(a)(i)We have so far considered rational models for an asset’s expected return. By ‘model’ I mean a mathematical expression for expected return. By saying that a model is ‘rational,’ I have assumed that some or all investors in the model make the best possible decision given all relevant information.
(a)(ii) The APT does not explicitly model investors making portfolio allocation decisions. Instead, it assumes that asset returns follow a factor structure, sufficient securities exist to form well-diversified portfolios, and there exist investors that are always looking for arbitrage opportunities. The activity of such ‘arbitrageurs’ eliminates compensation for idiosyncratic risk, giving rise to the multi-factor APT model for asset returns. In APT, the arbitrageurs play the role of the rational investor: They make the best possible decision given all relevant information.
(b) Behavioural Finance says that investors do not always make the ‘best possible decision.’ This can be due to (1) limits on how investors process information (e.g., investors tend to focus on recent information), and (2) behavioural biases (e.g., investors may behave differently towards the same decision depending on how the decision is ‘framed’).
(a) The information that is relevant to stock prices includes such things as recent and historical returns, financial performance, and earnings announcements. This information influences investor beliefs about how stocks are expected to perform. I refer to the process of updating beliefs as information processing, and the inability to correctly update beliefs as limits on information processing. If investors have limits on how they process information, then the trading decisions based on these beliefs will not be fully rational. I state four limits on information processing below: (i) forecasting errors due to overweighting recent information, (ii) overconfidence, (iii) conservatism or under reaction, (iv) representativeness or neglecting the size of the sample.
(b)(iii) Conservatism or under reaction Investors tend to be slow in incorporating new information into their beliefs about how good or bad a firm is doing. This means that stock prices might initially underreact to news about a firm, so that prices do not reflect new information immediately, as the Efficient Market Hypothesis would predict, but only after some time has elapsed. Such a bias would give rise to momentum in stock market returns.
(a) In addition to beliefs about stock prices, investor decisions about what stocks to trade may also depend on how investors act in different situations, that is, they may depend on ‘behavioural’ factors. Three such behavioural factors that give rise to decisions that appear to be inconsistent with ‘rational behaviour’ are (i) framing, (ii) time inconsistent preferences, and (iii) Prospect theory.
(b)(i) Framing Framing refers to the manner in which investors think about a decision, that is, how they “frame” a decision. A fully rational investor ought to focus on just the facts, not how the facts are presented, but an investor who is not fully rational is affected by the presentation. For example, an individual may reject a bet which is framed as a risk associated with possible gains, but may accept the same bet when it is framed as a risk associated with possible losses.
(b)(ii) Time inconsistent preferences You might decide that you will not eat dessert tomorrow, but when tomorrow comes around, you change your mind and have a large slice of chocolate cake. This is called time inconsistency. Your “optimal” decision regarding what to eat changed based on when you made your decision.
Prospect Theory states that people care about income relative to a reference point. For increases in income relative to that reference point, I exhibit the usual risk-averse behaviour. For decreases in income relative to that reference point, I behave differently, that is, I exhibit risk-loving behaviour. The Prospect Theory utility function is shown below.
We say that an investor who exhibits Prospect Theory preferences is “risk averse over gains” and “risk loving over losses.” We can infer this from the curve above by noting that the curve is concave when income gains are positive, and convex when income gains are negative, which is the same thing as saying that the curve is convex when there are losses.
The behavioural critique that investors are not fully rational is well taken. It is difficult to imagine any investor capable of instantaneously processing vast amounts of information. The behavioural approach offers some explanations for the anomalies we observe in Finance, however, behavioural Finance does not offer a unified theory such as the CAPM that is able to simultaneously explain and predict a number of phenomena. This is a substantial shortcoming.
1) When are markets considered to be efficient?
2) What are the three types of market efficiency, and how much information do they assume prices to contain?
3) What are abnormal returns?
4) Write down an example of a predictive regression of the next period’s market return.
5) If we wish to understand the relationship between firm size and abnormal returns, why would we look at the abnormal returns associated with a portfolio of firms rather than individual firms?
6) What is short-term momentum and long-term reversal?
7) Does the fact that smaller firms and higher book-to-market firms exhibit higher risk adjusted returns necessarily mean that the efficient market hypothesis is incorrect?
8) What makes a model rational?
9) What are the characteristics of the standard utility function?
10) What kind of risk appetite is demonstrated by a utility function that is (i) convex, (ii) concave, and (iii) a straight line?
11) How is Prospect Theory different from the standard risk-averse utility?
12) Why is a theory based on fully rational investors unrealistic?
13) Why are many Finance scholars skeptical of behavioural explanations?
- Assignment status: Already Solved By Our Experts
- (USA, AUS, UK & CA PhD. Writers)
- CLICK HERE TO GET A PROFESSIONAL WRITER TO WORK ON THIS PAPER AND OTHER SIMILAR PAPERS, GET A NON PLAGIARIZED PAPER FROM OUR EXPERTS