Investor Behavior and Capital Market Efficiency

The difference between a stock's expected return (what investors anticipate) and its required return (based on the security market line) is known as the stock's alpha. This difference shows how much better or worse a stock is expected to perform compared to its risk.

The Capital Asset Pricing Model (CAPM) is a widely used model for calculating the cost of capital. It considers the risk-free rate, market risk premium, and the beta (a measure of a stock's volatility) to determine the required return.

A stock's beta measures its volatility relative to the overall market. A beta of 1 means the stock fluctuates in line with the market. A beta greater than 1 means the stock is more volatile, while a beta less than 1 means it's less volatile.

The cost of capital represents the minimum return a company needs to earn on its investments to satisfy its investors. This return compensates investors for the risk they take by investing in the company.

The Security Market Line (SML) is a visual representation of the CAPM. It shows the relationship between a stock's expected return and its beta, representing the risk-return trade-off.

The phenomenon where smaller companies tend to outperform larger companies in terms of returns, even after accounting for their higher risk (beta).

Stocks of companies with relatively low market capitalization. In other words, smaller companies.

A portfolio formed by grouping stocks based on their market capitalization into 10 groups (deciles), with the smallest stocks in the first decile and the largest stocks in the tenth decile.

The process of dividing stocks into groups based on size, calculating their returns, and comparing their performance.

The average return of a portfolio over a specific period, usually a year, adjusted for risk.

The Capital Asset Pricing Model (CAPM) aims to explain how investors should rationally allocate their assets in a market with competing investors.

The CAPM assumes that all investors base their investment decisions solely on expected returns and risk, measured by variance.

New information in the market causes investors to reevaluate their portfolios, leading to buying and selling activities.

When investors adjust their portfolios, it leads to price changes in the market, driving towards a new equilibrium.

The CAPM equilibrium is reached when all investors hold portfolios that reflect the market's risk and return characteristics.

For one investor to outperform the market, another investor must underperform. This is a consequence of the zero-sum nature of the market.

Individual investors often make mistakes like overreacting to news, chasing trends, or being overly confident, impacting their returns negatively.

Some professional fund managers are able to capitalize on the mistakes of individual investors and generate profits, but the benefits of this may not always reach the fund holders.