The Missing Risk Premium: Why Low Volatility Investing Works
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Last annotated on May 11, 2016
“The opposite of courage in our society is not cowardice, it is conformity.” — ROLLO MAYRead more at location 159
PrefaceRead more at location 165
Note: COSA CONTA VERAMENTE NELLE SCELTE D INVESTOMENTO..... LTCM LA VERA STORIA... MATH INTIMIDATORIA... Tesi del libro: la teoria accademica è fondamentalmente fallata così come lo è la nozione di rischio che supporta. Questo errore trova una chiara conferms nei fatti... Oggi un PHD in finanza è poco utile per agire sui mercati: megio una laurea in fisica o in computer science... CAPM conta in borsa quanto Il Capitale di Marx in economia. Cosa insegna CAPM: ogni investimento ha un rischio divrrsificabile che si assume senza premi e un rischio specifico che si assume previacun premio... Ma la lezione di CAPM conta ben poco x gli investitori (tanto è vrro che in borsa il premio di rischio latita). Altri insegnamenti prevalgono: 1) studiare la storia delle crisi 2) considerare gli operatori di borsa come agenti in relazione tra loro e qs relazioni contano più delle analisi di rischio 3) pensare che l'investimento rende bene se si ha una conoscenza suprriore alla media. Quando nn la si ha stare coperti... LTCM (il fondo dei Nobel) è il classico esempio di come finanza accademica e finanza pratica collidano. Ma nn tanto x il fallimento del fondo, quanto xchè già da prima si era rinunciato ad applicare gli algoritmi dei Nobel... Nella finanza la matematica ha essenzialmente un ruolo: intimidire l'outsider... "Rischio" ormai è un concetto come "Trinità": usato da gente un pò confusa che crede in buona fede che la sua confusione derivi da comprensione insufficiente dei fatti... È giusto criticare l'ortodossia ma ancora più giusto criticare chi critica l'ortodosia in nome di una presunta irrazionalità del mercato... Edit
This book outlines an important flaw in finance and the academic notion of risk. It gets into how the original asset pricing model went wrong, why it is empirically bankrupt,Read more at location 166
In practical finance, a computer science or physics PhD is generally more attractive than an economics or finance PhD mainly because that person knows more programming, which is useful.Read more at location 176
If you want to teach and publish academic papers, modern asset pricing theory is very useful, but it has about as much relevance as Das Kapital to any practitioner.Read more at location 179
The risk premium emphasis of modern finance is not helpful to someone trying to truly understand this field.Read more at location 195
the main ideas from modern asset pricing theory are the following: the quantity of risk is measured by a covariance with priced risk factors which are as-yet unidentified time series like the stock market, and there’s a linear relation between this risk metric and expected returns.Read more at location 198
That is, the first key to investing is an understanding of history that comes from reading various accounts of the internet bubbleRead more at location 201
Secondly, I would emphasize that finance is as much about personal relationships asRead more at location 202
Thirdly, that investing is like any other endeavor, where above average performance depends on some kind of edge, so if you have no reason to presume you have an edge assume it is negative and invest in assets where this hurts you the least.Read more at location 203
A good example of the contrast between theory and practice comes from Long Term Capital Management (LTCM), the famed hedge fund that imploded in 1998. In theory, when it was working, outsiders thought they were using computer models to implement highfalutin theoretical insights from their two eminent financial theorists, Nobel Laureates Robert Merton and Myron Scholes. In practice, they put on some simple trades that were neither clever nor subtle, as they failed primarily due to a failed interest rate bet and a bet on volatility. Merton and Scholes were irrelevant to the investment decisions throughout, yet they were disingenuously presented for marketing the fund. That is the essence of modern finance: a rigorous, disingenuous façade, and a seat-of-the-pants practical side.Read more at location 206
Note: LTCM. UN FALLIMENTO DELL ACCADEMIA? NO UN SIMBOLO DELLO SCOLLAMENTO TRA ACCSDEMIA E REALTÀ Edit
discussion of mathematics, as applied to finance, does tend to become excessively pretentious, pedantic, and irrelevant, and is primarily used, like Merton and Scholes for the failed LTCM, for impressing and intimidating the many mediocre people who can be intimidated by credentials and math.Read more at location 218
