Report

The Missing Risk Premium: Why Low Volatility Investing Works Eric Falkenstein 2013 Copyright 2013 Eric G Falkenstein 1 Who am I • • • I’m an economics PhD who has worked as a quant, risk manager, and portfolio manager. See more at the following websites – www.betaarbitrage.com – Falkenblog – www.efalken.com Old Book Finding Alpha (2009) New Book The Missing Risk Premium, out this spring Copyright 2013 Eric G Falkenstein 2 My Interest • My 1994 dissertation, first 3 sentences: – “This paper documents two new facts. First, over the past 30 years variance has been negatively correlated with expected return for NYSE&AMEX stocks and this relationship is not accounted for by several wellknown prespecified factors (e.g., the price-to-book ratio or size). More volatile stocks have lower returns, other things equal.” • So, risk premiums and low-vol have been a bit of a hobby-horse Copyright 2013 Eric G Falkenstein 3 The Stakes “It is impossible to appreciate how the financial system works without understanding risk.” Stephen Cecchetti "Risk is not an add-on … it permeates the whole body of thought.“ Robert C. Merton Copyright 2013 Eric G Falkenstein 4 “most returns and price variation come from variation in risk premia” John Campbell E FutValue Price 1 r g Risk free rate Copyright 2013 Eric G Falkenstein Risk premium 5 Big Idea: this is the Risk-Return Tradeoff Copyright 2013 Eric G Falkenstein 6 Risk and Return • In general, in practice: risk is not positively related to return Copyright 2013 Eric G Falkenstein 7 Standard Theory is Intuitive • Risk aversion like aversion to smelliness • The logic applied to this idea, via a utility function that has decreasing marginal returns, generates many mathematically consistent results that seem highly plausible Copyright 2013 Eric G Falkenstein 8 …And Wrong Leveraged Firms B vs. BBB rated Bonds Out-of-the-money options vs. at-the-money options S and C corps vs. equity indexes Highest volatility vs. modest vol stocks R rated movies vs. G rated movies Lotto vs. ‘quick pick’ lotteries 50-1 horses vs. 3-1 horses Mutual funds, currencies, futures, countries, yield curve Copyright 2013 Eric G Falkenstein 9 Finance Misleading • Most practical finance is about generating expected values • Finding covariances to generate different discount rates is a massive waste of time, pure rationalization in practice Copyright 2013 Eric G Falkenstein 10 Conspiracy? • Economists find standard utility functions much more productive (in theory) • Asset managers can justify anything via ‘risk’, which is omnipresent and as yet unmeasurable • Amenable to rigorous sequence of lectures Copyright 2013 Eric G Falkenstein 11 Standard Theory Copyright 2013 Eric G Falkenstein 12 Marginal Utility St. Petersburg Paradox (1738): what is value of $1 paid if you get a head in a coin flip, where the payoff is (number of times coin flipped)^2? Should be infinity 1 1 1 1 E 1 2 4 8 ... 2 4 4 16 1 1 1 1 E ... 2 2 2 2 1 E j 1 2 Why not? Diminishing marginal returns Copyright 2013 Eric G Falkenstein 13 Basic Idea of Utility • Fundamental to economic reasoning • Marginal Revolution transformed economics in 1860s – Walras, Jevons, Menger – Pre 1860s ‘classical’ economists: Marx, Smith, Ricardo, Mill • Transformed Theory of Value Copyright 2013 Eric G Falkenstein 14 Where does Risk Premium Come From? • Global concavity of utility is the necessary and sufficient condition for the existence of a risk premium Copyright 2013 Eric G Falkenstein 15 Utility Theory and