Taylan Mavruk

Market Efficiency and the Standard Asset Pricing Models Used to Test Market Efficiency

This chapter reviews the efficient market hypothesis (EMH), proposed by Fama in 1970s. We discuss and exemplify the applications of the hypothesis that the equities are perfectly priced according to their characteristics, meaning that the market prices reflect the information made available to investors at any given time. The main focus of the chapter is to explore the relevance of the efficient market theory to the proximity-biased investors. We also review the standard asset pricing models used to test EMH.

Local News and Active Trading

This chapter presents select preliminary findings from a recent study conducted by Mavruk (2016) on what role local media plays—if any—in the trading activity and equity returns in local markets. His study examines the sources of local information and tests its direct effects on the local investments made by individual investors. The focus is mainly on if and how news in local media affects the trading activity and portfolio returns of individual investors who exhibit proximity (locally and/or birthplace) bias. The results contribute to the local bias literature by allowing us to infer information asymmetry between proximate individual investors and other remote investors and also separate informed local trades from uninformed local trades. By paying more attention to the local webpage news, remote individual investors may reduce their information search costs, and hence information asymmetry between them and local investors.

Motives and Reasons for Proximity Bias

This chapter presents and discusses the explanations for the proximity bias of investors based on the contemporary literature. The proximity bias of investors despite the well-documented gains from diversification still remains an unresolved empirical puzzle in the finance literature. Previous research offers a number of explanations for the proximity bias. In the international context, these explanations focus on, for instance, barriers to international investments such as foreign taxes, governmental restrictions on foreign and domestic investments, high transaction costs, exchange rate fluctuations, sovereign risk, cultural differences, language, hedging, and information asymmetry. In the domestic context, this strong preference might be explained by the information asymmetry, familiarity hypothesis, the passiveness of investors, or indisputable preference of investors. Our main focus is on the explanations for the domestic context.

The Relation Between Local Bias, Home Bias, and Financial Sophistication

This chapter offers some insight for determining the importance of geography effects in international portfolio choice relative to the domestic proximity bias. Relatively few studies have examined the relation between local bias and home bias of individual investors, let alone assessed the extent to which their local bias contributes to the international home bias puzzle. In this chapter, we add to these findings by extrapolating our results in Lindblom et al (2016), on individual investors’ proximity bias within Sweden, to the international scale by estimating the distance adjusted portfolio share of the Swedish individual investors on 82 countries. In a further attempt to add to our knowledge, we also identify the determinants of foreign bias and test the hypothesis that individual investors are likely to exhibit less foreign bias toward particularly countries in which financial sophistication is higher.

Investors’ Portfolio Choice and Portfolio Theory

This chapter introduces modern portfolio theory by first following the work of Markowitz and discussing how an optimizing investor would behave. Second, the chapter reviews the portfolio theory that is concerned with economic equilibrium assuming all investors optimize in the particular manner, the work by Sharpe and Lintner on capital asset pricing model (CAPM). The chapter also discusses the ways in which portfolio theory differs from the theory of the firm and the theory of the consumer behavior. Although diversification is a common and reasonable investment practice, understanding how uncertainty influences investments in these different markets is essential to the analysis of rational investment behavior.

The Measurement of Proximity Bias

This chapter focuses on the development of appropriate proximity bias measures. In international studies, country borders are more or less natural dividing lines when determining the extent to which investors are home biased or foreign biased. It is less evident how to determine to what extent investors are locally biased within a country. Domestic studies use either a distance-based or a non-distance-based, community-oriented definition of geographical-proximity bias. In this chapter, we review the commonly adopted proximity bias measures in the literature and propose ways to further develop these measures.

Decision-Making—Rational, Bounded, or Behavioral

This chapter covers decision-making under uncertainty. The main focus is on economic reasoning and the properties of expected utility functions. The chapter discusses and exemplifies alternative ways in which an investor may form decisions under uncertainty. To be rational in its simplest form implies that individuals ufeffknowufeff their preferences, can identify their options and assign probabilities for each possible outcome. In this chapter we discuss what happens if we relax these assumptions and instead describe decision making as rationally bounded, governed by heuristics or behaviufefforufeffally roufeffoufeffted.

The Financial Behavior of Individual Investors

The economic models that underlie the previous chapters built on the strong assumption that investors are rational agents who aim at maximizing their wealth while minimizing risk. These investors are able to assess the risk and return of all possible investment opportunities and hold a portfolio that satisfies their level of risk aversion. In contrast, the recent empirical evidence shows that real individual investors behave differently from investors in these models. In what follows, this chapter reviews the most recent findings on individual investor trading and the trade performance.

Portfolio Rebalancing by Individual Investors

In this chapter, we replicate the study of the rebalancing of mutual funds’ equity portfolios by Giannetti and Laeven (2016) on individual investors in Sweden. The authors find that mutual fund managers rebalance their equity portfolios, during time periods of high market volatility, by selling relatively fewer equities of local firms than of remote firms. We revise these results by examining whether aggregate uncertainty (defined as systematic risk factors) in the Swedish equity market leads individual investors to rebalance their equity portfolios toward local firms. Our results are consistent with the evidence from mutual fund investors shown in Giannetti and Laeven (2016). We contribute to their findings by documenting that the individual investors directly owning equities also exhibit such behavior and the results are stronger in urban regions.

Local Bias and Capital Structure

In this chapter, we aim to analyze whether the local bias of investors has any impact on the capital structure of firms. We discuss the decision-making within firms regarding their choice of financing and explore the existing capital structure literature related to proximity bias. We also perform an empirical test on the relation between a firms’ leverage and its local ownership. Particular interest is put on questions such as the following: Are firms with more local shareholders more or less leveraged than firms with more remote shareholders? What does this mean for the firm value? To what extent—if any—do local investors act as monitoring device? Does it matter whether investors are domestic or foreign? Are there systematic differences in local bias and the capital structure formation of local firms and multinational firms?