset as being a random variable. In
other words, the return next period is not perfectly predictable, but it is determined by
a probability distribution. One parameter characterizing this distribution is the expected
value of returns, denoted as E(Ri), where E(•) denotes expectation. The expected value
is a kind of distributional average. If one sampled from this distribution a very large
number of times, the average value of observations would converge to the expected
value. While investors care about the likely return, we know that they also focus on risk.
You would not be indifferent between two assets that have the same expected return but
very different levels of risk.
With the same expected return, an investor would prefer the asset that has a more
certain outcome or less uncertainty about possible returns. They want to know by how
much the actual return differs from the average return in a typical year. In other words,
we need a measure of the volatility of returns. Although there are different ways we
could measure uncertainty, for an individual asset, variance or dispersion from the mean
is the most common measure of volatility. The variance (σ2) of returns reflects squared
deviations from the mean so large deviations above or below the mean count equally.
The standard deviation (σ) of returns is simply the positive square root of the variance.
Variance and standard deviation are proxies for risk, and both rank securities in terms
of risk identically. The bigger the variance is, the more the actual returns tend to differ
from the average return. Also, the larger the variance or standard deviation is, the more
spread out the returns will be.
When considering an asset in isolation, notice that an investor really wants to know
the expected future return and future variance in returns. These parameters from the

distribution of returns are not observable. Therefore, in finance applications and

empirical research, it is common to estimate returns using historical data.
Risk and Return for Portfolios of Assets
Smart investors understand that the risk of a portfolio is not simply the average risk
of the assets in the portfolio. This is because by combining assets in a portfolio, investors
can eliminate some, but not all, variability. Recall the old adage that advises, “don’t put
all your eggs in one basket.” This is the principle of diversification. Finance theorists have
shown it to be an important factor when setting an investment strategy. How do we
know how much variability can be eliminated by combining two assets in a portfolio?
Consider the act of combining two assets. As long as the assets’ returns do not move
together in exactly the same way all the time, variability is reduced. Statistical measures
of how random variables are related are covariance and correlation. When one variable
tends to be above (below) its mean and at the same time the other variable tends to be
above (below) its mean, the covariance and correlation are positive. If the two variables
tend to move in opposite directions, the covariance and correlation are negative. The
correlation always lies between −1.0 and +1.0, whereas the covariance can take any
positive or negative value.
As long as the correlation is less than 1.0, the standard deviation of returns for the
portfolio will be lower than the weighted average of the standard deviations of returns
for the two assets. As more assets are added to the portfolio, the expressions expand
analogously, and additional variability is eliminated through diversification—up to a
limit.
The Optimal Portfolio
When choosing optimal portfolios, it is important to use distributions that generate

returns in the future, and we must remember that historical sample estimates are only
estimates for the true distributional parameters. Therefore we will now work in terms of
true expected values rather than sample means and true distributional variances rather than
sample variances.
For simplicity, suppose there are only two stocks and a risk-free asset in a market. The
stocks are ownership interests in High Tech Corporation and Low Tech Corporation, and the
risk-free asset can be thought of as investing in short-term government bonds (such as
Treasury bills) or depositing funds in a bank. Information for the three investment
opportunities is summarized in Table 4. High Tech has the highest expected return of 15%,
but also the highest variability in returns with a standard deviation of 30%. Low Tech is in
the middle with expected returns of 8% and variability of 10%. The risk-free asset provides
a low, but risk-free, return (4%). The returns to High Tech and Low Tech are negatively
correlated.
In our example, the risk-free asset’s returns are certain and uncorrelated with the other
assets’ returns. Note that zero variability in returns is what is meant by a risk-free
investment.

Table 4. Returns for High Tech and Low Tech
Expected Return Standard Deviation of

Returns
High Tech 15% 30%
Low Tech 8% 10%
Risk-free Asset 4% 0%
Correlation between HT and LT -0.10
Correlation between HT and RF 0
Correlation between LT and RF 0
Suppose you are considering investing in a portfolio of our two stocks, High Tech and
Low Tech. Using the formulas provided in the previous section with distributional
parameters For example, suppose you put 40% of your funds in High Tech and 60% in Low
Tech. The expected return for the portfolio is:
E(RP ) =[ x1 * E(R1) ] +[ x2 * E(R2)] … + xn * E(Rn)
E(Rp) = 0.40(0.15) + 0.60(0.08) = 0.108
And the variance of portfolio returns is:
σ2p = xA2 σ2A + xB2 σ2B + 2xAxBσAσBCorr(RA,RB)
σ2p = 0.4020.302 + 0.6020.102 + 2(0.40)(0.60)(−0.10)(0.30)(0.10)= 0.0166
Taking the square root of the variance gives a standard deviation of 0.1288 (or 12.88%).
Notice that the standard deviation is less than the weighted average of the standard
deviations of each stock. This reflects the fact that benefits from diversification have been
achieved.
While diversification benefits are evident, we still don’t know how much of our money
we should invest in each of the two stocks. More generally, if there are many stocks to choose
from, how much should we invest in each? Here is where the efficient frontier (or efficient
set) comes in. We begin with Figure 5. In this and the next two figures, risk is proxied by
standard deviation (of portfolio returns). Figure 5 depicts all possible risk-return
combinations of High Tech and Low Tech. The curve in the figure is constructed by varying
the weights for each asset and recalculating the expected return and standard deviation. The
curvature of this relationship stems from the correlation between the two securities: the
lower the correlation, the greater the curvature.
Investors actually have thousands of risky investment opportunities. If we consider all