Risk Aversion • Utility not applied between goods, but to everything • Von-Neumann-Morgenstern (1944) Copyright 2013 Eric G Falkenstein 16 U E r a 2 Copyright 2013 Eric G Falkenstein 17 Why we like efficient portfolios No points plot above the red line Expected Return All portfolios on the red line are efficient 100% investment in security with highest E(R) 100% investment in minimum variance portfolio Standard Deviation Copyright 2013 Eric G Falkenstein 18 Exp Return Port-1 U1 U2 Port-2 U3 U4 Volatility Copyright 2013 Eric G Falkenstein Port-3 19 Expected Return C B Rf Rz 1 z rf zrB z z B A Standard Deviation Copyright 2013 Eric G Falkenstein 20 Copyright 2013 Eric G Falkenstein 21 How to Derive The Capital Asset Pricing Model 1. E ri a im k every asset has same marg. value 2. E rf a fm k rf k ,risk free rate is k 3. E rm a k a 2 m 4. E ri E rm rf 5. E ri rf 2 m E rm rf m2 im rf im E rm rf 2 m 6. E ri rf i E rm rf aka the CAPM the SML Copyright 2013 Eric G Falkenstein 22 Market Portfolio E ( Ri ) R f i E ( Rm ) R f Expected Return where E ( Ri ) expected return on security i E(R) R f risk-free rate of interest i beta of Security i E ( Rm ) expected return on the market Rf 1.0 Beta Copyright 2013 Eric G Falkenstein 23 General Equilibrium aka Stochastic Discount Factor CAPM 1. U EU 1 r ' 0 ' 1 U1' 1 E ' 1 r U0 U1' 2. 1 E MR given M= ' U0 8. E[ R] R f 3. E[MR] E[M ]E[ R] cov( M , R) 1 4. E[ R] U 0' cov( Ri , Rm ) 7. E[ R] R f ' U 0' U1 1 cov( M , R) E[ M ] E[ M ] 9. letting R i =R m U1' 10. E[ R] R f 1 5. E[ R f ] R f E[ M ] U1' - Rm 6. M ' ' U0 U0 U ' 1 Rm cov( M , R) cov( Ri , Rm ) U1' var( Rm ) E[ Rm R f ] cov( Ri , Rm ) var( Rm ) E[ Rm R f ] 11. E[ Ri ] R f E[ Rm R f ] cov( Ri , Rm ) U ' 0 cov( Ri , Rm ) var( Rm ) 12. E[ Ri ] Rf E[ Rm Rf ] Copyright 2013 Eric G Falkenstein 24 Asset Pricing Theory Was Always Treated Well • 1971 Institutional Investor :“The Beta Cult: The New Way to Measure Risk.” • Contrast with almost constantly ridiculed Efficient Markets Hypothesis, which is much more successful (eg, it’s hard to outperform the indices) Copyright 2013 Eric G Falkenstein 25 Hope for Final Theory • linear in risk factors, covariances with something • include something very like the stock market as one of the prominent factors Copyright 2013 Eric G Falkenstein 26 Empirical Evidence Copyright 2013 Eric G Falkenstein 27 Volatility Often Used as a Risk Shorthand Brealey and Myers Investments Book Return 17.30% 13% 6.0% 5.70% 3.90% Small Stocks Stocks Corporate Bonds Government Bonds T-bills Volatility 33.4% 20.2% 8.7% 9.4% 3.2% From Cam Harvey (editor of Journal of Finance) website Copyright 2013 Eric G Falkenstein 28 If only this worked in more places… Copyright 2013 Eric G Falkenstein 29 The Risk Premium Problem After 45 years, there are no measure of risk that are generally positively correlated with returns Fama and French 1992 From Campbell 2000 Copyright 2013 Eric G Falkenstein 30 Fama-French (1992) • Show beta is just a size effect • Founding father (Fama) admits CAPM is ‘incomplete’, and beta itself useless Copyright 2013 Eric G Falkenstein 31 Example of how small firm effect showed up in beta tests Theory: Longer hair people are short Omitted variable: gender Theory: high beta firms have high returns Omitted variable: size Copyright 2013 Eric G Falkenstein 32 CAPM Recognized as Empirical Failure • “More empirical effort may have been put into testing the CAPM equation than any other result in finance. The results are quite mixed and in many ways