Ch13 Investor Behavior & Market Efficiency

Chapter 13
Investor Behavior &
Illustration: ©Johan Jarnestad/The Royal Swedish Academy of Sciences

Market Efficiency
Ziwei Wang
Wuhan University
THEN NOW LATER
Review
Harrison Holdings, Inc. (HHI) is publicly traded, with a current share price of $30
per share. HHI has 23 million shares outstanding, as well as $70 million in debt.
The founder of HHI, Harry Harrison, made his fortune in the fast food business.
He sold o part of his fast food empire, and purchased a professional hockey
team. HHI’s only assets are the hockey team, together with 50% of the
outstanding shares of Harry’s Hotdogs restaurant chain. Harry’s Hotdogs (HDG)
has a market capitalization of $803 million, and an enterprise value of $1.05
billion. After a little research, you nd that the average asset beta of other fast
food restaurant chains is 0.72. You also nd that the debt of HHI and HDG is
highly rated, and so you decide to estimate the beta of both rms’ debt as zero.
Finally, you do a regression analysis on HHI’s historical stock returns in
comparison to the S&P 500, and estimate an equity beta of 1.32. Given this
information, estimate the beta of HHI’s investment in the hockey team.
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• Fama is most well-known for what he
termed the e cient market
hypothesis, the assertion that markets
are so competitive it is impossible to
make money by trying to predict.
• Shiller argued the opposite, that the

excess volatility in markets results
from irrational behavior that can be
exploited.
• Hansen developed a statistical

method that is particularly well suited
to testing rational theories of asset
pricing.
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Competition and Capital Markets
• Suppose new information changed
the expected returns of some stocks.
• If market prices remain the same, the

e cient portfolio would change.
• How should we improve on the

market portfolio?
• We know from the last chapter that

we should invest more of stock i if
E[Ri] > ri = rf + βi ⋅ (E[RMkt] − rf ).
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• In other words, we should invest in
stocks with positive alphas, where
αi = E[Ri] − ri .
• But if all investors demand more of a
stock with positive alpha, the price
goes up.
• This means their expected return

goes down.
• In the new equilibrium, all stocks lie

on the security market line again.
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• Actually, if all investors are rational,
the expected returns “jump” to the
security market line without trade.
• For example, knowing that the price

of Walmart will rise, nobody will want
to sell its stock.
• This make sense, because the

market portfolio is still the e cient
portfolio in the new equilibrium.
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• So investors don’t need to trade —
prices automatically adjust to the
information.
• This echos the e cient market

hypothesis.
• Does this result depend on the

assumption of homogeneous
expectations?
• It does not.
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Rational Expectations
• Now let us assume that investors have heterogeneous information.
• With some re ection, one should understand that she can guarantee the
average return (i.e. earn an alpha of zero) simply by holding the market
portfolio. This can serve as an “outside option” of an investors strategy.
• One should also understand this: in order to pro t by buying a positive-alpha

stock (maybe because you have superior information), there must be
someone willing to take the loss and sell it.
• But if you are rational and someone makes an o er to buy from you, you can
infer that this guy has superior information. You should not sell.
• This is a famous result in micro theory called the no-trade theorem.

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Rational Expectations
• Let us get this straight.
• Because an investor can guarantee a zero alpha, rational investors should not
choose a portfolio with negative alpha.
• However, if no investor earns a negative alpha, then no investors can earn a

positive alpha. Otherwise the average would not be zero.
• The market portfolio must stay e cient after the informational shock.
• Therefore, the CAPM only requires rational expectations, which means that
all investors correctly interpret and use their own information, as well as
information that can be inferred from the market.
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The Behavior of Individual Investors
• Many investors do not appear to hold an e cient portfolio, but instead fail to
diversify and trade too much.
• For households that held stocks, the median number of stocks held in 2001
was four, and 90% of investors held fewer than ten di erent stocks.
• Moreover, these investments are often concentrated in stocks of companies

that are in the same industry or are geographically close.
• One reason is that investors su er from a familiarity bias.