Risk has become a concept like diversity or the Trinity, words that are either used by confused people of good faith certain that any inconsistency comes from insufficient understanding, or simple hucksters who use it as a red herring.4Read more at location 222
Though I am a critic of standard approaches, I find myself generally agreeing with economists who represent these approaches more than their critics. That is, the most common criticisms of modern financial theory are based on the argument that markets are irrational or inefficient, with reference to behavioral finance and systematic biases. This highlights that it is not sufficient to note the current status quo is wrong but in precisely what way because this matters.Read more at location 231
CHAPTER 1 IntroductionRead more at location 240
Note: Un caso per gli epistemologi: xchè CAPM gode di eccellente salute (almeno nelle scuole) quando il modello è ripetitamente confutato nella pratica?... CAPM: il valore di un titolo è il valore attuale della rendita che garantisce. I pagamenti della rendita sono scontati da un fattore di rischio tenendo presente che i rischi non-sistematici non generano alcun premio... Eppure forse nn esiste nel mondo delle scienze sociali un modello tanto testato (e disconfermato). Sono i suoi stessi sponsor a sostenerlo... Un po' come nell'800: si postulava l'esistenza dell'etere speculando sul xchè nn poteva essere misurato finchè nn ci si risolse a dire che nn c'era etere... CAPM postula un avversione al rischio degli operatori per cui sopportare un rischio in più genera un premio... CAPM è un pò come la Freud: puoi confutarlo finchè vuoi ma ci sarà sempre qlcn che ti dirà che la teoria è + sottile di quanto tu creda... Prendi la teoria dei prezzi: i lavori + onerosi sono i più pagati? Di solito sono i meno pagati, chiedete ai pulisci-cesso. La prima conclusione è logica ma confutata poichè il modello è incompleto, nn tiene conto dell'offerta: troppa gente vorrebbe farli. investire: attività meno rigorosa ma più difficile di quanto predice la teoria. capm razionalizza a posteriori: il rischio è sittile e multidimensionale. ma così facendo una teoria che dovrebbe semplificare complica. condizione x avere un risk premium rp: avere funzioni di utilità che dipendono solo dal bene (egoismo).. ma se l invidia pi. prevale sull egoismo e. tutto crolla: quando i miei pari detengono assets ad alto r. x me fare altrettanto è un comportamento a basso r. sostituiamo e. con i. e tutto va a posto. test dell assunto: denaro e felicità sono collegati? no: assunto confrrmato. massima: il rischip in borsa è come il rischio altrove: c è invidia innamoramenti ecc. Edit
it’s as though a conspiracy were acting to keep everyone from noticing that the riskiest investments are not those with the highest expected returns but rather like lottery tickets catering to the deluded.Read more at location 244
Note: ERRORE: IN FINANZA NN SIAMO AVVERSI AL RISCHIO... È COME CON LA LOTTERIA: IL RISCHIO SI CERCA Edit
Seminal work by Markowitz, Tobin, and Sharpe created modern portfolio theory and the capital asset pricing model (CAPM) with its “betas.”Read more at location 259
The basic idea of how the risk premium works is the following. An asset’s price is the present value of future payoffs, where the discount rate is the risk factor.Read more at location 264
The risk premium is an unobserved variable that connects the expected future payoff to the current price, and so price movements are often explained in terms of changes in riskRead more at location 269
The risk premium, g, is a function of a covariance with something like the S&P 500 stock indexRead more at location 272
Although the original CAPM has been replaced by a framework, it retains the same essential qualities of the CAPM. The keys are risk aversion over aggregate wealth, risk measured as the covariance of the asset with the risk factors, and a linear price for risk (twice the risk generates twice the excess return).Read more at location 277
The academic history of risk is usually presented as the crowning success story of the social sciences, with its cannon of heroes from Nobelists Harry Markowitz to Danny Kahneman.Read more at location 282
Peter Bernstein titled Against the Odds: The Remarkable Story of Risk,Read more at location 284
Like Prometheus, they defied the gods and probed the darkness in search of the lightRead more at location 288
As Mark Rubinstein said about the CAPM and its extensions, “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.”11 Eugene Fama and Kenneth French called the CAPM “empirically vacuous,”Read more at location 292
It’s a bit like nineteenth-century physicists who assumed the luminiferous aether was present and kept coming up with more fanciful explanations for why it couldn’t be measured.Read more at location 302
