In other words, they pay a premium to gamble. Among the stocks that fall into this category of “lottery tickets” are IPOs; small growth stocks that aren’t profitable; penny stocks; and stocks in bankruptcy. Limits to arbitrage and the costs or fear of shorting prevent rational investors from correcting the mispricings.
The CAPM also assumes that investors maximize the expected utility of their own personal wealth. Yet research shows that individuals care more about relative wealth. For example, the authors cite a study which found that an “overwhelming majority of people would rather earn $100k when others earn $90k, than $110k when others earn $200k, i.e. people prefer the higher relative, lower absolute wealth option.”
They note that the presence of both absolute- and relative-return-oriented investors implies a partial flattening of the security market line. The degree of flattening depends on the number of relative-return investors versus the number of absolute-return investors.
The CAPM also assumes that agents will maximize option values. But this may not always hold in the real world. For example, “portfolio managers are typically paid a base salary, on top of which they receive a bonus if performance is sufficiently high.”
This compensation arrangement “resembles a call option on the portfolio return, the value of which can be increased by creating a more volatile portfolio. In other words, there is a conflict of interest between professional investors, who have an incentive to engage in risk-seeking behavior, and their clients, who are more likely to be risk-averse as assumed by the CAPM.”
The authors explain that the optionality argument can be taken one step further “by arguing that the rewards to being recognized as a top manager are much larger than the rewards for, say, second quintile managers. For example, top managers receive a disproportionate share of attention from outside investors, such as making it to the front cover of Bloomberg magazine. In order to become a top investment manager one needs to generate an extreme, outsized return. This has the additional benefit of signaling to potential future investors and employers that one is truly skilled, as it is virtually impossible to distinguish between skill and luck in case of a modest outperformance. Delegated portfolio managers focused on realizing an extreme return in the short run may be willing to accept a lower long-term expected return on the high-risk stocks which enable such returns.”
Assumptions Of Rationality
The CAPM also assumes that investors have complete information, and that they rationally process the available information. But we know this also isn’t always the case in the real world. The research documents that mutual funds and individual investors tend to hold firms appearing more frequently in the news. They buy attention-grabbing stocks that experience high abnormal trading volume, as well as stocks with extreme recent returns.
The idea is that attention-driven buying may result from the difficulty investors have researching the thousands of stocks they could potentially buy. Such purchases can temporarily inflate a stock’s price, leading to poor subsequent returns. Attention-grabbing stocks are typically high-volatility stocks, while boring low-volatility stocks suffer from investor neglect. The attention-grabbing phenomenon is therefore another argument supporting the existence of the volatility effect.
The research also shows that investors (including active fund managers) are overconfident, another violation of the CAPM’s assumption of rational information processing.
The impact on the volatility effect is that, if an active manager is skilled, it makes sense for that manager to be particularly active in the high-volatility segment of markets, because that segment offers the largest rewards to skill. However, this results in excess demand for high-volatility stocks.
An Anomaly With Legs?
As you can see, the academic literature is filled with a large number of possible explanations. What does seem clear is that many of the explanations come from either constraints or agency issues that drive managers toward higher-volatility stocks.
Given that there doesn’t seem to be anything on the horizon that would have an impact on these issues, it seems likely that the anomaly can persist. In addition, human nature doesn’t change easily. Thus, there doesn’t appear to be any reason to believe that investors will abandon their preference for “lottery tickets.” And the limits to arbitrage, and fear and costs of margin, make it difficult for arbitrageurs to correct mispricings.
Finally, it’s important to remember that the anomaly is much more about the underperformance of high-volatility (or high-beta) stocks, and not so much about the outperformance of low-volatility (or low-beta) stocks. Because of this, one way to take advantage of the anomaly is simply to avoid high-volatility/high-beta stocks or invest in funds that screen them out.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.