combinations of securities (and there are clearly an infinite number of combinations), it can
be shown that a graph depicting all these combinations would show a solid curved mass,
which is sometimes compared to a “bullet.” Referring to Figure 6, notice that several
individual investments (A-D) and several portfolios (E-G) are shown. In the manner of
Figure 5, if we combine individual investments on a pairwise basis, we achieve
diversification as reflected in the (interior) risk-return trade-off curves. By mixing together

many assets, we can do even better. When we have moved as far to the left as possible (as in
portfolios E-G), we have reached the “skin” of the bullet.
Figure 5. Risk vs. Expected Return for High Tech and Low Tech
Above and to the right of the minimum risk point (the tip of the bullet, which is portfolio
G) is that portion of the curve called the efficient frontier. The efficient frontier represents
that set of portfolios that maximize expected return for a given level of risk. No investor
would choose a portfolio under the curve because this would not be optimal (i.e., there exists
another portfolio with the same risk, but higher return.) Thus, all rational investors would
choose a portfolio on the efficient frontier.
Figure 6. The Efficient Set
As more assets are added to the portfolio, the investor can eliminate more risk because
assets seldom move in tandem, or, synonymously, correlations are almost always less than
one for pairs of risky assets. We refer to the risk that can be eliminated as diversifiable risk
or nonsystematic risk. The risk that can be diversified is specific to the asset in question.
For a common stock, this would reflect firm-specific events. The risk we cannot eliminate is

called nondiversifiable risk or systematic risk. Systematic risk is common to all risky
assets in the system, so we cannot diversify it away no matter how many stocks are added
to the portfolio. If we add the assumption that all investors have the same, or homogeneous,
expectations, then all investors have the same efficient frontier.
We now know that only portfolios lying along the efficient frontier should be
considered. But, exactly which one do you want? You might find an investor whose primary
goal is to eliminate as much risk as possible, and he would locate himself right on the
minimum-risk point. Most of us, however, are not that risk averse. Investors recognize the
trade-off between risk and return and, depending on their risk attitude, may be willing to
take on some risk to earn a higher return.
An investor who is willing to take additional risk to generate a higher return will pick a
spot on the efficient frontier to the right of the minimum-risk portfolio. When we introduce
the risk-free asset to the mix, we see that there is just one portfolio of risky assets that will
be held by investors. Adding the risk-free asset is like adding an exchange mechanism that
allows investors to borrow or lend all they want at the risk-free rate. With the ability to
borrow and lend, we get two-fund separation. Separation means that investors maximize
utility by combining the risk-free asset with a fund of risky assets. Because the returns for
the risk-free asset are uncorrelated with the returns of the other assets, the return and risk
for a portfolio including the risk-free asset with any other risky asset will be a linear function
of the returns and risks.
Figure 7 shows the efficient frontier for all risky investment opportunities, along with
two lines representing investment in the risk-free asset in combination with the two
different portfolios of risky stocks. Consider the lower line, which combines the risk-free
security (Rf) and portfolio X located on the efficient frontier.
Figure 7. The Capital Market Line
All points on this line can be obtained by varying the weights in Rf and X. The line begins
at a return of Rf and risk of zero, which represents 100% investment in the risk-free asset.
Moving along the line, one increases the percentage invested in X. Points to the right of X
indicate borrowing (i.e., a negative weight in Rf) along with a more than 100% weighting in
X. A little thought, however, should indicate that there is a better risky portfolio than X. By

choosing as our risky portfolio another portfolio (not shown) above and to the right of X,
this new line would be everywhere above the first line. In fact, this argument holds true until
we reach our second line, which is the unique tangency portfolio. While portfolios below this
line can be achieved, they are suboptimal. Notice that any point on the line to the right of the
tangency represents borrowing because more than 100% of the available funds are invested
in the risky portfolio.
What exactly is the makeup of this tangency portfolio? Recall that as we add more and
more risky assets to our portfolio, we diversify away firm-specific risk. The tangency
portfolio is the market portfolio which includes all risky assets weighted by their value
because this is the most diversified portfolio possible, and we denote it as M. The line joining
Rf and M is called the capital market line (CML), and represents all combinations of the risk-
free asset and the market portfolio. The CML tells the investor how much more return can
be earned for taking on additional risk.
Capital Asset Pricing Model (CAPM)
According to this framework, rational investors hold the market portfolio in