discouraging.” – Mark Rubinstein • “empirically vacuous,” – Fama and French • “having a low, middle or high beta does not matter; the expected return is the same. – Stephen Ross Copyright 2013 Eric G Falkenstein 33 A Survey of Empirical Anomalies to the Standard Model • The standard theory involves a specific metric of covariance, and so it could be, we simply haven’t found the right one • As a ‘framework’, not a theory, it is nonfalsifiable • However, it’s hard to conceive of one not correlated with total volatility Copyright 2013 Eric G Falkenstein 34 Total Volatility and Returns • My Dissertation (1994) page 53 Copyright 2013 Eric G Falkenstein 35 Cross-Sectional Annual Returns Sorted by Idiosyncratic and Total Volatility Ang,, Hodrick, Xing and Zhang (JoF 2006) Copyright 2013 Eric G Falkenstein 36 Beta and Returns: 1962-2011 Beta-Low Beta0.5 Beta1.0 AnnRet 10.8% 11.4% 11.4% 8.2% 4.5% AnnStdev 13.1% 11.6% 17.4% 26.2% 33.9% 0.57 0.57 1.04 1.44 1.78 Beta Copyright 2013 Eric G Falkenstein Beta1.5 Beta-High 37 Equities and bond ratings (Distress) • Low Rated Equities also have lower returns StockReturns AAA 12.4% AA 13.9% A 14.3% BBB 14.2% BB 15.0% B 8.6% C -12.7% Copyright 2013 Eric G Falkenstein 38 Leverage and Equity Returns Penman, Richardson, and Tuna. 2007 Equity Returns Practice Theory Copyright 2013 Eric G Falkenstein 39 Penny Stocks: Eraker and Ready (2009) Volume($) > Price> 2,000 0.01 50,000 500,000 0.1 0.01 0.1 0.01 0.1 Count 7372 6685 6423 5757 4603 3939 AnnReturn -29.1% -35.4% -9.1% -13.5% -34.2% -41.0% Copyright 2013 Eric G Falkenstein 40 Call Options Sophie Ni (2007) Should amplify the equity risk premium the greater the out-of-the-money Copyright 2013 Eric G Falkenstein 41 Initial Public Offerings (IPOs) • IPO has a lot of Uncertainty • Jay Ritter (see his website). 1970-2011. • 8k observations Copyright 2013 Eric G Falkenstein 42 Analyst Disagreement • Deither, Malloy, and Scherbina (2002). Table 2. Data from 1983-2000. Copyright 2013 Eric G Falkenstein 43 Total Volatility over Time • Steve Sharpe and Gene Amromin (2005). People have higher expected returns when they have lower expected volatilities E rm rf a m2 b mf a, b 0 Copyright 2013 Eric G Falkenstein 44 Total Volatility over Time • Contemporaneous Correlation Clearly Negative E rm rf a m2 b mf a, b 0 Copyright 2013 Eric G Falkenstein 45 SPY Total Return to Overnight vs. Daily Return Periods Copyright 2013 Eric G Falkenstein 46 Small Business Returns • Moskowitz, and Vissing-Jorgensen (2002) Copyright 2013 Eric G Falkenstein 47 Currencies: Uncovered Interest Rate Parity rAUD ryen % change in yen+riskprem? Sharpe 0.99 from 1976-2008 in Burnside et al (2009) Here’s Long AUD, Short JPY Copyright 2013 Eric G Falkenstein 48 Corporate Bonds • Merrill High Yield Master II (HOAO) Merrill BBB-AA Index (COCO) • Indices here overstate realized returns Copyright 2013 Eric G Falkenstein 49 World Country Returns • Dimson, Marsh, Staunton (2005) • 17 Countries, 1900-2005, Annual Data Copyright 2013 Eric G Falkenstein 50 Emerging market Returns Copyright 2013 Eric G Falkenstein 51 Treasury Yield Curve • 1% premium from 0.25 to 3 years • No premium from 5 to 30 years • Volatility, Covariance, increasing linearly Copyright 2013 Eric G Falkenstein 52 Treasury Yield Curve • 1% premium from 0.25 to 3 years • No premium from 5 to 30 years • Volatility, Covariance, increasing linearly Copyright 2013 Eric G Falkenstein 53 Futures • Futures return from roll • Harvey and Erb (2007) copper, heating oil, and live cattle were on average in backwardization, • corn, wheat, silver, gold, and coffee were in contango • It isn’t clear what covariance, volatility has to do with this Copyright 2013 Eric G Falkenstein 54 Movie Returns by Rating • Devany and Walls (1999), 2015 movies from 1984-96 Copyright 2013 Eric G Falkenstein 55 Sports Books: Longshot Bias • Snowberg and Wolfers (2009) Copyright 2013 Eric G Falkenstein 56 Initial Public Offerings (IPOs) • IPO has a lot of Uncertainty • Jay Ritter (see his website). 