Q: If the expected return on an asset is too HIGH given its beta investors will: A: Buy the stock up to the point the expected return is again equal to that predicted by the SML. Explanation: If the expected return on an asset is temporarily too high given its beta (Which means the market price is too low), investors will buy the stock until the price rises to the point where the expected return is again equal to that predicted by the SML. I don’t understand how " the expected return on an asset is temporarily too high given its beta (Which means the market price is too low)" Any help?
Yeah that makes sense to me. A stock that is trading below what is should be, then the expected return would be above the expected return that the beta suggests it should have. Ie the stock is cheap. So like the answer says, investors will buy it up until it hits a price where the expected return equals the expected return that the beta suggest it should have. Seems pretty straigtforward to me but maybe I’m missing something.
In other words, the less the market value of a stock (relative to what is should be trading at, given its intrinsic value) the higher the expected return on it. They move in opposites.
Let’s say: The market (maybe portfolio) return as indicated (predicted) by the SML is 15% The security, given its beta (let’s say it matches the market beta, 1.0), has an expected return right now of 18%. Investors will buy the stock so that the expected return decreases. Assume that you would calculate expected return as per the dividend discount model - at which case when the price of the security increases in conjunction with investors purchasing it - the expected return decreases. Investors will want to purchase it until the price reaches a point where the expected return is equal to the SML.
Thanks guys.
Stock at $50, SML says that it will be at $55 (10%) a year later. Your model says it will be at $60. If true, you and others will start buying it, until it rises to $54.55. At that price, SML still says 10% rise from this level (to $60), and your model is corrected to indicate 10% rise as well.