combination with the risk-free asset because otherwise more risk could be diversified away.
Investors will not be compensated for taking on diversifiable risk unrelated to market
movements. This is the critical insight provided by the capital asset pricing model (CAPM).
Remember that we are assuming that beliefs are identical across individuals, which means
that investors have the same efficient frontier, implying that all investors hold the same
portfolio of risky assets, the market portfolio.
According to the CAPM, only risk related to market movements is priced in the market.
The variance or standard deviation of returns for an asset is not the appropriate gauge of
risk because it measures total risk, including both diversifiable, firm-specific risk, and
systematic, market risk. The CAPM’s measure of risk, beta (β), takes into account an asset’s
sensitivity to the market and, thus, only measures systematic, nondiversifiable risk. It can be
proved that under these conditions the expected return for asset i is given by:
E(Ri) = Rf + βi(E(Rm) – Rf)
where E(Rm) is the expected return for the market. This relationship is depicted in
Figure 8. The beta for stock i is calculated as:
σ(Ri, Rm)
βi =
σ2m
In other words, beta is the covariance of stock i’s returns with the market’s returns,
divided by the variance of the market return. The beta for the market is one, because the
market moves exactly with itself. With a positive beta, the expected return on an asset
increases with increases in the market risk premium (E(Rm) − Rf). The market risk
premium (or equity premium) is the expected return on the market in excess of the risk-
free rate.

Figure 8. The Security Market Line
Operationalizing the CAPM
Let us provide an example using U.S. data. The return for the market is often measured
using a broad-based stock index, such as the New York Stock Exchange (NYSE) Composite
Index, and the risk-free rate is often proxied by the rate on short-term U.S. Treasury bills.
Table 4 provides some historical information for the NYSE index and U.S. Treasury bills, as
well as a few stocks selected for illustrative purposes. Average returns and standard
deviations of returns are computed using five years of data from January 2002 through
December 2006. Betas for the four firms are taken from the Value Line Investment Survey
and are also estimated using five years of data. For the few stocks selected, there is no clear
relationship between return, standard deviation, and beta. Remember that the CAPM is a
theoretical relationship regarding the trade-off between risks and expected future return
and predicts higher returns with higher betas. In Table 4, we have a firm with a low beta and
high average return (CytRx Corp.) and another with a high beta and low average return (JDS
Uniphase). This, in fact, is the opposite of what the CAPM predicts, but given randomness
Table 4. Risk Measures for the NYSE Composite Stock Index and Selected Stocks

(remember the CAPM is in terms of expectations) and the fact that our sample is short, this
is not overly alarming (and certainly is not sufficient evidence to call the model into
question).
The first tests of the CAPM generally indicated that the model was a success. Expected
returns seemed to be positively correlated with beta, and beta appeared to do a good job
explaining how returns varied across firms. Researchers, however, began to find evidence
that beta, alone, could not satisfactorily explain returns. Perhaps most significantly,
researchers found that other factors, in addition to the excess return on the market, were
helpful in explaining variation in expected returns across stocks.
Market Efficiency
Capital markets are crucial to the development and functioning of an economy because
they perform a critical service. It is through efficient and well-performing capital markets
that resources are allocated to their best use. Ideally, markets transfer funds from savers to
borrowers with good investment opportunities. Borrowers may have opportunities that
provide good returns based on their level of risk, but insufficient capital to proceed with
such investment. With efficient capital markets, lenders are better off because they earn a
higher risk-adjusted return, and borrowers are better off because they do not have to forgo
profitable opportunities.
Eugene Fama has provided a careful description of an efficient market that has had a
lasting influence on practitioners and academics in finance. According to Fama:
The primary role of the capital market is allocation of ownership of the economy’s capital
stock. In general terms, the idea is a market in which prices provide accurate signals for
resource allocation: that is, a market in which firms can make production-investment
decisions, and investors can choose among the securities that represent ownership of
firms’ activities under the assumption that security prices at any time “fully reflect” all
available information. A market in which prices always “fully reflect” available
information is called “efficient.”
Because prices always accurately reflect information, they are good signals of value and
encourage the best allocation of capital. If a market is efficient, information is fully and
instantaneously reflected in prices. Notice that the definition of an efficient market relies
critically on information. Fama defined three versions of market efficiency to clarify what is
intended by “all available information.”
1. Weak form - prices reflect all the information contained in historical returns.
2. Semi-strong form - prices reflect all publicly available information, including past
earnings and earnings forecasts, everything in the publicly released financial
statements (past and most recent), everything relevant appearing in the business
press, and anything else considered relevant.
3. Strong form - prices even reflect information that is not publicly available, such as
insiders’ information.

