- The difference between a stock’s expected return and its required return according to the security market line is the stock’s alpha:
- While the CAPM conclusion that the market is always efficient may not literally be true, competition among savvy investors who try to “beat the market” and earn a positive alpha should keep the market portfolio close to efficient much of the time.
- If all investors have homogeneous expectations, which states that all investors have the same information, all investors would be aware that the stock had a positive alpha and none would be willing to sell. The only way to restore the equilibrium in this case is for the price to rise so that the alpha is zero.
- An important conclusion of the CAPM is that investors should hold the market portfolio (combined with risk-free investments), and this investment advice does not depend on the quality of an investor’s information or trading skill. By doing so they can avoid being taken advantage of by more sophisticated investors.
- The CAPM requires only that investors have rational expectations, which means that all investors correctly interpret and use their own information, as well as information that can be inferred from market prices or the trades of others.
- The market portfolio can be inefficient only if a significant number of investors either do not have rational expectations or care about aspects of their portfolios other than expected return and volatility.
- There is evidence that individual investors fail to diversify their portfolios adequately (underdiversification bias) and favor investments in companies they are familiar with (familiarity bias).
- Investors appear to trade too much. This behavior stems, at least in part, from investor overconfidence: the tendency of uninformed individuals to overestimate the precision of their knowledge.
- In order for the behavior of uninformed investors to have an impact on the market, there must be patterns to their behavior that lead them to depart from the CAPM in systematic ways, thus imparting systematic uncertainty into prices.
- Examples of behavior that could be systematic across investors is the disposition effect (the tendency to hang on to losers and sell winners), investor moods swings that result from common events like weather, and putting too much weight on their own experience. Investors could also herd—actively trying to follow each other’s behavior.
- It is not easy to profit simply by trading on news, but professional investors might be able to do so by, for example, being better able to predict takeover outcomes. However, in equilibrium, individual investors should not expect to share any of the benefit of this skill by investing with such professional investors. The empirical evidence supports this—on average investors earn negative alphas when they invest in managed mutual funds.
- Because beating the market requires enough trading skill to overcome transaction costs as well as behavioral biases, CAPM wisdom that investors should “hold the market” is probably the best advice for most people.
- The size effect refers to the observation that historically stocks with low market capitalizations have had positive alphas compared to the predictions of the CAPM. The size effect is evidence that the market portfolio is not efficient, which suggests that the CAPM does not accurately model expected returns. Researchers find similar results using the book-to-market ratio instead of firm size.
- A momentum trading strategy that goes long stocks with high past risk-adjusted returns and short stocks with low past returns also generates positive CAPM alphas, providing further evidence that the market portfolio is not efficient and that the CAPM does not accurately model expected returns.
- Securities may have non-zero alphas if the market portfolio that is used is not a good proxy for the true market portfolio.
- The market portfolio will be inefficient if some investors’ portfolio holdings are subject to systematic behavioral biases.
- The market portfolio will be inefficient if either investors care about risk characteristics other than the volatility of their traded portfolio or if investors are exposed to other significant risks outside their portfolio that are not tradable, the most important of which is due to their human capital.
- When more than one portfolio is used to capture risk, the model is known as a multifactor model. This model is also sometimes called the Arbitrage Pricing Theory (APT). Using a collection of N well-diversified portfolios, the expected return of stock s is
- A simpler way to write multifactor models is to express risk premiums as the expected return on a self-financing portfolio. A self-financing portfolio is a portfolio that costs nothing to construct.By using the expected returns of self-financing portfolios, the expected return of a stock can be expressed as
- The portfolios that are most commonly used in a multifactor model are the market portfolio (Mkt), small-minus-big (SMB) portfolio, high-minus-low (HML) portfolio, and prior one-year momentum (PR1YR) portfolio. This model is known as the Fama-French-Carhart factor specification: