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Understanding Premiums and Explanations: SMB, HML, and Behavioral Finance

Explore the reasons behind size and value premiums in the long term, with insights from Chicago School and behavior finance. Delve into risk-based and behavioral explanations for the differences between value and growth stocks.

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Understanding Premiums and Explanations: SMB, HML, and Behavioral Finance

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Presentation Transcript

  1. Additional slides on FF Chapter 11.3

  2. SMB and HML • Average SMB > 0 over the long term • Average HML > 0 over the long term • Why should there be a size premium (i.e., why should small-cap stocks have a higher return over the long term)?

  3. Why is there a value premium? • Why should value (high B/P) stocks have a higher return than growth (low B/P) stocks over the long term? • Explanations from two different schools of thought • Chicago school • Risk-based explanation • Behavioural finance

  4. Chicago School • No free lunch plan • In an efficient market, there is always a risk/return tradeoff • If a premium exists for value stocks, it must be because they are riskier • However, their standard deviations (of returns) are typically not higher than that of growth stocks • Fama-French’s verbal explanation: value stocks are in distress (earnings are temporarily depressed), and therefore riskier

  5. Risk-Based Explanations • Petkova and Zhang (2005), Zhang (2005) • Allow beta to vary over time, in particular, over the business cycle, in their model • Value companies have greater amounts of tangible capital, and the latter tends to be irreversible (difficult to scale back, or difficult to divest). Hence: • In a recession, value firms suffer from excess capacity • During market downturns, value stocks have more systematic risk • Value stocks are therefore riskier in this sense

  6. Behavioural Explanation • Behavioural finance will be covered in the last class • Explains why growth stocks underperform • Investors overreact to “glamour” stocks • High valuations not justified or sustainable • Bubble eventually bursts

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