Investment Theory and Risk Management, + Website

Summary

There are vast anomalies in the literature. This chapter was not an attempt to survey that literature. Rather, my objective was to balance the presentation of rational pricing models of the preceding chapters with their inability to adequately incorporate the impact of cognitive failures. Pricing models are by nature restrictive so they may be tractable. The CAPM is one such model that fails statistically to adequately explain the cross-section of returns. Neither are markets as efficient as proposed by the efficient markets hypothesis. Since these models abstract away the complexities of human behavior, it is no real surprise that they fall short. However, these failures should not be construed as a reason to discard these models. The CAPM, for example, is a powerful tool to help organize our thinking about how markets price assets, and extensions of the CAPM can go a long way in improving our understanding of the pricing mechanism. The new generation of multifactor models, which are covered in Chapter 9, explicitly recognize perceived cognitive failures by extending the single-factor model beyond the Fama-French three-factor model to include variables explicitly designed to account for cognitive traits such as overreaction and momentum as well as early anomalies attributed to size, value, and liquidity.