• For example, a study of large plans found that employees invested close to a
third of their assets in their employer’s own stock.
• (The only long-run investment I made was in Nintendo, because I like it.)
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• According to CAPM, investors should hold
the market portfolio of all risky assets in
combination with risk-free assets.
• The market portfolio is a passive portfolio,

with which you don’t need to trade.
• In reality, a tremendous amount of trading

occurs each day. At its peak in 2008, annual
turnover on the NYSE was nearly 140%.
• Individual investors tend to trade very

actively, with average turnover almost one
and a half times the overall rates reported in
the gure.
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• Psychologists discovered that uninformed individuals tend to overestimate
the precision of their knowledge. We call this overcon dence bias.
• For example, many sports fans sitting in the stands con dently criticize the
coaching decisions on the eld, truly believing that they can do a better job.
• Many inexperienced 王者荣耀 players always think “我能反杀” when being

ganked, but they can’t.
• Similarly in stock markets, individual investors believe they can pick winners
and losers when, in fact, they cannot; this overcon dence leads them to trade
too much.
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• An implication of this overcon dence
bias is that, assuming they have no
true ability, investors who trade more
will not earn higher returns.
• Instead, their performance will be

worse once we take into account the
costs of trading.
• The left gure documents precisely

this result, showing that much
investor trading appears not to be
based on rational assessments of
performance.
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• Psychological studies have shown that, in areas such as nance, men tend to
be more overcon dent than women.
• Consistent with the overcon dence hypothesis, they documented that men
tend to trade more than women, and that their portfolios have lower returns
as a result.
• These di erences are even more pronounced for single men and women.
• For Finnish investors, researchers nd that trading activity increases with
psychological measures of overcon dence.
• Interestingly, they also nd that trading activity increases with the number of
speeding tickets an individual receives (a measure of sensation seeking).
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Individual Behavior vs Systematic Behavior
• In reality, individual investors are under-diversi ed and trade too much,
violating a key prediction of the CAPM.
• But this observation does not invalidate the conclusion of CAPM.

• This is because for a rational investor, the irrational investors behave in
random, idiosyncratic ways, which would cancel out in aggregate.
• On average, individual irrational behaviors will not have an e ect on market

prices or returns.
• The market will be a ected if investors su er from correlated, common,

systematic, and predictable biases.
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Individual Behavior vs Systematic Behavior
• “萨默斯以及我本⼈的导师施莱佛教授也写过⼀篇著名的⽂章，说明在股市上如
果⾮理性的⼈⾜够多，那么理性⼈将被迫按照⾮理性⼈的投资⽅式进⾏投资。
其中的道理是，如果绝⼤部分⼈都错误地认为股市在上涨，则将买⼊股票，推
⾼股价，这个时候头脑再清晰的⼈也必须跟着买⼊，否则将丧失价格上涨的投
资良机。这就是股票市场上“笨蛋”领着“聪明⼈”⾛的很好的例⼦。”
——李稻葵推荐序，《钓愚操纵与欺骗的经济学》
（原著：George Akerlof and Rober Shiller, 翻译：张军）
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Systematic Trading Biases
• Investors tend to focus on single stocks instead of the whole portfolio.
• Moreover, they hold on to stocks that have lost value and sell stocks that
have risen in value since the time of purchase.
• This tendency is called the disposition e ect.

• For example, in a study of all trades in the stock market in Taiwan from 1995–
1999, investors in aggregate were twice as likely to realize gains as they were
to realize losses. Nearly 85% of individual investors were subject to this bias.
• The losing stocks that small investors continue to hold tend to underperform
the winners that they sell.
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• This can be explained by the Prospect Theory proposed by Daniel
Kahneman (2002 Nobel Laureate) and Amos Tversky.
• It suggests that agents are risk averse when winning and risk seeking when
losing.
• Consider two scenarios:

