Blog - Investing Notes

February 19, 2008 - The Behavioral Asset Pricing Model

Do investors price stocks based mostly on rational analysis or feelings? In their February 2008 paper entitled "Affect in a Behavioral Asset Pricing Model", Meir Statman, Kenneth Fisher and Deniz Anginer use survey results to investigate both the objective and subjective (perceived) connections between risk and return. Using results of: (1) the 1982-2006 annual Fortune surveys of senior executives, directors and security analysts regarding the long-term investment value of companies; and (2) May and July 2007 surveys of high-net worth clients of a large investment firm, they conclude that:

• Investors prefer stocks with positive images, and these preferences boost the prices and depress the future returns of such stocks. The mean annualized return of a portfolio of stocks deemed Admired (Despised) by Fortune survey respondents, rebalanced every four years during
  1982-2006, is 15.1% (19.7%).
• The Fortune survey Despised stocks have on average higher objective risk than Admired stocks: higher betas, lower market capitalizations, higher book-to-market values and lower short-term momentum. Despised stocks also tend to have higher earnings-to-price ratios, higher cash flow-to-price ratios, lower past sales and earnings growth rates and lower returns on assets. In other words, stocks with higher returns tend to carry higher objective risks.
• However, separate surveys of high-net worth investors yield a negative correlation between subjective (perceived) risk and expected return for a large subset of the Fortune survey companies. (See the figure below.) This negative correlation suggests that investors rely more on emotion than reason in assessing the risk-return relationship.
• Market capitalization and book-to-market ratio relate positively to emotional response (investors tend to have more positive attitudes toward large growth than small value) and may be proxies for it.

The following chart, taken from the paper, relates the mean relative expected return and perceived risk (both on ten-point scales) of 210 stocks, as determined by surveys of high-net worth investors. The resulting negative correlation (high return scores correspond to low risk scores) indicates that investors view the risk-return relationship emotionally rather than rationally per the Capital Asset Pricing Model. They see stocks that elicit positive (negative, or less positive) emotions as offering both high (low) future returns and low (high) future risk.

In summary, investors on the whole base their (mis)perceptions of risk and return on feelings rather than rational pricing analysis. Contrarians may be able to exploit the underpricing of "despised" stocks by focusing on small value.

For related research, see Blog Synthesis: Animal Spirits Round-up. See also Blog Synthesis: The Size Effect and Blog Synthesis: The Value Premium.