1980-2008. • IPO Returns -3.7% annually below sizematched firms for first 5 years Copyright 2013 Eric G Falkenstein 57 Trading Volume • Turnover of stock a proxy for disagreement • Highly correlated with beta Copyright 2013 Eric G Falkenstein 58 Equity Risk Premium • Top line return is not the same as average or marginal return Copyright 2013 Eric G Falkenstein 59 What is the Equity Risk Premium? Eri rf E i rm rf E rm rf The most important constant in finance Copyright 2013 Eric G Falkenstein 60 Equity Premium Evolution • Lorie and Fisher (1964): 9.0% raw return (no bond return) • Ibbotson and Sinquefield (1976): 10.9% • Mehra and Prescott (1986): 6.2% • 1999 Barclays and CSFB estimated 8.8% • Ibbotson (1926-97): 8.9% • Finance Texts (1998): 8.5% • Ivo Welch Survey (1998): 8.5% Crash! • AIMR estimate (2002): 3.0% • WSJ survey (2005): 2.0% • CFO Magazine (2005): 5% • Ivo Welch (2009): 2%-4% at most 1%-8% Copyright 2013 Eric G Falkenstein 61 Geometric vs. Arithmetic Averages • 1 to 2 to 1 has a total return of 0% • 100%, -50% return has average of 25% • Arithmetic returns useful if you rebalance, as opposed to invest all your money at inception • Stock returns have volatility around 20%, for the indices, which implied a 2% adjustment rG rA 2 2 Copyright 2013 Eric G Falkenstein 62 Bad Market Timing • Dichev (2005) • 1, 2, 1 – return 0% if cf is {-1,0,+1} – return -17.7% if cf is {-1,-1,+1.5} • Total return different than Internal Rate of Return based on timing of investments • • • • Distributions Dividends-New Money Corr(Distributionst,Returnt+1)= +33% Corr(Distributionst+1,Returnt)= -27% bad timing Copyright 2013 Eric G Falkenstein 63 Transaction Costs • Commissions, – 8.5% load through 1970’s to buy a mutual fund • bid-ask cross – Stocks quoted at 8 ¾ - 9 in the 1990s – buy at 9, sell at 8 ¾, lose 2.78% – Phantom cost: most investors don’t know real time prices • Stoll and Whaley (1983) 1.78% comm+bid-ask • Bhardwaj and Brooks (1992): 4.4% total • Currently very low if you are smart (0.2%) Copyright 2013 Eric G Falkenstein 64 Survivorship Bias • USA primary data point in World Value Weighted Index • Coincidentally, – 2-0 in World Wars – Never went communist • Brown, Goetzmann, and Ross (1995) – Czechoslovakia, Hungary, Poland, Russia, and China all zeroed out • Jorion and Goetzmann (1999) – US real return 350 basis points above median for 39 countries in 20th century Copyright 2013 Eric G Falkenstein 65 Peso Problem • • • • • Peso-Dollar FX rate fixed from 1954-76 Higher interest rate in Peso Peso ‘floated’ in 1976: lost 45% Peso devalued by 82% in 1982 Small probability, big loss, explains interest rate premium • Robert Barro (2006) argues a correct probability of a significant catastrophe explains much of the equity premium, about 300 basis points – 2% change of a 15% to 45% GDP decline Copyright 2013 Eric G Falkenstein 66 Taxes • 10% stock return: 6% post tax with a 40% tax rate • Gannon and Blume (2006) apply this to S&P500 assuming 20% turnover from 1961-2005, using