Notice that if prices always reflect all information, we must be assuming that the cost of
information acquisition and generation is zero. Of course, we all know this is not reasonable.
Thus, a better working definition of the EMH is that prices reflect all information such that
the marginal benefit of acting on the information does not exceed the marginal cost of
acquiring the information. In other words, no investor can consistently generate excess
returns.
In this context, it is important to note that excess means after all costs have been
considered. Other than obvious trading costs, we must take into account the cost of acquiring
information or undertaking analysis (or paying someone to do so on your behalf). For
example, if a particular mutual fund is able to on average beat the market by 1.5% (on a
gross basis), but charges a 1.5% management expense ratio (MER) to investors, which
means that investors would only match the market’s return, this is not evidence against the
EMH. Further complicating the meaning of excess is the requirement to “risk-adjust,” an
issue which we discuss later in the context of the joint hypothesis problem.
What Does Market Efficiency Imply?
In accounting, finance, and economics, an efficient market is often taken to imply that an
asset’s price equals its expected fundamental value. For example, according to the present
value model of stock prices, a stock’s price equals the present value of expected future
dividends.
Tests of the present value model must specify the information available to traders in
forming their expectations of future dividends. The present value model of stock prices says
that in an efficient market a stock’s price is based on reasonable expectations of its
fundamental value. For most people information means knowledge, but in finance when we
say “information” we mean items that are truly unanticipated. If it is announced that the
unemployment rate has risen to 6% and most people already expected the unemployment
rate to be 6%, this is not considered to be true information. Because information arrival is
by definition unpredictable, stock price changes, if they are only driven by information, must
themselves be unpredictable. This is the basis for the argument that stock prices should
follow a random walk. The next step in a random walk is unpredictable, and the best forecast
of where you will land on the next step is where you are today. If stock prices follow a
random walk, any return on a stock in excess of the risk-adjusted expected return is random
and cannot be predicted.
Proponents of the EMH argue that technical analysis based on charts of historical data
and fundamental analysis based on publicly available financial information will not
successfully generate excess returns. Often a passive investment strategy in which the goal
is to track, rather than attempt to beat, the market is recommended. In this case, an investor
avoids individually held stocks, instead investing in index mutual funds or exchange-traded
index funds (ETFs).
Misconceptions about Market Efficiency
Market efficiency does not suggest that individuals are ill-advised to invest in stocks. Nor
does it suggest that all stocks have the same expected return. The EMH does not suggest that
any stock or portfolio is as good as any other. While a manager cannot systematically
generate returns above the expected, risk-adjusted return, stocks are priced fairly in an

efficient market. Because investors have different attitudes toward risk, they may have
different portfolios.
In addition, while the EMH suggests that excess return opportunities are unpredictable,
it does not suggest that price levels are random. Prices are fair valuations of the firm based
on the information available to the market concerning the actions of management and the
firm’s investment and financing choices.
Joint Hypothesis Problem
As stated before, an excess return is a return that exceeds the return that both nets out
all costs, but also one that would be considered fair given the level of risk of the investment.
Because an excess return is defined in relation to a risk-adjusted return, the measurement
of excess returns requires a model of returns.
The joint-hypothesis problem arises because of the need to utilize a particular risk-
adjustment model to produce required returns, that is, to risk-adjust. This is safe if we know
with certainty what the correct risk-adjustment model is, but unfortunately we do not. If a
test rejects the EMH, is it because the EMH does not hold, or because we did not properly
measure excess returns? We simply do not know the answer to this question. Early empirical
tests of the EMH were generally supportive of the hypothesis. These tests suggested that
excess returns could not be consistently generated by using mechanical trading rules, and
prices reacted quickly and appropriately to new information. Moreover, money managers
did not seem to be able to generate positive excess returns after all costs were considered,
including transaction costs and management fees. More recent research, however, has
reported a series of persistent anomalies, that is, findings that appear to be contrary to the
EMH.
Consider the value premium. It has been found that investing in value stocks (i.e., stocks
with low prices relative to book value or earnings) has historically been a winning strategy.
Such a simplistic strategy seems to be evidence against the EMH, but what if value stocks are
riskier, and what if their risk is insufficiently captured by the CAPM? Then we may not have
an anomaly after all, just an inappropriate asset pricing model. In fact, the famous Fama-
French three-factor model includes a value risk factor.
Agency Theory
An agency relationship exists whenever someone (the principal) contracts with

someone else (the agent) to take actions on behalf of the principal and represent the
principal’s interests. In an agency relationship, the agent has authority to make decisions for
the principal. An agency problem arises when the agent’s and principal’s incentives are not
aligned.
In firms, conflicts of interest often surface, particularly between owners and managers.
Agency theory has important implications concerning the structure of a corporation because
of principal-agent problems between managers and stockholders. Agency costs that arise
from principal-agent problems are both direct and indirect. These costs are incurred
because managers’ incentives are not consistent with maximizing the value of the firm.
Direct costs include expenditures that benefit the manager but not the firm, such as
purchasing a luxury jet for travel. Other direct costs result from the need to monitor

