BF Notes Session 2 - Session 2 - Perceptions About Risk and...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Session 2 - Perceptions About Risk and Return (Ch. 4) Overview Chapter 4 (Shefrin) describes how managers, analysts, strategists, and investors perceive the relationship between risk and return. Most appear to rely on representativeness in some form or fashion, and as a result are predisposed to particular biases. In contrast to one of the cornerstone principles in traditional finance, corporate managers’ judgments about risk and return implicitly associate higher risk with lower returns. In this regard they perceive the security market line to feature a negative slope, not the positive slope described in traditional finance. Managers appear to associate higher expected returns to growth stocks than to value stocks, a pattern that is at odds with the finding that value stocks have outperformed growth stocks historically. Security analysts also associate higher expected returns to growth stocks than to value stocks. However, unlike corporate managers, they appear to view the slope of the security market line as positive. In forming estimates of the market risk premium, managers associate a higher premium with lower volatility, thereby again treating the relationship between risk and return as being negative. In this regard, managers exhibit the hot hand fallacy, whereby they expect high returns to follow high returns and low returns to follow low returns. Individual investors also exhibit the hot hand fallacy . However, Wall Street strategists exhibit the opposite error, gambler’s fallacy , meaning they unduly predict reversals. Security analysts’ return expectations, as implied by their target prices, exhibit gambler’s fallacy. Likewise, when engaged in insider trading, the pattern of buying and selling behavior by managers is consistent with gambler’s fallacy.
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
When computing net present value (NPV) for the purpose of capital budgeting, managers do not appear to vary project discount rates to reflect different degrees of project risk. Instead they use a single discount rate , thereby injecting the potential for bias into their project selection decisions. Traditional Treatment of Risk and Return One of the cornerstone principles of traditional finance is that risk and return are positively related. This relationship is typically described in terms of a factor pricing framework such as the capital asset pricing model (CAPM). In the CAPM, the positive relationship between risk and return is embodied within the security market line. The slope of the security market line reflects the market risk premium. There is a range of opinion about the value of the market risk premium. The CAPM is a single factor framework. An example of a multi-factor framework is the Fama-French model. In the Fama-French model, the risk factors relate to the market risk premium, firm size, and book-to-market equity. The latter two factors are assumed to proxy for risk not captured by beta. In the Fama-French model, the positive relationship between risk and return is reflected by the fact that expected return is negatively related to
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 10/30/2009 for the course FIN 645 taught by Professor Arshapalli during the Fall '09 term at University of Maryland Baltimore.

Page1 / 8

BF Notes Session 2 - Session 2 - Perceptions About Risk and...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online