Although many have emphasized that empirical failure is caused by the subtlety of risk and expected return, consider beauty, which like risk in that it is omnipresent and subjective.Read more at location 304
In contrast, risk has devolved into something like Freud’s Oedipal complex, where a young boy presumably wishes to have sex with his mother and fears castration from his father, and this causes all sorts of issues. Most people find this absurd, but if you have ever met someone who invested in psychoanalysis, that person will just tell you the theory is much more subtle, so much so it is clearly nonfalsifiableRead more at location 309
The standard theory assumes people are paid to withstand an objective undesirable, like receiving a dollar for every extra minute you leave your hand in hot water—those who have the highest pain tolerance achieve the highest returns on average.15 Yet in practice, onerous or smelly jobs usually pay poorly, as any toilet cleaner knows, because too many are willing to submit themselves to large amounts of unpleasantness for higher rewards.Read more at location 321
Note: ANALOGIA CON I LAVRI DI FATICA: SONO I PIÙ BRUTTI MA ANCHE I MENO PAGATI. L OFFERTA È TROPPA Edit
The idea that to get rich you need to take risk seems to imply that risk begets higher returns, but this is just a logical fallacy, like using successful gamblers as role models for investing.Read more at location 327
any measure of risk is at best uncorrelated with average returns and is often negative.Read more at location 338
the academy has been quick to amend its previous theory with a simple addendum: risk is really subtle, multidimensional, and sometimes people are risk lovingRead more at location 339
The effect of a good theory is to make an accurate view of the world less complicated, not more, but instead modern researchers focus on the framework’s potential and its usefulness for post hoc rationalization.Read more at location 343
There is just one necessary and sufficient condition for the existence of a risk premium: standard utility functions, which assume that our happiness is solely dependent on our individual wealth and increases at a decreasing rate.Read more at location 352
If people are primarily envious, as opposed to greedy, the same logic that generates a positive risk premium generates a zero risk premium.Read more at location 356
if your benchmark is the average return of your peers, then the risk-minimizing strategy is to do what everyone else is doing.Read more at location 358
Although most of us don’t like to think we are driven by envy, most admit benchmarking against the consensus which is really just a semantic difference;Read more at location 361
Eugene Fama, who described his foray into small-cap stocks as experiencing a “depression” in the late 1980s, when, in fact, it was only true on a relative basis. These depressed stocks were up 50 percent from 1985–1989, which is pretty high compared to other periods.Read more at location 363
This assumption is more consistent with a variety of other facts, such as that happiness does not increase as societies get wealthier,Read more at location 370
The effect is for really high-risk investments to have the most delusional investors, the most opportunistic sellers, and pathetic returns. This would be a mere curiosity if the indexes did not indiscriminately weight equities regardless of this attribute. By ridding your asset classes of these objectively bad assets, you can improve your returns rather simply, and this has been demonstrated in real time via the dominance of low-volatility investing.Read more at location 395
risk taking in investments is no different than risk taking in other dimensions of your life, something you apply in concert with your comparative advantage and in the right context. To the extent you take a risk without any specialized knowledge, expect to pay a price for the chutzpah of expecting to be rewarded for your hubris.Read more at location 399
CHAPTER 6 Why Envy Explains More than GreedRead more at location 2143
a relative utility function can explain the general absence of a risk premiumRead more at location 2146
evolution favors a relative utility function as opposed to the standard absolute utility function, and the evidence for this is found in psychology, ethology, anthropology, and neurology.Read more at location 2155
The instinctive utility that guides individual decisions under all time periods is presumably the same.Read more at location 2158
It seems reasonable to assume the fraction of investor portfolios allocated to risky assets has remained stableRead more at location 2160
CHAPTER 7 Why We Take Too Much Financial RiskRead more at location 2437
Note: 7@©©©©©©©©©©©©©©LA NATURA CI VUOLE RISK TAKER I SETTE MOTIVI CHE CI ONDUCONO A PRENDERE RISCHI Edit
