Overview

The debate between proponents of market efficiency and proponents of behavioral finance that was described in the previous chapter rests on the following question: If risk premia are determined by the Fama French factors and momentum, then do those factors proxy for risk that is fundamental, or do they reflect investor sentiment as well?

Proponents of behavioral finance argue that the Fama French factors and momentum reflect sentiment as well as fundamental risk. Fama and French (1992, 1996) appear to argue that book-to-market equity and size proxy for risks associated with distress, presumably a fundamental factor. Some proponents of market efficiency may well say that it does not matter whether the factor reflects fundamentals alone or a mix of fundamentals and sentiment, that it is all risk.

Theorem 16.2 established that expected returns decompose naturally into a fundamental component and a sentiment premium. Chapter 17 established that risk premiums can also be expressed in terms of a mean-variance efficient benchmark portfolio and beta, where beta admits a similar decomposition. The focus in these chapters is general and structural. Daniel, Hirshleifer, and Subrahmanyan (2002) focus on more specific issues, and propose a beta-based theory that explains the relationship between returns and valuation measures such as book-to-market equity in the presence of mispricing stemming from overconfidence. The point is that the identification of factors and betas should not be interpreted as necessarily implying that prices are efficient in the sense of being objectively correct.

Chapter 11 made the point that prices cannot be...