Saturday, May 26, 2012

Paper: "Low Risk Stocks Outperform within All Observable Markets of the World"

As Whitebox Selected Research writes, "The Basic Pillar of Modern Finance has Fallen".

A study by Robet A. Haugen and Nardin L. Baker claims that "Low Risk Stocks Outperform within All Observable Markets of the World". From the paper:

"The fact that low risk stocks have higher expected returns is a remarkable anomaly in the field of finance. It is remarkable because it is persistent – existing now and as far back in time as we can see. It is also remarkable because it is comprehensive. We shall show here that it extends to all equity markets in the world. And finally, it is remarkable because it contradicts the very core of finance: that risk bearing can be expected to produce a reward."
In other words, the Capital Asset Pricing Model and the EMH, which are still in textbooks and taught to students, are wrong. A great deal of money is managed with the assumption that risk=reward, and managers buy volatile securities that are now shown to have lower expected returns. Why would this inefficiency exist? The authors' hypothesis is that
"agency issues create demand by professional investors and their clients for highly volatile stocks. This demand overvalues the prices of volatile stocks and suppresses their future expected returns."
In other words, if your compensation mechanism is an option, then volatility in the asset portfolio increases the value of your option. And enough managers do this that the volatile assets are overpriced, and underperform. However, the authors also note that
"significant amounts of assets are now being shifted from inefficient capitalization-weighted portfolios dominated by over-valued growth stocks into more efficient investments"
This is an astonishingly important paper (5/5) and yet it has fewer than 1,000 downloads!

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