1. Choose between getting $900 or taking a 90% chance of winning $1000
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• This can be explained by the Prospect Theory proposed by Daniel
Kahneman (2002 Nobel Laureate) and Amos Tversky.
• It suggests that agents are risk averse when winning and risk seeking when
losing.
• Consider two scenarios:

1. Choose between getting $900 or taking a 90% chance of winning $1000
2. Choose between losing $900 and taking a 90% chance of losing $1000
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• This is can generate inconsistency of an agent’s choices due to a framing
e ect.
• In an experiment, Daniel Kahneman and Amos Tversky presented participants

with 2 scenarios.
• Scenario 1: Participants started with $1000. They then could choose

between: (A) Winning $1000 with a 50% probability (and winning $0 with a
50% probability), or (B) Getting another $500 for sure.
• Scenario 2: Participants started with $2000. They then could choose

between: (A) Losing $1000 with a 50% probability (and losing $0 with a 50%
probability), or (B) Losing $500 for sure.
• These two scenarios should be the same for rational individuals.

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• Investment behavior seems to be a ected by investors attention and mood in
a systematic way.
• Studies show that individuals are more likely to buy stocks that have recently
been in the news.
• In New York City, the annualized market return on perfectly sunny days is
approximately 24.8% per year versus 8.7% per year on perfectly cloudy days.
• One study estimates that a loss in the World Cup elimination stage lowers the
next day’s stock returns in the losing country by about 0.50%, presumably
due to investors’ poor mood.
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• An alternative reason why investors
make similar trading errors is that they
are actively trying to follow each other’s
behavior.
• This phenomenon, in which individuals

imitate each other’s actions, is referred to
as herd behavior.
• This behavior can lead to an

informational cascade e ect (连锁反应)
in which traders ignore their own
information, and thus all traders
coordinate on a wrong decision.
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• Here, we present a simple model of informational herding.
• “A Theory of Fads, Fashion, Custom, and Cultural Change as Informational
Cascades” by Bikhchandani, Hirshleifer, and Welch on JPE (Cited by 9101).
• Let’s suppose the economy is either G or B with equal probabilities.

• An investor would invest if she believes that the economy is G with a
probability higher than 1/2, and would not invest otherwise.
• If the investor is indi erent, i.e. holds a belief of 1/2, she randomly makes an
investment decision (that is, chooses to invest with 1/2 probability).
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• Each investor can observe an informative signal g or b. We assume
P(g | G) = P(b | B) = 0.6 and P(b | G) = P(g | B) = 0.4.
• Suppose the economy is really B, but investors do not know.
• We have a large number of investors, and each of them obtains one
independent signal.
• If an omniscient (先知的) investor knows all signals, then about 60% are bad
signals, so the investor knows that the economy is B and won’t invest.
• We consider a more realistic case: Investors make decisions sequentially, and

each investor only observes her own signal and what previous investors did.
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• Let’s consider a speci c case: The rst two investors both invest. This
happens with probability 0.4 × 0.4 + 0.4 × 0.6 × 0.5 = 0.28, given that
economy is B.
• What should the third investor do?

• If her signal is b, the economy is G with unconditional probability
0.5 × (0.6 × 0.6 + 0.6 × 0.4 × 0.5) × 0.4 = 0.096
and the economy is B with unconditional probability
0.5 × (0.4 × 0.4 + 0.4 × 0.6 × 0.5) × 0.6 = 0.084.
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• This means the probability that the economy is G conditional on her signal b
and the fact that both previous two investors invest is
0.096
= 0.533 > 0.5.
0.096 + 0.084
• Therefore, the third investor should invest even though his signal is b. Of
course, if her signal is g, she should invest with even more con dence.
• Wow, this means if the rst two investors both invest, the third investor will
invest regardless of her own signal.
• But if her investment decision does not re ect her own signal, all later
investors are in the same position as her — They will all invest!
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Performance of Fund Managers
• When individual investors make mistakes, can sophisticated portfolio
managers pro t at their expenses? The answer is yes.
• The value added by a fund manager is equal to the fund’s alpha before fees
(gross alpha) multiplied by the fund’s assets under management (AUM).
• The average mutual fund manager is able to identify pro table trading
opportunities worth around $3 million per year.
• For managers with at least ve years experience, this number is almost $9

