Behavioral Finance Economics 437 Behavioral Finance Fama French

Behavioral Finance Economics 437 Behavioral Finance Fama French Mch 28, 2017

Capital Asset Pricing Model n This is a “market model” n n n Presupposes that market is efficient Is a model of what determines asset prices Potentially many other “market models” may be possible n Fama and French n n n Believe firmly in “efficient markets” Despised CAPM…………. . why? CAPM stressed the role of “beta” Behavioral Finance Fama French Mch 28, 2017

Beta n What is beta n n Covariance between overall market return with individual stock return (divided by the variance of overall market returns) Basically, the relationship between overall market return and individual stock return n Behavioral Finance Beta of zero means no relations Negative beta means one goes up when the other goes down Beta of one is a “market stock” – behaves just like the overall market Fama French Mch 28, 2017

Data in Fama and French n 1962 -1989 data n Book Value (leverage and price/earnings) at previous year end n Returns starting on July 1 of the following year (also use the market n n n equity as of July 1 for size, but use market equity at previous year end for B/M calculation) Calculate monthly returns Each month the cross-section of returns is regressed on explanatory variables. Prior research used “portfolio betas”; F-F use individual stocks Sort stocks into “size deciles” n n Sort each size decile into 10 portfolios based on beta Calculate equal weighted monthly returns on the portfolios for the next 12 months (from July to June). Behavioral Finance Fama French Mch 28, 2017

Results on Beta n Portfolios in size deciles (without breaking them into 10 beta portfolios) show a relationship between beta and return n Large size means lower beta and lower returns n When size deciles are subdivided into beta ranked decile portfolios Larger size firms have lower returns n “no relation between average return and beta” n Behavioral Finance Fama French Mch 28, 2017

Results on Book/Market n What is book to market Book is firm net worth reported on 10 -Ks n Market is: shares outstanding times price Book/market is positively related to returns n Size still matters but B/M is much more important n B/M swamps leverage and E/P Leverage: book or market leverage? January “slopes” twice slopes of other months Overall largest decile book to market beats smallest decile book to market by 1. 53 % per month n n n Behavioral Finance Fama French Mch 28, 2017

Significance of F-F n Provided a simple rule for investing success n Seems to contradict Semi-Strong EMH n Made “respectable’ earlier work that provided simple, but successful investment rules n De. Bondt and Thaler, for example Behavioral Finance Fama French Mch 28, 2017

The End Behavioral Finance Fama French Mch 28, 2017