Investment Theory and Risk Management, + Website

Behavioral Finance

Why does the CAPM fail? Surely, if prices deviate from fundamentals, then mispricing will be profitably exploited by rational agents. If mispricing persists, then this anomaly may reflect something else; for example, the notion that the book-to-market factor (HML) in the Fama and French three-factor model explains the overreaction anomaly that the single-factor CAPM cannot. The anomalies discussed in the previous section suggest that either the model is misspecified in the sense that risk factors are missing (Eugene Fama's argument) or that the behavior implicit in the model—rational agents with identical preferences acting as mean variance optimizers—is not representative of the underlying market dynamic.

The theory of rational expectations posits that agents’ subjective distributions of outcomes coincide with nature's objective distribution of outcomes, that is, that agents’ models are correctly specified. This is a strong assumption. In fact, agents’ information sets are asymmetric and their models are at best incomplete. Even with learning, agents’ behavior may not be able to adjust adequately to ensure convergence to rational expectations equilibria. In short, equilibrium pricing models like the CAPM as well as the notion of efficient markets may fall victim to various imperfections in the rational paradigm.

Mainstream economics finds comfort in the argument that markets are self-correcting; that irrational agents will present arbitrage opportunities to ...