million per year.
• However, the median mutual fund actually destroys value.
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• Do investors bene t by identifying the pro t-making funds and investing in
them? This time the answer is no.
• The average fund’s alpha after fees (net alpha), which is the alpha earned by
investors, is −0.34 % .
• This doesn’t appear to provide superior returns than investing in passive

index funds without a manager.
• The reason is that on average, the value added is o set by the fees the funds
charge.
• This is so even if di erent funds charge the same percentage fee.
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• If investors could predict that a skilled manager would generate positive alpha
in the future, they would rush to invest with this manager.
• Then this manager is ooded with capital, but the pro table opportunities will
eventually be exhausted.
• If investors choose managers in a competitive way, managers should

eventually produce the same net alpha.
• But better managers have gathered more capital, their unique skills are
rewarded by higher aggregate fees.
• As a result, fund size is a strong predictor of the future value added by fund
managers.
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Problem
Allison and Bill are both mutual fund managers, although Allison is more skilled than Bill.
Both have $300 million in assets under management and charge a fee of 1%/year. Allison is
able to generate a 2% alpha before fees and Bill is able to generate a 1% alpha before fees.
(a) What is the net alpha investors earn in each fund (that is, the alpha after fees are taken
out)?
(b) Which fund will experience an in ow of funds?
(c) Assume that both managers have exhausted the supply of good investment
opportunities and so they will choose to invest any new funds received in the market
portfolio and so those new funds will earn a zero alpha. How much new capital will ow into
each fund?
(d) Once the new capital has stopped owing in, what is the alpha before and after fees of
each fund? Which fund will be larger?
(e) Calculate each manager’s compensation once the capital has stopped owing. Which
manager has higher compensation?
The inflow of capital will cease when the
32 fund’s alpha is no longer positive
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Style-Based Techniques and Efficiency
• We now investigate some trading
strategies that have generated
higher returns historically than the
CAPM predicts.
• As we discussed in Chapter 10,

small stocks have historically earned
higher average returns than the
market portfolio.
• While small stocks do tend to have

high market risk, their returns appear
high even accounting for their higher
beta, an empirical result we call the
size e ect.
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• Researchers have found similar
results using the book-to-market
ratio.
• Recall that practitioners refer to

stocks with high book-to-market
ratios as value stocks, and those
with low book-to-market ratios as
growth stocks.
• The gure demonstrates that value

stocks tend to have positive alphas,
and growth stocks tend to have low
or negative alphas.
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• How to explain the two observations above?
• If the market portfolio is not e cient, a positive alpha implies that the stock
has a relatively high expected return.
• A higher return implies a lower price, which in turn implies a lower market
capitalization.
• At the same time, a lower market cap means a higher book-to-market ratio,
and hence the stock is more likely to be categorized into a value stock.
• These arguments are not in absolute terms, but characterize a correlation.
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• Researchers have also used past stock returns to form portfolios with positive
alphas.
• For the years 1965 to 1989, Jegadeesh and Titman ranked stocks each
month by their realized returns over the prior 6–12 months. They found that
the best-performing stocks had positive alphas over the next 3–12 months.
• Investors can exploit this result by buying stocks that have had past high
returns and (short) selling stocks that have had past low returns, which is
called a momentum strategy.
• Jegadeesh and Titman showed that over the period 1965–1989, this strategy
would have produced an alpha of over 12% per year.
36
• The persistence of positive alphas generated by these strategies goes against
CAPM. How can we explain?
• One possible explanation is the proxy error.

