Behavioral Finance

CHAPTER 2

The EMH and the “Market Model”

RISK AND RETURN—THE SIMPLEST VIEW

If stocks don't earn positive returns over time, why would anyone own them? This commonplace observation suggests that stocks with high risk, however that may be defined, should earn higher returns than stocks with lower risk. This observation leads to a fairly simple model of stock prices. Under this simple view, stock prices should be such that riskier stocks, over time, make higher returns on average than less risky stocks. Some of those risky stocks will blow up, but the risky stocks that do well will compensate owners for taking the risk by producing larger returns. This theory is interesting as far as it goes, but it doesn't tell us much about what we should own in a portfolio of stocks. It suggests that folks who like to take on risk should buy the riskier stocks and more conservative investors should own less risky stocks.

A number of economists tackled this “portfolio” problem in the 1950s and 1960s. Harry Markowitz formulated the portfolio problem as an optimization problem for an individual investor.1 Markowitz assumed that each stock could be described by the mean and variance of its returns. Consequently, any portfolio of stocks could be considered an asset itself based on its mean and variance of returns. A stock's return in each period consists of the gain or loss in price plus any dividends received during the period. This sum was then divided by the price at the beginning of the period ...