Behavioral Finance Noise Traders Feb 17, 2011 Behavioral Finance Economics 437

Behavioral Finance Noise Traders Feb 17, 2011 Baker, Bradley Wurgler Published in 2011 in the Financial Analysts Journal Addresses age-old issue that high risk stocks earn low returns and low risk stocks earn high returns Shouldn’t be that way…should be the opposite

Behavioral Finance Noise Traders Feb 17, 2011 Actual results Use beta or use standard deviation (the two are highly correlated) Portfolios of high beta stocks (high standard deviation stocks) perform poorly when compared to portfolios of low beta stocks (low standard deviation stocks Reasons Could be “limits to arbitrage” ala Shleifer Could be “over confidence,” etc. But, could be “managing to a benchmark”

Behavioral Finance Noise Traders Feb 17, 2011 Benchmark Significance Imagine you are a manager of common stocks and you are judged by how you do compared to the S&P500 Index To buy a low beta stock would imply that, if efficiently priced it would earn less than your portfolio (which is assumed to have a beta equal to one). Thus it lowers your return unless the “α” has to be greater than the difference between 1 and the beta Levering the position could alter that result

Behavioral Finance Noise Traders Feb 17, 2011 Other articles coming out Question some of the empirical result. Important inefficiencies found mainly among low liquidity stocks (Li and Sullivan, forthcoming) But, more importantly, argue that transaction costs would eat up any potential profit from the strategy