managers, including the cost of hiring outside auditors. Indirect costs are more difficult to
measure and result from lost opportunities. For example, managers of a firm that is an
acquisition target may resist the takeover attempt because of concern about keeping their
jobs, even if the shareholders would benefit from the merger.
With the large size of modern corporations and possibly thousands of stockholders, day-
to-day interaction between owners and managers is not realistic. The separation of
ownership and management can allow businesses to flourish—that is, if managers act in the
shareholders’ best interest. Much finance theory has focused on how to design an optimal
compensation contract to align the interests of shareholders and managers. The best design
of the contract will depend on many factors including whether the manager’s actions are
observable, the degree of information asymmetry between managers and shareholders,
adequacy of performance measures, and differing horizons of managers and shareholders.
To motivate agents, principals include rewards and penalties in compensation contracts,
which are referred to as “carrots and sticks.” Good corporate governance, including optimal
incentive contract design, is critical to the maximization of the value of a firm and the optimal
allocation of capital in our economy.
Prospect Theory
Prospect theory, developed in the late 1970s, is a collection of ideas that provides an
alternative to classical, rational economic decision making. The foundation of prospect
theory rests on the idea that investors are much more distressed by prospective losses than
they are happy about prospective gains. Researchers have found that a typical investor
considers the pain of a P 1,000 loss to be about twice as great as the pleasure received from
the gain of P 1,000. Also, researchers have found that investors respond in different ways to
identical situations. The difference depends on whether the situation is presented in terms
of losses or in terms of gains.
Investors seem to be willing to take more risk to avoid the loss of a pesos than they are
to make a profit. Also, if an investor has the choice between a sure gain and a gamble that
could increase or decrease the sure gain, the investor is likely to choose the sure gain.
Choosing a sure gain over a gamble is called risk-averse behavior. If the same investor is
faced with a sure loss and a gamble that could increase or decrease the sure loss, the investor
is likely to take the gamble. Choosing the gamble over the sure loss is called risk-taking
behavior. This focus on gains and losses and the tendency of investors to be risk-averse with
regard to gains, but risk-taking when it comes to losses, is the essence of prospect theory. In
contrast, a fully rational investor (in an economic sense) is presumed to care only about his
or her overall wealth, not the gains and losses associated with individual pieces of that
wealth.
To give a simple example, suppose you own just two stocks (which is, of course, a bad
idea from a diversification standpoint). On a particular day, one stock goes up sharply, but
the other goes down so that your total wealth in unchanged. On another day, neither stock
changes price at all. In both cases, your total wealth was unaffected, but in the first case you
would probably be upset that your big gain was canceled out. If you are, you are focusing on
the individual pieces, not the big picture. As we will see in the next few subsections, this kind
of thinking can lead to potentially damaging errors in judgment.

Frame Dependence
If an investment problem is presented in two different (but really equivalent) ways,

investors often make inconsistent choices. That is, how a problem is described, or framed,
seems to matter to people. Some people believe that frames are transparent; that is,
investors should be able to see through the way the question is asked. Do they? Do you? Try
this: Jot down your answers in the following two scenarios.
Scenario One. Suppose we give you P 50,000. You have the following choice:
A. You can receive another P 25,000 for sure.
B. You can flip a fair coin. If the coin-flip comes up heads, you get another P 50,000, but
if it comes up tails, you get nothing.
Scenario Two. Suppose we give you P 100,000. You have the following choice:
A. You can lose P 25,000 for sure.
B. You can flip a fair coin. If the coin-flip comes up heads, you lose P 50,000, but if it
comes up tails, you lose nothing.
What were your answers? Did you choose option A in the first scenario and option B in
the second? If that’s what you did, you are guilty of just focusing on gains and losses, and not
paying attention to what really matters, namely, the impact on your wealth. However, you
are not alone. About 85 percent of the people who are presented with the first scenario
choose option A, and about 70 percent of the people who are presented with the second
scenario choose option B.
If you look closely at the two scenarios, you will see that they are actually identical. You
end up with P 75,000 for sure if you pick option A, or else you end up with a 50-50 chance
of either P 50,000 or P 100,000 if you pick option B. So, you should pick the same option in
both scenarios. Which option you prefer is up to you, but the point is that you should never
pick option A in one scenario and option B in the other. But people do this because the
phrasing, or framing, of the question leads people to answer the questions differently. This
phenomenon is known as frame dependence.
Our frame dependence example offers several important investment lessons. First, an
investor can always frame a decision problem in broad terms (like wealth) or in narrow
terms (like gains and losses). Second, broad and narrow frames often lead the investor to
make different choices. Although using a narrow frame (like gains and losses) is human
nature, doing so can lead to irrational decisions. Therefore, using broad frames, like overall
wealth, results in better investment decisions.
Mental Accounts and Loss Aversion
When you add a new stock to your portfolio, it is human nature for you to associate the
stock with its purchase price. As the price of the stock changes through time, you will have
unrealized gains or losses when you compare the current price to the purchase price.
Through time, you will mentally account for these gains and losses, and how you feel about
the investment depends on whether you are ahead or behind. This behavior is known as
mental accounting.