actual capital gains, dividend top-tier tax rates • Cap gain avg: 26% • Top tax rate avg; 49% (includes 6% state tax) • Lorie and Fisher (1964) found 2.2% adjustment • Total after tax equity return 6.72%, vs. 10.62% pre tax • Long Term Municipal Bond Buyer Index return: 6.14% Copyright 2013 Eric G Falkenstein 67 People ignore costs all the time • • • • Beardstown Ladies investment club 1983-94 return 23.4% Best selling authors Audited financials: 9.1%, below 14.9% for market • Failed to include contributions Copyright 2013 Eric G Falkenstein 68 Investors Don’t Match Indices • Dalbar study from the Investment Company Institute: • 1990-2010 Annual Returns • S&P500 return: 9.1% • Average equity mutual fund investor: 3.3% Copyright 2013 Eric G Falkenstein 69 Returns not Like in Representative Agent Model Equity Return Uncorrelated with GDP growth over a Century Copyright 2013 Eric G Falkenstein 70 Hedge Fund Money Goes to Insiders • From Simon Lack Copyright 2013 Eric G Falkenstein 71 Equity Premium Subtractions • • • • • • • Geometric vs. Arithmetic Averaging Survivorship Bias Peso Problems Taxes Adverse Market Timing Transaction Costs Sum 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 6.0% • Most estimates around 3.5% for equity premium. With these additions, the Marginal Investor clearly could be seeing a 0% equity premium. Copyright 2013 Eric G Falkenstein 72 Scope of the Risk Premium Failure Positive Risk Premium (3) 1. 2. 3. Short End of Yield Curve BBB-AAA Corporate Spread Efficient Equity Investor Zero Risk Premium (14) 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. Long-End of Yield Curve B to BBB Bond Futures Private Investments Movies Mutual Funds VIX and Equity World Equity Emerging Markets Hedge Funds Real Estate CTAs Private Equity Intraday Stock Return Negative Risk Premium (12) 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. Average Equity Investor Betas Volatility Financial Distress Trading Volume Analyst Disagreement Equity Options Lotteries Sports Betting Currencies IPO equity Returns MVPs Copyright 2013 Eric G Falkenstein 73 New Theory • In general, risk and return are uncorrelated because risk is a deviation from the consensus • This makes risk symmetric, too much or too little exposure generates similar risk • Thus, volatile assets don’t need extra return to be held… Copyright 2013 Eric G Falkenstein 74 Basic Idea of Relative Risk and no Premium Total Return Avg. X Y State 1 0 -10 State 2 20 30 Relative Return X Y –5 5 –5 25 –5 5 Copyright 2013 Eric G Falkenstein 75 Utility Proof • Taking the first order condition, we have m = R f + a s 2 (a Ei - a E- i ) a Ei = a E- i • Since each agent is identical, in equilibrium each agent holds the same amount m = Rf • So • Which means, the expected return on risky assets is te risk free rate Copyright 2013 Eric G Falkenstein 76 Utility Proof Benchmark • Taking the first order condition in the standard model we have m = R f + as 2a Ei • This is the standard result, that higher volatility generates a higher return, linear in the variance, adjusted by the coefficient of risk aversion • Because the exponential utility is CARA, not CRRA, higher amount in the risky asset generates a higher risk premium Copyright 2013 Eric G Falkenstein 77 Relative Utility and Different Beliefs • See how relative utility model explains – Why when investors take risks, they expect above average returns – Returns are relative to the risk free rate – Don’t short assets with expected return<Rf m = R f + a s 2 (a Ei - a E- i ) m = R f + as 2a Ei Copyright 2013 Eric G Falkenstein 78 Relative Risk in academia 1 • Abel (1990): U ct , Ct 1 1 ct C t 1 1 • Gali (1995): U c, C 1 a 1 c1aC a • DeMarzo,, Kandiel, Kremer (2003): U cg , cs 1 a • Roussanov (2010): 1 c 1 a g 1 a s c i W C 1 a 1 a s Ws 1 a Ws Copyright 2013 Eric G Falkenstein 79 Outside the Box Evidence • Like any truth, it has lots of footprints Copyright 2013 Eric G Falkenstein 80 Easterlin’s Paradox (1974) • • • Within a society, rich people tend to be much happier than poor people. But, rich societies tend not to be happier than poor societies (or not by much). As countries get richer, they do not get happier. Copyright 2013 Eric G Falkenstein 81 Easterlin’s Paradox • Progress and Happiness a Puzzle – Gregg Easterbrook’s The Progress Paradox, – David Myers’s The American Paradox, and – Barry Schwartz’s The Paradox of Choice • Japan: between 1958-1987 per capita income rose 500% – No change in subjective well-being • Knight and Song (2006): Chinese villagers more affected by relative than absolute wealth, compared to their villages • Choose between – World A: $100,000 a year in perpetuity while others earned $90,000 – World B: earn $110,000 while others earned $200,000 – Most prefer World A Copyright 2013 Eric G Falkenstein 82 Buy Recommendations exclude low risk firms • Half of all stocks have expected returns below the market • Zero recommendations for firms with expected returns below the market return Buy! Expected Return Who cares? Risk Copyright 2013 Eric G Falkenstein 83 Home Bias • Should invest in world portfolio • Chan, Covrig, and Ng (2005): Everyone is investing mainly in domestic portfolio • Avoiding easy way to diversify risk • Low covariance with risks from home economy Copyright 2013 Eric G Falkenstein 84 Everyone Benchmarks • “I want a product to be defined relative to a benchmark” Bill Sharpe • ‘Risk, see Benchmarking’ Kenneth Fisher’s Only Three Questions that Count • “small stocks were in a depression” in the 1980’s Eugene Fama, Merton Miller Copyright 2013 Eric G Falkenstein 85 The Most Prominent Economists Can Be Read as Relative Utility Proponents • “…rank among our equals, is, perhaps, the strongest of all our desires.” – Adam Smith • “Men do not desire merely to be rich, but to be richer than other men.” – John Stuart Mill • “any individual or group of individuals, who consent to a reduction of money-wages relatively to others, will suffer a relative reduction in real wages, which is sufficient justification for them to resist it” – JM Keynes • “The motive is emulation–the stimulus of an invidious comparison... especially in any community in which class distinctions are quite vague” – Thorsten Veblen • Our wants and pleasures have their origin in society; we therefore measure them in relation to society; we do not measure them in relation to the objects which serve for their gratification.” – Karl Marx , Wage Labour and Capital, chapter 6 Copyright 2013 Eric G Falkenstein 86 Hard Wired For Envy • Relative Status makes more evolutionary sense than absolute wealth as a utility function • Evidence for this instinct Copyright 2013 Eric G Falkenstein 87 Evolutionary Biology • genetic success is always relative, why spite works Copyright 2013 Eric G Falkenstein 88 Evolutionarily Robust • Special Utility needed for interest rate to be 1 a C stable over generations U C 1 a • But then, refinement really has to vary • Eye cones and color • Rayo and Becker (2007) Copyright 2013 Eric