All asset pricing models, whether of securities, cars or watches,
are versions of the basic demand and supply model where prices are determined
by the intersection of demand and supply. The demand and supply functions
reflect the preferences of consumers and producers. The demand and supply
structure is evident in the CAPM. In that model investors on both the demand
and supply sides prefer mean-variance-efficient portfolios and the aggregation
of their preferences yields an asset pricing model where expected returns of securities
vary by beta. The demand and supply structure is not nearly as evident in the Fama
and French 3-factor asset pricing model. Market capitalization and book-to-market
ratios were associated with anomalies relative to the CAPM long before their
debut in the 3-factor model, but the argument that market capitalization and
book-to-market ratios proxy for risk is not fully supported by the evidence.
The purpose of this paper is to help link asset pricing models to the
preferences of investors. We outline a behavioral asset pricing model where
expected returns are high when objective risk is high and also when subjective
risk is high. High subjective risk comes with negative affect and low
subjective risk comes with positive affect. Affect is the specific quality of
‘goodness’ or ‘badness.’ It is a feeling that occurs rapidly and automatically,
often without consciousness. Investors prefer stocks with positive affect and
their preference boosts the prices of stocks with positive affect and depresses
their returns.
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