When you engage in mental accounting, you unknowingly have a personal relationship
with each of your stocks. As a result, selling one of them becomes more difficult. It is as if you
have to “break up” with this stock, or “fire” it from your portfolio. As with personal
relationships, these “stock relationships” can be complicated and, believe it or not, make
selling stocks difficult at times.
In fact, you may have particular difficulty selling a stock at a price lower than your
purchase price. If you sell a stock at a loss, you may have a hard time thinking that purchasing
the stock in the first place was correct. You may feel this way even if the decision to buy was
actually a very good decision. A further complication is that you will also think that if you
can just somehow “get even,” you will be able to sell the stock without any hard feelings. This
phenomenon is known as loss aversion, which is the reluctance to sell investments, such as
shares of stock, after they have fallen in value. Loss aversion is also called the “break-even”
or “disposition effect,” and those suffering from it are sometimes said to have “get-evenitis.”
Legendary investor Warren Buffett offers the following advice: “The stock doesn’t know you
own it. You have feelings about it, but it has no feelings about you. The stock doesn’t know
what you paid. People shouldn’t get emotionally involved with their stocks.”
To see if you are likely to suffer from loss aversion, consider the following two
investments:
Investment One. A year ago, you bought shares in Fama Enterprises for P 2,000 per
share. Today, these shares are worth P 1,000 each.
Investment Two. A year ago, you bought shares in French Company for P 250 per share.
Today, these shares are worth P 1,000 each.
What will you do? Will you (1) sell one of these stocks; (2) sell both of these stocks; (3) hold
one of these stocks; or (4) hold both of these stocks?
Because you are reading about loss aversion, you will undoubtedly recognize that if you
choose to keep the shares in Fama Enterprises, you might be suffering from loss aversion.
Why do we say might? Well, consider this. Suppose you are considering a new investment in
Fama Enterprises. Does your rational analysis say that it is reasonable to purchase shares at
P 1,000? If the rational answer is no, then you should sell. If the rational answer is yes, then
you do not suffer from loss aversion. However, if you argued to yourself that if shares in
Fama Enterprises were a good buy at P 2,000, then they must be a steal at P 1,000, you
probably have a raging case of loss aversion. So, to summarize, there are two important
lessons from this example:
• Lesson One: The market says that shares in Fama Enterprises are worth P 1,000.
The market does not care that you paid P 2,000 a year ago.
• Lesson Two: You should not care about your purchase price of Fama Enterprises
either. You must evaluate your shares at their current price.
How about the shares in French Company? Do you sell them and take the profit? Once
again, the lessons are the same. The market says that shares in French Company are worth
P 1,000 per share today. The fact that you paid P250 a year ago is not relevant. Note that
selling either of these stocks has tax consequences. Your careful analysis should
acknowledge the existence of taxes and transaction fees, and their impact on the net
proceeds available to you after you sell a security. How destructive is loss aversion? Perhaps
the most famous case of loss aversion, or “get-evenitis,” occurred in 1995, when 28-year-old

Nicholas Leeson caused the collapse of his employer, the 233-year-old Barings Bank. At the
end of 1992, Leeson had lost about £2 million, which he hid in a secret account. By the end
of 1993, his losses were about £23 million, and they mushroomed to £208 million at the end
of 1994 (at the time, this was $512 million). Instead of admitting to these losses, Leeson
gambled more of the bank’s money in an attempt to “double-up and catch-up.” On February
23, 1995, Leeson’s losses were about £827 million ($1.3 billion) and his trading
irregularities were uncovered. Although he attempted to flee from prosecution, he was
caught, arrested, tried, convicted, and imprisoned. Also, his wife divorced him.
It is unlikely that you will suffer from a case of loss aversion as severe as Nicholas
Leeson’s, but loss aversion does affect everyday investors. For example, we know that
individual investors sell “winners” more frequently than they sell “losers.” If a typical
individual investor had 100 stocks with unrealized gains, the investor might sell 15 of them
and keep 85. If the same investor had 100 stocks with unrealized losses, the investor would
tend to sell 10 of them and keep 90. That is, individual investors are typically about 1.5 times
more likely to sell a stock that has gone up in price than they are to sell a stock that has fallen
in price.
This effect is worse when investors hold mutual funds. With mutual funds, when
investors choose to sell, they are more than 2.5 times as likely to sell a winning fund as a
losing fund. How about professional money managers who manage the mutual funds? They
also suffer from loss aversion.
House Money
Casinos in Las Vegas (and elsewhere) know all about a concept called “playing with
house money.” The casinos have found that gamblers are far more likely to take big risks
with money that they have won from the casino (i.e., the “house money”). Also, casinos have
found that gamblers are not as upset about losing house money as they are about losing the
money they brought with them to gamble.
It may seem natural for you to feel that some money is precious because you earned it
through hard work, sweat, and sacrifice, whereas other money is less precious because it
came to you as a windfall. But these feelings are plainly irrational because any peso you have
buys the same amount of goods and services no matter how you obtained that peso. The
lessons are:
• Lesson One. There are no “paper profits.” Your profits are yours.
• Lesson Two. All your money is your money. That is, you should not separate your
money into bundles labeled “house money” and “my money.”
Let us return to the shares of Fama Enterprises and French Company. Suppose both were
to decline to P 750. You might feel very differently about the decline depending on which
stock you looked at. With Fama Enterprises, the decline makes a bad situation even worse.
Now you are down P 1,250 per share on your investment. On the other hand, with French
Company, you only “give back” some of your “paper profit.” You are still way ahead. This
kind of thinking is playing with house money. Whether you lose from your original
investment or from your investment gains is irrelevant.

