Swedroe: Beware Stars Of Investment Balls

October 31, 2014

History and solid research tell us that following the crowd is usually a bad idea.

Let’s define “popular” as being liked or admired by the general public. One might reasonably think that popularity is a good thing, right? But when it comes to investing, research shows popularity often comes with lower returns.

This correlation can sometimes result in a conflict with traditional economic theory, where risk and expected return should be positively related.

Not surprisingly, and consistent with traditional economic theory, investors dislike risk. Thus, riskier assets generally have higher returns. For example, riskier stocks have provided higher returns than safer bonds, riskier small stocks have provided higher returns than safer large stocks, and riskier long-term bonds have provided higher returns than safer short-term bonds.

Nevertheless, we have an anomaly in that riskier small growth stocks have underperformed safer large growth stocks. They have also underperformed even more risky small value stocks.

The Downtrodden Win

What, then, explains the underperformance? One explanation for this and other anomalies —offered by Roger Ibbotson and Thomas Idzorek in their paper, “Dimensions of Popularity,” which appears in the 2014 special anniversary issue of the Journal of Portfolio Management —is that there are certain characteristics that make investments popular.

That popularity induces investment, which in turn drives up prices and drives down returns. Conversely, there are securities with characteristics that make them unpopular with investors. Investors tend to avoid them, driving down their prices and increasing their expected returns.

Research in behavioral finance has provided us with numerous examples where investor preference has created an anomaly. For example, the poor performance of small-cap growth stocks (sometimes referred to as the “black hole of investing”) is explained by their popularity. Individual investors seem to have a preference for assets with a distribution of returns resembling that of a lottery ticket (positive skewness and excess kurtosis).

It turns out that many kinds of securities with low (or even negative) expected returns but also the small chance of a “jackpot” payout have poor risk-adjusted returns, and not just small growth stocks. Others “jackpot” assets include deep out-of-the-money options, IPOs, penny stocks and stocks in bankruptcy.

 

 

Find your next ETF

Reset All