An Analysis of Theories on Stock Returns

Abstract

Objective in writing this article is to provide an overview of the theories that has been developed for stock returns which is an important area of financial markets’ researches. Since the researches in this field are very active for the past quarter, it is not possible to describe all works that has been done in this area. Most important researches will be discussed without going deeper in mathematical tools and theories.Empirical works have been showing that stock returns are predictable cross-sectional and by time. The discussions about prediction of stock price behavior started with Markowitz with his article –Portfolio Selection-. Markowitz won Nobel Prize in 1990 for his research about portfolio theory. However he criticized by many economists since implementation of the theory requires lots of effort to evaluate data and since it uses historical data the prediction will not be accurate. In addition the assumption that stock returns are normally distributed is not true in reality. Sharpe, Lintner, and Mossin independently developed a model which has come to be known CAPM (capital asset pricing model) in 1964, 1965, and 1966 respectively. Beta coefficient is a key parameter in CAPM world. Beta measures risk of an asset in relation to the market such as S&P500 or an alternative factor. Actually the CAPM is a simple model which is based on sound reasoning and some of the assumptions -all investors have the same information, information is costless, and there are no taxes transactions costs- are unrealistic in market. APT (arbitrage pricing theory) presented for a better estimation for stock returns than CAPM. CAPM is a modified theory while APT is a completely different model. APT’s multiple factors provide a better indication of asset risk and a better estimate of expected return. There are n-factors effecting stock returns in APT but the number of factors are unknown. Furthermore CAPM and APT are single-period models. To get multi-period aspects of market ICAPM was developed. After that CCAPM (consumption-oriented capital asset pricing model) was introduced. It tried to explain behavior of stock returns by a logical extension of APT. A long literature exist on prediction of stock market returns but especially after the latest financial crisis these theories must be analyzed and suggested new ideas for forecasting behavior of stock returns. Keywords: Stock Returns, Markowitz, CAPM, APT, ICAPM, CCAPM, Fama-French 3-factor model.