Frame dependence, mental accounting, and the house money effect are all consistent
with the predictions of prospect theory. Many other types of judgment errors have been
documented. Here are a few examples:
• Myopic loss aversion: This behavior is the tendency to focus on avoiding short-
term losses, even at the expense of long-term gains. For example, you might fail to
invest “retirement” money into stocks because you have a fear of loss in the near
term.
• Regret aversion: This aversion is the tendency to avoid making a decision because
you fear that, in hindsight, the decision would have been less than optimal. Regret
aversion relates to myopic loss aversion.
• Sunk cost fallacy: This mistake is the tendency to “throw good money after bad.” An
example is to keep buying a stock or mutual fund in the face of unfavorable
developments.
• Endowment effect: This effect is the tendency to consider something that you own
to be worth more than it would be if you did not own it. Because of the endowment
effect, people sometimes demand more money to give up something than they would
be willing to pay to acquire it.
• Money illusion: If you suffer from a money illusion, you are confused between real
buying power and nominal buying power (i.e., you do not account for the effects of
inflation).
It is important to realize that the efficient markets hypothesis does not require every
investor to be rational. As we have noted, all that is required for a market to be efficient is
that at least some investors are smart and well-financed. These investors are prepared to
buy and sell to take advantage of any mispricing in the marketplace. This activity is what
keeps markets efficient. Sometimes, however, a problem arises in this context.
Limits to Arbitrage
The term limits to arbitrage refers to the notion that under certain circumstances,
rational, well-capitalized traders may be unable to correct a mispricing, at least not quickly.
The reason is that strategies designed to eliminate mispricing are often risky, costly, or
somehow restricted. Three important impediments are:
1. Fundamental/Firm-specific risk. This issue is the most obvious risk facing a

would-be arbitrageur. Suppose that you believe that observed price on General
Motors stock is too low, so you purchase many, many shares. Then, some
unanticipated negative news drives the price of General Motors stock even lower. Of
course, you could try to hedge some firm-specific risk by shorting shares in another
stock, say, Ford. But there is no guarantee that the price of Ford will fall if some firm-
specific event triggers a decline in the price of General Motors. It might even rise,
leaving you even worse off. Furthermore, in many, if not most, cases there might not
even be a stock that could be considered a close substitute.
2. Noise trader risk. A noise trader is someone whose trades are not based on
information or financially meaningful analysis. Noise traders could, in principle, act
together to worsen a mispricing in the short run. Noise trader risk is important
because the worsening of a mispricing could force the arbitrageur to liquidate early
and sustain steep losses. As Keynes once famously observed, “Markets can remain

irrational longer than you can remain solvent.” Noise trader risk is also called
sentiment-based risk, meaning the risk that an asset’s price is being influenced by
sentiment (or irrational belief) rather than fact-based financial analysis. If
sentiment-based risk exists, then it is another source of risk beyond the systematic
and unsystematic risks we discussed earlier.
3. Implementation costs. These costs include transaction costs such as bid-ask

spreads, brokerage commissions, and margin interest. In addition, there might be
some short-sale constraints. One short-sale constraint arises when there are not
enough shares of the security to borrow so that the arbitrageur can take a large short
position. Another short-sale constraint stems from legal restrictions. Many money
managers, especially pension fund and mutual fund managers, are not allowed to sell
short. When these or other risks and costs are present, a mispricing may persist
because arbitrage is too risky or too costly. Collectively, these risks and costs create
barriers or limits to arbitrage. How important these limits are is difficult to say, but
we do know that mispricing occur, at least on occasion.
Key Points to Remember_
 Modern finance models are based on the models of economics, and neoclassical
economics is the dominant paradigm.
 The key assumptions of neoclassical economics are that individuals and firms are
self-interested and attempt to optimize to the best of their ability in the face of
constraints on resources; the value (or price) of goods and assets is determined in
markets, subject to the influences of supply and demand; and people have rational
preferences across possible outcomes or states of nature.
 Utility functions describe preferences and assign numbers to possible outcomes so

that preferred choices receive higher numbers.
 Expected utility theory is used to define rational behavior when people face
uncertainty.
 The expected utility function is useful in defining risk preferences. A risk averse
individual prefers the expected value of a prospect to the prospect itself. A risk
seeker would rather have the prospect than the expected value of the prospect with
certainty. A risk-neutral person derives the same utility from a gamble and its
expected value.
 The Allais paradox is a frequently cited example of a violation of expected utility

theory.
 How a prospect question is framed or presented sometimes impacts peoples’

choices.

 Investors recognize a trade-off between return and risk. Expected return and risk
are commonly proxied by historical mean return and variance (or standard
deviation) of returns.
 Covariance and correlation are statistical measures of how random variables are
related.
 The efficient frontier represents portfolios that maximize expected return for a given
level of risk. No rational investor would choose a portfolio below the curve because
a portfolio with higher return and the same risk exists.
 In a portfolio of assets, firm-specific risk can be diversified away. Systematic, market

risk, however, cannot be eliminated.
 The capital market line gives combinations of the risk-free asset and the market
portfolio. Rational investors should choose a portfolio on this line in order to achieve
the highest return with the lowest risk.
 According to the capital asset pricing model, investors will not be compensated for
taking on diversifiable risk.
 Beta measures risk related to market movements. An asset’s beta can be used to
estimate its expected return.
 The efficiency of markets is important because it allocates capital across firms.
 In an efficient market, no investor can consistently earn excess returns.
 An agency problem may exist when an agent’s incentives are not aligned with the
principal’s.
 Conflicts of interest between the owners and managers of large corporations are
potentially costly.
 Optimal compensation contracts align the incentives of stockholders and

management.
 Using decision-making problems, psychologists have noted violations of expected

utility theory.
 Prospect theory, developed by Daniel Kahneman and Amos Tversky, is the most
accepted behavioral model of individual behavior.
 There are three key aspects of observed behavior: risk aversion in gains and risk
seeking in losses; gains and losses are defined relative to a reference point; and
losses loom larger than gains (loss aversion).
 In prospect theory, the value function replaces the idea of utility.