• The true market portfolio consists of all traded investment wealth in the
economy, including bonds, real estate, art, precious metals, and so on.
• We cannot include most of these investments in the market proxy because

competitive price data is not available.
• Consequently, standard proxies like the S&P 500 may be ine cient compared
with the true market, and stocks will have nonzero alphas.
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• Another possibility is that investors subject to systematic behavior biases.
• For example, they may be attracted to large growth stocks that receive
greater news coverage. Or they may sell winners and hang on to losers,
following a contrarian strategy.
• More sophisticated investors hold an e cient portfolio, but because supply

must equal demand, this e cient portfolio must include more small, value,
and momentum stocks to o set the trades of biased investors.
• While alphas are zero with respect to this e cient portfolio, they are positive
when compared with the market portfolio.
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• Investors may have alternative risk preferences and non-tradable wealth.
• They may care about risk characteristics other than the volatility of their
traded portfolio.
• For example, they may be attracted to investments that have a small

probability of an extremely high payo . As a result, they might be willing to
hold some diversi able risk in order to obtain such a payo .
• In addition, investors are exposed to other signi cant risks outside their
portfolio that are not tradable, the most important of which is due to their
human capital.
• For example, a banker at Goldman Sachs is exposed to nancial sector risk,

while a software engineer is exposed to risk in the high-tech sector.
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Multifactor Models of Risk
• We have discussed that the expected return of any security is a function of
the expected return of the e cient portfolio:
eff
E[Rs] = rf + βs × (E[Reff ] − rf ) .
• When the market portfolio is not e cient, what should we do?
• It is not actually necessary to identify the e cient portfolio itself.
• As long as we can identify a collection of well-diversi ed portfolios from which
an e cient portfolio can be constructed, we can use the collection to
measure systematic risks.
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• Suppose we have identi ed a collection of portfolios, called factor portfolios,
from which an e cient portfolio can be constructed: RF1, …, RFN.
• The expected return of asset s is then given by:

F1 F2 FN
E[Rs] = rf + βs × (E[RF1] − rf ) + βs × (E[RF2] − rf ) + ⋯ + βs × (E[RFN] − rf ) .
F1 FN
• The betas βs , …, βs are called factor betas. Each factor beta is the
expected percentage change in the excess return of a security for a 1%
change in the excess return of the factor portfolio.
• This model is consistent with the CAPM. It is also referred to as the Arbitrage
Pricing Theory.
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• We can simplify this equation further by thinking of each E[RFi] − rf as the
expected return of a portfolio in which we borrow at rf and invest in the factor
portfolio Fi.
• Because this portfolio costs nothing, it is called a self- nancing portfolio.

• A self- nancing portfolio can also be constructed by going long some stocks
and going short other other stocks with equal market value.
• If we require all factor portfolios be self- nancing, we have

F1 F2 FN
E[Rs] = rf + βs E[RF1] + βs E[RF2] +⋯+ βs E[RFN] .
In general, a self-financing portfolio is any portfolio with portfolio weights that sum to zero
rather than one
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• What self- nancing portfolios should we choose to construct an e cient
portfolio?
• A straightforward choice is the market portfolio. Even if it may not be e cient,

it still captures many components of systematic risks.
• We have discussed that trading strategies based on market cap, book-to-

market ratios, and momentum appear to have positive alphas.
• Therefore, these portfolios are good candidates for our factor portfolios.
• We now construct them in order.
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• Market capitalization strategy. We place rms into two portfolios depending
on their market cap:
• Firms with market value below the median of NYSE rms form an equally
weighted portfolio S; Firms above the median form an equally weighted
portfolio B.
• A trading strategy that each year buys S and nances this long position by
short selling B has produced positive alphas historically.
• This self- nancing portfolio is known as the small-minus-big (SMB) portfolio.
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• Book-to-market ratio strategy.
• Firms with book-to-market ratios less than the 30th percentile of NYSE rms
form an equally weighted portfolio L; Firms above the 70th percentile form an
equally weighted portfolio H.
• A trading strategy that each year takes a long position in H nanced by short
selling L has produced positive alphas historically.
• This self- nancing portfolio is known as the high-minus-low (HML) portfolio.
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• Past returns (momentum) strategy.
• Each year we rank stocks by their return over the last one year.
• We construct a portfolio that goes long the top 30% of stocks and short the
bottom 30%.
• We hold this portfolio for a year, and then form a new self- nancing portfolio
to hold for the next year.
• The resulting self- nancing portfolio is known as the prior one-year

