Revisiting the three factor model in light of circular behavioural simultaneities
ISSN: 1940-5979
Article publication date: 6 July 2018
Issue publication date: 25 July 2018
Abstract
Purpose
The authors construct asset portfolios comprising small-sized companies and value stocks that provide with higher returns for the UK market based on a three-factor model with incorporated behavioural features. The authors were able to demonstrate that value factor model is vulnerable to behavioural patterns, especially corporate fraud. In all of the above, the authors utilised a new proportional sorting methodology against the value ranking approach, commonly employed in empirical studies. Strong evidence is observed that portfolio performance based on various syntheses of allocated assets reveals counter-intuitive results related to the BE/ME, namely, that expected returns based on size and BE/ME produce significant errors and small firms retain consistently better returns. The reason might be the unusual accounting techniques many firms follow to receive extended capital after management decisions. The paper aims to discuss these issues.
Design/methodology/approach
The authors were able to demonstrate that value factor model is vulnerable to behavioural patterns, especially corporate fraud. In all of the above, authors utilised a new proportional sorting methodology against the value ranking approach, commonly employed in empirical studies. Strong evidence is observed that portfolio performance based on various syntheses of allocated assets reveals counter-intuitive results related to the BE/ME, namely, that expected returns based on size and BE/ME produce significant errors and small firms retain consistently better returns. The reason might be the unusual accounting techniques many firms follow to receive extended capital after management decisions.
Findings
Value factor model is vulnerable to behavioural patterns, especially corporate fraud. In all of the above, the authors utilised a new proportional sorting methodology against the value ranking approach, commonly employed in empirical studies. Strong evidence is observed that portfolio performance based on various syntheses of allocated assets reveals counter-intuitive results related to the BE/ME, namely, that expected returns based on size and BE/ME produce significant errors and small firms retain consistently better returns. The reason might be the unusual accounting techniques many firms follow to receive extended capital after management decisions. Overall, asset pricing models with embedded risk factors which entail either shares or dividends are logically circular behavioural simultaneities, thus invalid when tested and estimated by statistical methods as an outcome of the EMH.
Originality/value
In distinctive contrast to the recent literature, the authors show that the returns from a size factor model of small stocks tend to outperform big stocks especially in crisis periods. Moreover, the authors were able to demonstrate that value factor model is vulnerable to behavioural patterns, especially corporate fraud. In all of the above, the authors utilised a new proportional sorting methodology against the value ranking approach, commonly employed in empirical studies. Strong evidence is observed that portfolio performance based on various syntheses of allocated assets reveals counter-intuitive results related to the BE/ME, namely, that expected returns based on size and BE/ME produce significant errors and small firms retain consistently better returns. The reason might be the unusual accounting techniques many firms follow to receive extended capital after management decisions. Overall, asset pricing models with embedded risk factors which entail either shares or dividends are logically circular behavioural simultaneities, thus invalid when tested and estimated by statistical methods as an outcome of the EMH.
Keywords
Acknowledgements
The authors would like to thank the Editor Professor Robert Hudson for his valuable suggestions and comments. The authors are also grateful to faculty members at the Economics Department of the European University Institute (EUI) for helpful comments. The first author has received funding from the project “Original Scientific Publications ELKE-AUEB (17-18)”. The usual disclaimers apply.
Citation
Bekiros, S., Loukeris, N., Eleftheriadis, I. and Uddin, G. (2018), "Revisiting the three factor model in light of circular behavioural simultaneities", Review of Behavioral Finance, Vol. 10 No. 3, pp. 210-230. https://doi.org/10.1108/RBF-08-2017-0079
Publisher
:Emerald Publishing Limited
Copyright © 2018, Emerald Publishing Limited