 Prospect theory uses overweighting of small probabilities to explain why a person

might buy a lottery ticket and insurance.
 Cumulative prospect theory, an extension of the original model, includes more

flexible decision weights that reflect overweighting of low probabilities and different
weights for gains and losses of equal size.
 The certainty effect is the finding that people overweight more certain outcomes.
 Kahneman and Tversky used experimental evidence to propose functional forms for
value and weighting functions.
 How a problem is framed or presented can affect the choices people make.
 People use mental accounting to organize, evaluate, and monitor financial matters.
 Three aspects of mental accounting are important: the decision frame, assignment
of accounts, and frequency of account evaluation.
 An anomaly is an empirical result apparently contrary to market efficiency.
 Some major anomalies are lagged reactions to earnings announcements, the small-
firm effect, the value advantage, and momentum and reversal.
 Market efficiency theoretically rests on three supports. Markets are efficient if

investors are rational. Failing this, if their errors are random, markets are efficient.
And failing this, if arbitrage is unlimited, markets are efficient.
 Noise exists when some traders base value on misinformation. If many make the
same kind of mistake at the same time, sentiment exists.
 Noise-trader risk is the risk that “wrong” prices will become even more wrong.
 There are limits to arbitrage because of fundamental risk, noise-trader risk, and
implementation costs.
Reference
Ackert, Lucy., & Deaves, R. (2015). Behavioral Finance: Psychology, Decision Making and
Markets. Pasig City, Philippines: Cengage Learning Asia Pte Ltd.
Jordan, B., & Miller, T. Jr. (2009). Fundamentals of Investments Valuation and Management
(5th Ed.). New York, USA: McGraw-Hill Companies, Inc.

Unit Ii: Conventional Finance, Prospect Theory and Market Efficiency

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Unit Ii: Conventional Finance, Prospect Theory and Market Efficiency

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E L E C TI V E 8 – B E HA V I O R A L F I N A N C E

UNIT II: CONVENTIONAL FINANCE, PROSPECT THEORY AND

The behavior of individuals, practitioners, markets, and managers is sometimes

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 1

Neoclassical economics makes some fundamental assumptions about people:

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 2

Table 1. Logarithmic Utility of Wealth

Wealth (in P 10,000s) u(ѡ) = ln(ѡ)

Figure 1. Utility Function

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 3

Expected Utility Theory

U(P1) = 0.40u(50,000) + 0.60u(1,000,000)

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 4

u(E(w)) = ln(62) = 4.1271

Figure 2. Utility Function for a Risk Averse

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 5

A risk-averse person is willing to sacrifice for certainty. The certainty equivalent is

u(30.17) = u(w) = U(P1) = 0.40(1.6094) + 0.60(4.6052) = 3.4069

Figure 3. Utility Function for a Risk Seeker

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 6

Figure 4. Utility Function for a Risk-neutral Individual

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 7

Table 2. Prospect Choices

U(A) = u(P 1,000,000) > .89u(P 1,000,000) + .1u(P 5,000,000) = U(A*)

Since .11u(P1,000,000) > .1u(P5,000,000) and .1u(P5,000,000) > .11u(P1,000,000)

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 8

Table 3. Reconsidering the Prospect Choices

To understand this contradiction, consider the following. Suppose a person is indifferent

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 9

The Pricing of Risk

Risk and Return for Individual Assets

Modern portfolio theory provides a practical framework that assumes that

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 10

distribution of returns are not observable. Therefore, in finance applications and

Risk and Return for Portfolios of Assets

The Optimal Portfolio

When choosing optimal portfolios, it is important to use distributions that generate

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 11

Table 4. Returns for High Tech and Low Tech

Expected Return Standard Deviation of

E(RP ) =[ x1 * E(R1) ] +[ x2 * E(R2)] … + xn * E(Rn)

E(Rp) = 0.40(0.15) + 0.60(0.08) = 0.108

And the variance of portfolio returns is:

σ2p = xA2 σ2A + xB2 σ2B + 2xAxBσAσBCorr(RA,RB)

σ2p = 0.4020.302 + 0.6020.102 + 2(0.40)(0.60)(−0.10)(0.30)(0.10)= 0.0166

Investors actually have thousands of risky investment opportunities. If we consider all

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 12

Figure 6. The Efficient Set

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 13

Figure 7. The Capital Market Line

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 14

Capital Asset Pricing Model (CAPM)

According to this framework, rational investors hold the market portfolio in

E(Ri) = Rf + βi(E(Rm) – Rf)

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 15

Figure 8. The Security Market Line

Operationalizing the CAPM

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 16

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 17

What Does Market Efficiency Imply?

Misconceptions about Market Efficiency

UNIT II: COVENTIONAL FINANCE, PROSPECT THEORY AND MARKET EFFICIENCY 18