MODERN FINANCE &

CORPORATE FINANCE
SESSION 4 – RISK & RETURN PART II

Johanna Sophie Jost

PhD fellow – Center for Corporate Governance – 16.09.2022
 I. Investor behavior and
capital market efficiency
10 Minute Break
AGENDA II. What is really happening on
financial markets?
III. Behavioral finance
IV. Wrap-Up & Discussion
Who am I and how to reach me
▪ PhD fellow – Department of Accounting, Center for
Corporate Governance
▪ Solbjerg Plads - C5.14; jsj.acc@cbs.dk
▪ Background in Philosophy, Economics and Business
Administration from University of Bayreuth and CBS
▪ Research interests: Behavioral Finance, Financial
Literacy, Financial Advice, Investor behavior

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 I. INVESTOR BEHAVIOR AND
CAPITAL MARKET EFFICIENCY

Photo by Tomas Eidsvold on Unsplash

Investor behavior and the EMH
A Recap

Efficient Market Hypothesis (EMH): Asset prices reflect all information currently available to investors.

Implication: It is impossible to consistently beat the market as competition among investors eliminates all
positive NPV trading opportunities. Does this make sense?
▪ For Public, easily interpretable information: EMH holds well. High competition between investors,
asset price should react nearly instantaneously to news.
▪ For Private or difficult-to-interpret information: EMH might not hold well at the beginning as some
investors may realize profit by trading on this information. But then, trading will move up prices and
reflect the additional information.

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Investor behavior and capital market efficiency
A Recap

Capital Asset Pricing Model (CAPM)

𝐸 𝑅𝑖 = 𝑟𝑓 + 𝛽𝑖 X (𝐸 [𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 )

Read as: The expected return of an investment i equals the risk-free-rate plus beta times the market-risk-
premium. With:
▪ 𝑟𝑓 : The risk-free-rate being the interest you receive on the market without taking on any risk
▪ 𝛽𝑖 : Beta measuring the volatility due to market risk in comparison to the market as a whole
▪𝐸 [𝑅𝑀𝑘𝑡 ] − 𝑟𝑓 : The market-risk-premium being the difference between the expected market return
minus the interest free rate.
CAPM equilibrium: The market portfolio is efficient. All (rational) actors hold the market portfolio
Implication: It is impossible to consistently do better than the market without additional risk.

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Capital Asset Pricing Model and Security Market Line
A Recap

See Berk, DeMarzo (2019) p. 425.

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News announcement and the stock’s alpha
What happens when news are announced?
→ It raises/lowers the expected return of some stocks
→ The market portfolio is no longer efficient as alternative portfolios offer higher expected return and/or
a lower volatility
→Investors alter their investments to reach an efficient portfolio by comparing the expected return of
each security with its required return from CAPM

A stock’s alpha: The difference between a stock’s expected return and its required return according to
the security market line.
𝛼𝑠 = 𝐸 𝑅𝑠 − 𝑟𝑠

▪ When the market portfolio is efficient, all stocks are on the security market line and have zero alpha

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Investor behavior with news announcement

See Berk, DeMarzo (2019) p. 482 f.

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Investor behavior and capital market efficiency
Benefiting from non-zero alpha stocks:
▪ If expected returns change, some investors aim to profit by buying or selling stocks accordingly,
which leads to changes in the stock prices.
▪ As stock prices change, so do expected returns, until a new “equilibrium” is reached:
buying “good” (positive alpha) stocks raises their price and lowers their expected return
selling “bad” (negative alpha) stocks lowers their price and raise their expected return
Thus, investors’ actions have 2 consequences:
1. Competition among “savvy investors” to “beat the market” keeps the market close to efficient
most of the time. Thus, CAPM is an approximate description of a competitive market.
2. There may be trading strategies that take advantage of non-zero alpha stocks and thus can beat
the market.

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Investor behavior and capital market efficiency
1. Under what circumstances could an investor benefit from trading a non-zero alpha stock?
→ Information asymmetry: informed (sophisticated) vs. uninformed (naïve) investors
CAPM’s strategy to avoid being outsmarted independent of access to information and trading skill:
Holding the market portfolio.

2. Under what circumstances can the market portfolio be inefficient?

→ Irrationality: A significant number of investors…
… has irrational expectations.
… cares about aspects of their portfolios other than expected return and volatility.

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The 2013 Nobel Prize
"Markets are efficient, but there are different dimensions
of risk and those lead to different dimensions of expected
returns. That's what people should be concerned with in
their investment decisions and not with whether they can
pick stocks, pick winners and losers among the various
managers delivering basically the same product."
Eugene Fama

“I also hope to challenge financial thinkers to improve

their theories by testing them against the impressive
evidence that suggests that the price level is more than
merely the sum of the available economic information, as
is now generally thought to be the case.”
Rob Shiller

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10 MINUTES BREAK
 II. WHAT IS REALLY HAPPENING
ON FINANCIAL MARKETS?

Photo by Marie Bellando Mitjans on Unsplash

Experiment 1

Guess a number from zero to 10, with the goal of making your guess as
close as possible to two-thirds of the average guess of all those
participating in the contest.

