Investor Disagreement And The Risk-return Relation

Asset pricing models by the representative as CAPM constitutes the main body of traditional asset pricing theory, on this basis, also derived friom a number of branches, after decades of continuous improvement and development, already formed a fairly complete theoretical system, which are collectively referred to as "classic (traditional) asset pricing theory". However, this comprehensive theoretical framework encounters many problems in a growing number of empirical tests. A lot of empirical studies and observations have shown that there are many anomalies in the stock market, which can not be explained by standard financial theory. These facts will undoubtedly put traditional financial theory to a very awkward position. To explain these anomalies, scholars began to make continuous improvements and corrections for traditional financial theory. Therefore, Behavioral Finance, an emerging subject that uses psychology, behavioral science and sociology to study the decision-making behavior of people in financial activities, came into being.Behavioral financial experts have been making up the "rational agents" hypothesis of traditional finance. After a lot of experimentation and research, behavioral financial experts ultimately concluded that investors are "bounded rationality", who made decisions far from perfectly rational decisions. People’s wishes are reasonable in their decision-making process, but because of the influence of cognitive bias, emotion, preference, etc., they tend to make mistakes when making important decisions. From the perspective of "bounded rationality" of investors, this paper studies the asset pricing behavior in China’s capital market. Specifically, we focus on "bounded rationality" expressed as the heterogeneous beliefs among investors. Traditional capital asset pricing models assumes homogeneous expectations among investors, that is all investors hold same objective evaluations about assets and future economic trends. Obviously, this assumption is not realistic. Based on the impact of heterogeneous priors, information differences and cognitive biases, it is difficult for investors to hold same objective expectations about future earnings distribution, but is more likely to exhibit vastly diverse judgements, which is called "heterogeneous beliefs" by academic circles, also known as investor disagreement. Obviously, for it is the different judgements about buying and selling by investors, that make the market transactions active. Compared with foreign mature markets, the extent of investor disagreement in China’s capital market is more serious. Therefore, asset pricing research based on disagreement is of great significance for China’s capital market.It is generally believed that investment decisions are based on investors’ recognition of the distribution of stock returns, and the variance (risk) of stock returns is the most important factor that affacts investment behavior. Therefore, the research on the relationship between expected return of the stock market and its risk has important theoretical significance and practical value. This paper will focus on the risk-return tradeoff in China’s capital market under the assumption of investor disagreement. We elaborate on this issue from the perspective of information asymmetry and cognitive bias, and get the following conclusions:1. Investor disagreement attenuates the market risk-return tradeoff. Individual investors not only lack sufficient decision-making information, but also more susceptible to cognitive biases, and thus often exhibit irrational investment behavior. Individual investors, who face information disadvantage, can hardly make unbiased estimates. What’s more, individual investors tend to be inexperienced and naive investors, who are likely to have a poor understanding of how to measure risk, resulting to a distorted market risk compensation. Moreover, even if they are able to correctly estimate the risk, but because of the presence of cognitive biases, individual investors also tend to make wrong decisions, which would weaken the positive risk-return tradeoff. When the disagreement becomes serious, indicating that the participation of individual investors in the market increased, and thus exerting stronger influence on sotck prices, leading to an otherwise positive risk-return tradeoff being weakened.2. There is a positive risk-return tradeoff in the low-disagreement periods. Based on our theoretical analysis, when the disagreement is small, rational investors, who are risk averse, dominate the market, thus risk will be compensated, leading a positive relationship between risk and return.3. The impact of investor disagreement on the risk-return tradeoff is much stronger in small-scale stocks. Under Miller’s (1977) framework, disagreement will reduce future stok returns. And many empirical researches suggest that this effect appears to be more significant in the stocks of small-scale companys.4. When the disagreement is small, the positive relationship between risk and return is much stronger in small-scale stocks, which could be resulting from the size effect. Based on thought of complex market structure and institutional background of China’s stock market, Wang and Zhou (2002) suggest that "bankers" in China’s stock market prefer to manipulate small-scale stocks, and each intervention and withdrawal of large funds must be accompanied by high market impact costs, resulting in the manipulators’ premium target being increased, pushing stock prices continued to rise.This paper conducts an empirical test to the above theoretical analysis from both cross section and market level. The specific empirical conclusions are as follows:1. There is a negative relationship between the risk and the cross-section of returns in A-share stock market, resulting from "the mystery of idiosyncratic volatility". Investor disagreement obviously weakens the risk-return tradeoff for individual stocks, but the stocks with low-disagreement could "improve" the negative relationship between the risk and the cross-section of returns. The above two phenomena appeaer to be more significant in small-scale stocks.2. There is a positive risk-return tradeoff in both Shanghai and Shenzhen A-share stock market. However, in contrast, Shenzhen stock market demands a higher risk premium, and Shanghai stock market tends to be slightly speculative. This paper argues that this is due to that Shenzhen market is small-scale stocks based, thus becoming the primary target for "bankers", leading to a stronger demand for risk premium.3. Investor disagreement has a strong ability to distinguish two regimes with different degrees of aversion to risk. In the low-disagreement periods, there is a positive risk-return tradeoff in both Shanghai and Shenzhen A-share stock market, and investors are risk averse. However, this positive tradepff is badly undermined when the disagreement is serious, resulting in the risk-return coefficient is close to zero, and investors tend to be risk neutral. Thus, investor disagreement can lead to time-varying risk premium.4. In addition, the above time-varying risk premium caused by investor disagreement is more obvious in small-cap stocks. This means that in the low-disagreement periods, small-cap stocks demand a higher risk premium. But at the same time, the passive impact on the risk-return tradeoff is also more evident in small-cap stocks. The effects above are particularly significant in Shanghai stock market, since that there is a big difference between the market value of listed companies in Shanghai.5. The empirical results of this paper show that investor disagreement can indirectly predicts future stock returns by influencing the the compensation for bearing risk. For individual stocks, the predictive ability of investor disagreement to the cross-section of returns, both direct and indirect, can work at the same time. However, for the market, compared with the direct predictability of disagreement, indirect predictability will come into play faster.The potential contributions and innovations of this paper includes:first, this paper studies the impact of disagreement on the risk-return tradeoff from both cross section and market level. We argue that the above two kinds of directions are largely different:1. The former focuses on the cross-sectional differences of companies, while the latter focuses on the changes in disagreement levels of the whole market in time dimension; 2. Compared to market returns, the factors affecting the cross-section of stock returns are more complex. In view of the current domestic academic community for the views of the market, the research is not sufficient, so this study may enrich the relevant areas of research results. Second, the research findings of this paper find a new mechanism for the forecast of the stock future earnings. From Miller (1977), the majority of scholars focus on the direct impact of investor opinion differences on the future earnings of stocks. However, through theoretical analysis, we find that the differences of opinion can indirectly forecast the stock return through the risk premium. Finally, in order to ensure the robustness of the conclusions, this paper takes some innovative attempts in empirical methods and variables designs, which are mainly embodied as:1. This paper also use trading volume and analyst forecast dispersion index to measure the differences between the views of investors, and the latter in the domestic academic circles belong to more innovative attempt; 2. Most of the existing studies find that, empirical evidence of the risk-return tradeoff are sensitive to empirical methodology, especially the volatility models. Therefore, this paper uses a variety of empirical methods and volatility models in empirical research, in order to guarantee the reliability and robustness of the conclusions.