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The investment CAPM

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Investment CAPM.

The finance literature has documented numerous anomalies, that is, stock return is predicted by various firm characteristics instead of risk. These anomalies defy the traditional asset pricing theory, such as CAPM (the capital asset pricing model). Understanding these anomalies is one of the most important challenges for researchers in field of asset pricing. Behavioural finance borrows findings from psychological studies to explain these anomalies. The underlying theme of behavioural finance is that investors make irrational decisions due to psychological biases, which gives rise to anomalies. The commonality between traditional asset pricing theory and behavioural finance is that they both focus on investors’ behaviours. Recently, a new path – the investment CAPM – has emerged to explain these anomalies. The investment CAPM focuses on firms’ behaviours instead of investors’ behaviours. According to the investment CAPM, a firm keeps investing until its cost of capital (i.e. stock return under simplified assumptions) equals its investment return (i.e. marginal benefit of investment divided by marginal cost of investment). Because investment return is associated with firm characteristics, stock return should naturally be associated with firm characteristics. Therefore, the investment CAPM offers an alternative explanation for the anomalies, which does not rely on investor irrationality.

Research at CCFin shows that two anomalies, which are commonly interpreted as consequences of investors’ behavioural biases, can be explained by the investment CAPM. These two anomalies are the PTH (the ratio of current price to 52-week high price) anomaly where high-PTH stocks earn high future returns, and the BM (the ratio of book value to market value) anomaly where high-BM stocks earn high future returns.

George, T., Hwang C.-Y. and Li, Y. (2018) “The 52-week high, q theory and the cross-section of stock returns.” Journal of Financial Economics (forthcoming)

Li, Y. (2018) “Book-to-market ratio and inflexibility: the effect of unrecorded R&D capital.” (Available online)