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The Thaler challenge
Guess a number from zero to 100, with the
goal of making your guess as close as possible
to two-thirds of the average guess of all those
participating in the contest.

Experiment run in financial times:

▪ What did people guess? Around 13
▪ What’s the Nash equilibrium? 0

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 III. BEHAVIORAL FINANCE

Photo by Mylius, GFDL 1.2, https://commons.wikimedia.org/w/index.php?curid=18466257

Introduction to Behavioral Finance

Traditional finance Behavioral finance

Prescriptive Descriptive

Economics Psychology, Social Sciences

EMH, CAPM, MPT Behavioral biases, Bubbles, Heuristics

Key assumptions: Key Assumptions:

▪ Rational agents ▪ Biased and boundedly rational agents
▪ Maximizing risk/return relationship ▪ Systematic irrationality
▪ Homogenous expectations ▪ Information asymmetry
▪ No information asymmetry & market frictions

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Experiment 2

What do you think about how safely you drive an automobile?

All drivers are not equally safe drivers. Please compare your own skill to the
skills of the other people in this classroom. By definition, there is a least safe
and a most safe driver in this room. Please indicate your own estimated
position in this experimental group (and not e.g., people in Copenhagen or
in Denmark). Of course, this is a difficult question because you do not know
all the people gathered here today, much less how safely they drive. But
please make the most accurate estimate you can.

Svenson, 1891
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Overconfidence bias
Definition: Overconfidence bias is the tendency of individuals to consider themselves above average on
positive characteristics. In other words, people systematically overestimate their own abilities.

Empirical evidence:
▪ Overconfidence about driving abilities
▪ Entrepreneur’s overconfidence about chances of failure
▪ Individuals being too optimistic about their future prospects

What does this mean for investor behavior?

▪ People believe they can outsmart or time the market
▪ Overtrading

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Experiment 3

You are gambling. Make a choice

1.a) Get DKK 900 for sure

1.b) 90% chance of getting DKK 1000

2.a) Loose DKK 900

2.b) 90% chance of loosing DKK 1000

Svenson, 1891
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Loss aversion & Framing effect
Definition: Loss aversion is the tendency to prefer Definition: The framing effect occurs when
avoiding losses to acquiring equivalent gains decisions are influenced by the way information is
presented. Equivalent information can be more or
Empirical evidence: less attractive depending on what features are
▪ The pain of losing is around twice as powerful as highlighted.
the pleasure of gaining (Kahneman & Tversky,
1977).
▪ Logins to brokerage accounts decrease when
investors incur losses.
What does this mean for investor behavior?
▪ Stock market participation: The fear of losses
can prevent investors from taking well-
calculated risks.

https://thedecisionlab.com/
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Mental accounting & Disposition effect
Definition: Mental accounting describes the
tendency to attach subjective value to money,
usually in ways that violate economic theory.
What does this mean for finance?
▪ Investment considered as opening an account
and selling considered closing (Zhang &
Sussmann, 2018)
▪ Realization of gain or loss only experienced at
account closing - price changes in between are
neglected (Frydman, Hartzmark & Solomon,
2018)
Definition: Disposition effect is the tendency to
hang on to losing and sell winning stocks.
Investors are driven to sell winning investments in
order to ensure a profit but are averse to selling
losing investments in hopes of turning them into
gains.
Empirical evidence:
▪ 85% of retail investors are found to be subjects
to the disposition effect (Dhar & Zhu, 2006)
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Experiment 4

Do more English words start with the letter K or do more words have K as
their third letter?

Svenson, 1891
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Familiarity & home bias, Availability heuristic
Definition:
Familiarity bias describes the tendency to favor familiar investment
opportunities
Home bias describes the tendency to favor domestic investment
opportunities
Availability heuristic refers to the pattern of estimating frequency
or probability by the ease with which instances or associations could
be brought to mind

What does this mean for investor behavior?

▪ Under diversified portfolios
▪ Affects retail and professional investors

https://thedecisionlab.com/
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Herd behavior & Confirmation bias
Definition: Herd behavior refers to the tendency to
mimic actions of the majority.
What does this mean for investor behavior?
▪ Can lead to informational cascade effect (traders
ignore their own information hoping to profit
from the information of others)
▪ Bubble building
Definition: Confirmation bias describes the
tendency to focus and give greater credence to
evidence that fits with our preconceived beliefs.
What does this mean for investor behavior?
▪ Failure to assess information correctly
▪ Concentration of holdings
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 IV. WRAP-UP & DISCUSSION

Photo by Maria Orlova: https://www.pexels.com/de-de/foto/mann-in-der-schwarzen-jacke-die-fahrrad-auf-strasse-reitet-4947124/

What does this mean for investor behavior
and the relationship of risk and return?
▪ How can we explain current trading frequency?
▪ Why is there active portfolio management?
▪ What about bubbles?
▪ What if departures from CAPM are individual and cancel each other out?
▪ Will irrational investors automatically loose money?

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Any more questions?
▪ Reach me on: jsj.acc@cbs.dk
▪ Open to supervision
▪ Research interests: Behavioral Finance, Financial Literacy, Financial Advice, Stock market
behavior, Corporate Governance

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