G Falkenstein 89 Reverse Dominance Hierarchies • Chris Boehm • primates usually have dominant males • With tools, easy to kill dominant males, so hierarchies are not ‘natural’ for humans Copyright 2013 Eric G Falkenstein 90 Imitating Others Dominant Strategy • We copy all the time: parents, then peers, then anyone doing well • Mark Pagel: zero, soap, the wheel, language, iPads. – Division of labor, accumulation of science, implies innovating only after a lot of copying, and generally relying on others Copyright 2013 Eric G Falkenstein 91 Social Context Hard Wired • Specialized neural mechanisms process social information, empathy • Can’t ‘not see’ context • Mirror neurons tie others to us Copyright 2013 Eric G Falkenstein 92 Relative Utility Matters more than Absolute • • • • Econometrics fMRI Psychologists rank in one’s peer group is more important than the level of income Copyright 2013 Eric G Falkenstein 93 Endocrinology of Envy • Robert Sapolsky found baboon status related to glucocorticoid levels • Whitehall Studies found correlation between British civil servant grade level and mortality. Copyright 2013 Eric G Falkenstein 94 Moderation in All Things – – – – – – Vitamin A Radiation Oxygen Politeness Loyalty Honesty Risk • Greek proverb • too much, too little, both bad: - Relative 0 Exposure Copyright 2013 Eric G Falkenstein 95 Courage Premium • Aristocracy asserted their privileged position came from battlefield courage • The upper classes truly were courageous in battle, as WW1 showed, but no one will pay for that, and taxes on the rich went up Copyright 2013 Eric G Falkenstein 96 Why Take Uncompensated Risk? • Necessary, not sufficient condition for success • Every irrevocable act entails some kind of risk – We all take risks (marriage, jobs) • Taking the right risks, at the right time, given our particular strengths, is good Copyright 2013 Eric G Falkenstein 97 Why a Negative Premium? • With relative risk, an abnormal demand for highly volatile assets is not totally countered in equilibrium, leaving a price impact • Higher demand, higher price, lower future return • Without relative utility, one needs ad hoc constraints Copyright 2013 Eric G Falkenstein 98 High Vol Demand: Winner’s Curse • If no short selling….assets with higher valuation uncertainty will have higher prices, lower returns Copyright 2013 Eric G Falkenstein 99 High Vol Demand: Overconfidence • People are generally overconfident about their relative competency on socially desirable trates • Overconfidence makes one happier, lowers mortality Copyright 2013 Eric G Falkenstein 100 High Vol Demand: Risk-Loving • Preference for positive skew • Consistent with global risk aversion only if skew risk premium <15% of standard risk premium • Risk loving looks like overconfidence Copyright 2013 Eric G Falkenstein 101 High Vol Demand: Gambling Preferences • Robert Sapolsky and dopamine generation based on rewards: – Higher for probabilistic payoffs Copyright 2013 Eric G Falkenstein 102 High Vol Demand: Information Costs • High volatility stocks generate more news – Easier to form opinion – Easier to sell a story • Falkenstein (1996) looked at mutual fund ownership and news stories, stock age Copyright 2013 Eric G Falkenstein 103 High Vol Demand: Representativeness Bias • Great stocks of past had great risk…. • “To get rich, you have to take risk.” • Prob( higher return|higher risk)=Prob(big return|big risk ) >0 – So risk is correlated with higher returns (?) P A prob risky P B prob high return