The key to the dominance of low volatility equities is that high volatility stocks are bad investments on the two main dimensions of stockworthiness: volatility and return. Volatile stocks by definition have high volatility, and also high correlation with the overall market (CAPM beta) and the business cycle. They all have below average returns. So why do so many people like them?
In 1996 I documented that mutual funds prefer stocks with higher than average volatility, which was fine as long as I didn’t try to suggest this explain why highly volatile stocks underperform. That was crazy-talk. Back then, partial equilibrium reasons for asset price movements was simply not allowed in polite company because it implied factor arbitrage, highlighting that what counts as ‘science’ is subject to fashion. Anyway, the Council of Financial Elders now accepts these stories, so here are eight reasons why so many people like to invest in the highflyers:
Overconfidence: An investor who thinks they are smarter than others will apply this superior stock picking to stocks with the greatest upside. If you can identify those stocks with higher returns, this is better applied to Google and Apple as opposed to Coke and GE.
Investor flows to Fund Performance: Sirri and Tufano (1993) documented that mutual fund inflows are convex: increasing in relative performance, and then turning upward strongly for the top performers. This generates a ‘call return’ payoff, so that the higher the volatility of the fund the higher the expected return to the fund manager.
Winner’s Curse: Ed Miller (1977) showed that if investors invest in stocks they think are going to have high returns, stocks with greater variance in their expected return will have a winner’s curse to them, in that those with the higher variance will have owners with greater return expectations. This mechanism needs a short selling constraint, but most people will accept that.
Information Costs: Stocks with higher volatility generate more news than less volatile firms. Such stocks are then ‘in play’, and so become relevant to the investor interested in deviating from the index. Given short constraints or overconfidence, this increased focus on volatile stocks leads to lower future returns.
Alpha discovery: Many people believe they have an ability to pick stocks successfully. In order to demonstrate this ability to themselves they have to actually try this. It may all be luck, but if people believe that their short run performance signals alpha, that information would be considered valuable regardless. This biases investors towards the more volatile assets so they can assess their investing alpha more clearly.
Lottery preferences: Friedman and Savage (1948) discussed the paradox that people liked lotteries where payoffs are 100+ to 1 though the expected return is negative, but were also generally variance averse. The popularity of lotteries continues, and suggests a deep preference towards positive skew. Journal of Finance editor Cam Harvey thinks that this explains many anomalies.
Representativeness Bias: This is from Kahneman, Tversky, and Slovac (1984). The idea is base rate information is neglected in a Bayesian sense relative to the ease to which some anecdotes are presented. So, new listings are potential Microsofts or Googles in spite of their poor base rate, because most investors ignore or are unaware of base rates, and focus on the anecdotes. Highly volatile stocks generate a lot of favorable anecdotes.
Signaling: If one is starting out in investing, the top investment managers generate a disproportionate share of attention from outside investors. To get into the Bloomberg’s list of top portfolio managers, you need a home run, a ’10 bagger’ in Peter Lynch’s term, something that can generate an outsized return that will generate to future investors or bosses that one is an investor with ‘alpha’. If you can outperform the indices by 2 percent a year but without any really great years that stand out, standard tracking error implies your customers will need a lifetime to discern your alpha, so you might not even bother unless you have really good connections.
So, when all of those extra incentives to invest in highly volatile companies goes away, then we’ll have to re-evaluate.