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Berk-DeMarzo_CF2e_13--Investor%20Behavior -...

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Investor Behavior and Capital Market Efficiency A S FUND MANAGER OF LEGG MASON VALUE TRUST, William H. Miller had built a reputation as one of the world’s savviest investors. Miller’s fund outperformed the overall market every year from 1991–2005, a winning streak no other fund manager came close to matching. But in 2007–2008, Legg Mason Value Trust fell by nearly 65%, almost twice as much as the broader market. As a result of this per- formance, investors in the fund since 1991 effectively gave back all of the gains they had earned relative to the market in the intervening years and Miller’s reputation lay in tatters. Was Miller’s performance prior to 2007 merely luck or was his performance in 2007–2008 the aberration? 1 According to the CAPM, the market portfolio is efficient, so it should be impossible to consistently do better than the market without taking on additional risk. In this chapter, we will take a close look at this prediction of the CAPM, and assess to what extent the market portfolio is or is not efficient. We will begin by looking at the role of competition in driving the CAPM results, noting that for some investors to beat the market, other investors must be willing to hold portfolios that underperform the market. We then look at the behavior of individual investors, who tend to make a number of mistakes that reduce their returns. But while a few professional fund managers are able to exploit these mistakes and profit from them, it does not appear that much, if any, of these profits makes it into the hands of the investors who hold their funds. On the other hand, we will also consider evidence that certain invest- ment “styles,” namely holding small stocks, value stocks, and stocks with high recent returns, perform better than predicted by the CAPM, indi- cating that the market portfolio may not be efficient. We explore this evi- dence, and then consider how to calculate the cost of capital if indeed the market portfolio is not efficient by deriving an alternative model of risk— the multifactor asset pricing model. NOTATION x i portfolio weight of investment in i R s return of stock or portfolio s r f risk-free rate of interest α s alpha of stock s beta of stock s with portfolio i ε s residual risk of stock s β s i 412 13 1 T. Lauricella, “The Stock Picker’s Defeat,” Wall Street Journal , December 10, 2008. Berk-DeMarzo_CF2e_13 12/3/09 5:25 PM Page 412
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13.1 Competition and Capital Markets 413 13.1 Competition and Capital Markets To understand the role of competition in the market, it is useful to consider how the CAPM equilibrium we derived in Chapter 11 might arise based on the behavior of indi- vidual investors. In this section, we explain how investors who care only about expected return and variance react to new information and how their actions lead to the CAPM equilibrium.
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Berk-DeMarzo_CF2e_13--Investor%20Behavior -...

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