OCOB Ann Rep 07-08 - Orfalea College of Business - Cal Poly San ...

FACULTY REPORTSCan Behavioral Finance Explain Stock Prices?BY SAMIR DUTT, ASSOCIATE PROFESSOR, FINANCE AREAIntroductionIf an investor buys a risk-free asset like a U.S. Treasurybond, he or she can be certain that the bond will pay thepromised amount if it is held to maturity. The return onthis investment is determined by how much the investorpays for the bond, and is commonly referred to as the riskfreerate. What if the investor buys an asset like IBM stock?Buying IBM stock, or any corporate stock for that matter,does not have a predictable outcome. The investment maymake a profit or a loss. Its payoff is uncertain. What shouldit cost? Since the payoff is uncertain, it must, on average,provide a higher return than the risk-free rate because noone would buy an asset that was both risky and paid out alower return on average than a Treasury bill. But how muchmore should the risky asset pay out relative to the risk-freeasset? How do we determine an asset’s risk premium?The capital asset pricing model, or CAPM (asset riskpremium = ß x market risk premium), provides one answer.It specifies the premium that must be paid by a riskyasset like stock over the return from holding a risk-free assetlike a U.S. Treasury bill in terms of the risky asset’s beta (ameasure of how closely the risky asset’s returns track theups and downs of the return on the market portfolio) andthe market portfolio’s risk premium, with the market portfolioproxied by a broad-based index like the S&P 500 or theWilshire 5000.Tests of the CAPM against market data, however, donot work particularly well. Recent work by Fama andFrench (1992) suggests that a stock’s beta may be essentiallyuncorrelated with its risk premium, which implies thatthe CAPM cannot reliably be used to calculate the fair priceof an asset.How about CAPM-like multifactor models, like theArbitrage Pricing Theory, which have become fund managementindustry standards? They work in the sense that regressingrisk premiums against a sufficient multitude offactors can explain more and more of an asset’s excess returnover the risk-free rate. This is an ad hoc procedure, notdeeply rooted within the Expected Utility Theory paradigmfavored by economists, who prefer to obtain equilibriumasset prices from investors’ beliefs, preferences, and endowments(as the CAPM does).Expected Utility Theory (EUT) is, very simply, a wayto rank gambles from best to worst. Consider two gambles,A and B. A: win $10 (50 percent) or lose $10 (50 percent).B: win $11 (50 percent) or lose $10 (50 percent). If theyboth cost the same, any rational person would prefergamble B to gamble A. This is, however, a very simple situationwith a very obvious answer. In more complex situations,as when an investor chooses among all the stockslisted on the New York Stock Exchange and puts togetheran investment portfolio, it is not as easy to decide whichstocks to choose and how much to invest in each stock.Expected Utility Theory provides the investor with one setof tools to rank all possible portfolios from best to worst,and to then choose a portfolio that is compatible with hisor her appetite for risk (a retiree’s optimal portfolio mightbe mainly in U.S. Treasuries, while a young woman’s optimalportfolio might be mainly in equities, with only a littlein Treasuries).Can we find a better set of tools for ranking portfolios,a set more in line with how investors actually express theirpreferences in the market? Can we find a way to calculatethe risk premium of an asset based on the latest understandingof how investors respond to risk and reward? Yes, butfirst some spadework.The assumptions underlying the CAPM are part of thestandard canon of finance and economics, and are not to betoyed with lightly. The underlying assumptions are (i) thatinvestors prefer more to less; (ii) that investors be riskaverse expected utility optimizers; and (iii) that asset returnsbe normally distributed. The first assumption, that investorsprefer more to less, cannot seriously be doubted,while the last assumption, that of asset normality, is a technicalrequirement for the CAPM to hold for a general classof concave utility functions (investors’ appetite for risk). Itis to the second assumption, that investors maximize theexpected utility of their total wealth, that we must look forchange.That individuals presented with gambles make choiceswhich violate the foundational axioms of EUT has beenknown since the work of Allais (1953) more than 50 yearsago. Since then, experiments in the laboratory and in thefield have revealed further systematic violations of theseaxioms (Camerer 1992). Many of the anomalies uncoveredhave a somewhat esoteric flavor, involving as they do violationsof the “independence” axiom, the “transitivity”axiom, and others. A more easily palpable anomaly regardingrisk aversion is provided by an example in Rabin andThaler (2001), who assert that despite the “central place”of “expected utility maximization of a concave utility-ofwealthfunction ... this explanation for risk aversion is notplausible in most cases where economists invoke it.”Rabin and Thaler (2001): Given that “Johnny is a riskaverseexpected utility maximizer, and that he will alwaysturn down the 50-50 gamble of losing $10 or gaining $11,”the authors ask “What else can we say about Johnny?Specifically, can we say anything about bets Johnny willbe willing to accept in which there is a 50 percent chance14 ❚ ANNUAL REPORT 2007-08