momentum (PR1YR) portfolio.
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• The collection of these four portfolios — the excess return of the market
(Mkt − rf ), SMB, HML, and PR1YR — is currently the most popular choice
for the multifactor model.
• Using this collection to represent the systematic risks, the expected return of
security s is given by
Mkt SMB HML PR1YR
E[Rs] = rf + βs (E[RMkt] − rf ) + βs E[RSMB] + βs E[RHML] + βs E[RPR1YR] .
• This collection of portfolios is referred to as the Fama-French-Carhart (FFC)

factor speci cation.
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Market Efficiency: A Debate
• https://www.bilibili.com/video/BV16s411N798/
48

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Chapter 13

Investor Behavior &

Illustration: ©Johan Jarnestad/The Royal Swedish Academy of Sciences

• Shiller argued the opposite, that the

• Hansen developed a statistical

• If market prices remain the same, the

• How should we improve on the

• We know from the last chapter that

E[Ri] > ri = rf + βi ⋅ (E[RMkt] − rf ).

• This means their expected return

• In the new equilibrium, all stocks lie

• For example, knowing that the price

• This make sense, because the

• This echos the e cient market

• Does this result depend on the

• One should also understand this: in order to pro t by buying a positive-alpha

• This is a famous result in micro theory called the no-trade theorem.

• However, if no investor earns a negative alpha, then no investors can earn a

• Moreover, these investments are often concentrated in stocks of companies

• One reason is that investors su er from a familiarity bias.

• The market portfolio is a passive portfolio,

• In reality, a tremendous amount of trading

• Individual investors tend to trade very

• Many inexperienced 王者荣耀 players always think “我能反杀” when being

• Instead, their performance will be

• The left gure documents precisely

• But this observation does not invalidate the conclusion of CAPM.

• On average, individual irrational behaviors will not have an e ect on market

• The market will be a ected if investors su er from correlated, common,

（原著：George Akerlof and Rober Shiller, 翻译：张军）

• This tendency is called the disposition e ect.

• Consider two scenarios:

• Consider two scenarios:

• In an experiment, Daniel Kahneman and Amos Tversky presented participants

• Scenario 1: Participants started with $1000. They then could choose

• Scenario 2: Participants started with $2000. They then could choose

• These two scenarios should be the same for rational individuals.

• This phenomenon, in which individuals

• This behavior can lead to an

• Let’s suppose the economy is either G or B with equal probabilities.

• We consider a more realistic case: Investors make decisions sequentially, and

• What should the third investor do?

0.5 × (0.4 × 0.4 + 0.4 × 0.6 × 0.5) × 0.6 = 0.084.

• For managers with at least ve years experience, this number is almost $9

• However, the median mutual fund actually destroys value.

• This doesn’t appear to provide superior returns than investing in passive

• This is so even if di erent funds charge the same percentage fee.

• If investors choose managers in a competitive way, managers should

(b) Which fund will experience an in ow of funds?

• As we discussed in Chapter 10,

• While small stocks do tend to have

• Recall that practitioners refer to

• The gure demonstrates that value

• These arguments are not in absolute terms, but characterize a correlation.

• One possible explanation is the proxy error.

• We cannot include most of these investments in the market proxy because

• More sophisticated investors hold an e cient portfolio, but because supply

• For example, they may be attracted to investments that have a small

• For example, a banker at Goldman Sachs is exposed to nancial sector risk,

• The expected return of asset s is then given by:

• Because this portfolio costs nothing, it is called a self- nancing portfolio.

• If we require all factor portfolios be self- nancing, we have

• A straightforward choice is the market portfolio. Even if it may not be e cient,

• We have discussed that trading strategies based on market cap, book-to-

Ch13 Investor Behavior & Market Efficiency

Ch13 Investor Behavior & Market Efficiency