P A | B P B P B | A P A Copyright 2013 Eric G Falkenstein 104 High Vol Demand: Alpha Discovery • Many people jump in and want to know if they have ‘it’ • Trade bio-techs, not utilities Copyright 2013 Eric G Falkenstein 105 High Vol Demand: Convex Payoffs to Stock Pickers • Top stock analysts often have 100% winners • Mutual fund inflows highly convex – Greater value to greater volatility via call option Copyright 2013 Eric G Falkenstein 106 High Vol Demand: Asset Buyers Bullish • Most equity buyers tend to think the market is going to rise more than the ‘equity risk premium’ • Given those beliefs, it Copyright 2013 Eric G Falkenstein 107 Academic Confabulations Copyright 2013 Eric G Falkenstein 108 Praise for a Vacuous Theory ‘it would be irresponsible to assume that [the CAPM] is not true’ William Sharpe ‘theoretical tour de force’ though ‘empirically vacuous’ Eugene Fama ‘stochastic discount factor(s) … so general, they place almost no restrictions on financial data’ John Campbell Finance is “the only part of economics that works” Andy Lo Copyright 2013 Eric G Falkenstein 109 Snipe hunt for factor that works • • • • • Oil prices Consumption growth Per-capita labor income Consumption/wealth ratio Statistical (latent) Factors • Etc. Copyright 2013 Eric G Falkenstein 110 Implications Copyright 2013 Eric G Falkenstein 111 MVP Construction • Find weights with added constraints – No shorts – Cap on weight of 2% for S&P500, 4% for other indices – Stocks found generally at max limit for longs – Redo each 6 months based on daily data from prior year Min w HFA w s.t. w ' 1 0 wi 0.02 i Copyright 2013 Eric G Falkenstein 112 Indexes are not near 'Efficient' AnnRet FTSE FTSEMVP MSCIEur MSCIMVP NikkeiS&P500Nikkei MVP S&P500 MVP 2.7% 7.4% -0.6% 2.6% -1.6% AnnStdev 15.0% Beta 0.0% 4.2% 9.2% 12.0% 19.5% 13.1% 19.8% 13.5% 16.5% 12.3% 0.65 0.59 Copyright 2013 Eric G Falkenstein 0.50 0.47 113 Beta Strategies Beta-Low Beta-05 Beta-10 Beta-15 Beta-High S&P500 GeoMean 11.3% 11.9% 12.2% 9.6% 6.4% 10.1% AnnStDev 13.0% 11.6% 17.4% 26.2% 34.4% 15.1% Sharpe 0.45 0.56 0.39 0.16 0.03 0.31 Inf. Ratio 0.10 0.22 0.21 0.15 -0.02 SMB Beta 0.53 0.34 0.69 1.45 1.78 0.26 HML Beta -0.06 0.10 -0.29 -0.96 -1.35 -0.39 Mkt Beta 0.60 0.57 1.04 1.44 1.82 Data from Jul-1962 to Jun-2012 monthly returns, annualized used top 80% of NYSE market cap (about 1500 stocks today) Portfolios with 100 stocks Copyright 2013 Eric G Falkenstein 114 Total Vol vs. Beta vs. IdioVol • Top 2000 stocks, extrapolated backward, 1952-2008, Sorted differently Volatility Beta Idio low high low high low high Arith 10.3% 7.9% 12.1% 11.1% 10.5% 9.0% Geo 10.2% 2.2% 12.0% 5.3% 10.5% 3.7% Stdev 10.2% 33.5% 11.9% 34.1% 10.2% 32.5% Sharpe* 1.00 0.07 1.01 0.16 1.03 0.11 Copyright 2013 Eric G Falkenstein 115 Investment Advisor • Assume people want to do what everyone else is doing – Appealing asset allocation based on consensus, not volatility • Sell idea of trading envy for greed • MVPs • Beta Arbitrage • Will deviate from the benchmark Copyright 2013 Eric G Falkenstein 116 Implication • Focus on payoffs and probabilities – not expected returns – Not discount rates • Don’t derive an expected return from a covariance or factor loading E ret a 2 E ret a pi Copyright 2013 Eric G Falkenstein 117 Implications • Don’t expect to be rewarded for risk taking per se • Accept some envy; moderation in all things • People like being appreciated: it shows they are relatively competent, a status maximizing metric Copyright 2013 Eric G Falkenstein 118