If risk taking did not pay off, presumably no one would do it because, by definition, risk is something we do not like.Read more at location 2439
Risk taking, however, is unavoidable, and it does pay off, just not in the way implied by the standard model, where incremental amounts of risk taking, which is the same for everyone, pays off.Read more at location 2441
Consider the optimal stopping problem,Read more at location 2442
Assume you are looking to get married and have kids, and your lifetime and fertility are finite.Read more at location 2444
The question is about the optimal strategy (stopping rule) to maximize the probability of selecting the best mate,Read more at location 2447
your choice relative to the optimal choice seen by an omniscient deity is invariably inferior.Read more at location 2451
Both choosing to move on or staying with what you have involves risk; risk cannot be avoided.Read more at location 2452
historically, 80 percent of females have reproduced, but only 40 percent of males have passed on their genes. The rest of the males have been genetic dead ends.Read more at location 2456
Males have to beat out other males to get access to females. Thus men built ships and traveled to far-off lands because those were the guys who had more children, whereas a bunch of women could bear children just as easily staying put.Read more at location 2459
Everyone’s male ancestors have been disproportionately risk takers;Read more at location 2461
not taking risk is genetic suicide,Read more at location 2462
Risk takers dominate our lives via their disproportionate effect on our genes and their influence on our technology and culture.Read more at location 2463
One might say this is not relevant to markets where rational traders at the margin determine prices and returns.Read more at location 2469
stupid investors do influence equilibriumRead more at location 2471
given the multidimensional complexity of any asset class, where different trading tactics and complementary positions generate very different returns,Read more at location 2472
The economist Robert Aumann discussed the difference between rule and act optimality and gave the following example.148 In the ultimatum gameRead more at location 2475
Most people reject an offer less than 20 percent of the pool. Economists see this as irrational because there is no upsideRead more at location 2480
but Aumann sees it as rational in the general sense that one does not want to appear a chump, even if the appearance is just to oneself. The chump rule overrides our act rationalityRead more at location 2482
humans have evolved to follow rules, as it is simply too costly to go through life without such heuristics.Read more at location 2483
People have an intuitive rule that risk taking is good.Read more at location 2487
People should see risk taking as a process of self-discovery,Read more at location 2489
If some risk taking demands nothing of you other than willingness, it is surely foolhardy because such willingness is hardly in short supply, so these types of risks do not generate higher-than-average-returns as a general rule.Read more at location 2491
Textbook investment choices are usually completely defined and reducible to simple logic.Read more at location 2497
Yet it is precisely because real risk taking is quite different, making different decisions than the consensus based on a radically different interpretation of the objective odds implicit in the investment, that we experience anxiety.Read more at location 2500
In practice, financial risk taking involves a great deal of anxiety, not about the realization of objective odds but rather sensing whether or not one has correctly ascertained the correct odds, what is called “ambiguity aversion.”Read more at location 2502
Note: NON È LA PRESENZA DI UN RISCHIO A RENDERCI ANSIOSI MA LA POSSIBILITÀ DO DEC IDERTE MALE. SE SCELGO SU UN DADO SONO MENO ANSIOSO Edit
Classic investors like J.P. Morgan and Benjamin Graham distinguished between gambling and investing, the former being simple exposure to randomness, the latter something amenable to special insight and intuition.Read more at location 2506
Economists have long known the behavioral implications of the CAPM were incorrect. Investors are underdiversified,Read more at location 2509
25 percent of investors have only one stock, and more than 50 percent owned fewer than three stocks.Read more at location 2511
consider that brokerages recommend only stocks with above-average returns.Read more at location 2513
In practice, no one, not even the high priests of this view, act as if their theory were true whenever they discover a higher-than-average returning strategy.Read more at location 2529
doing things that generate above average returns because of perceived systematic errors made by the masses.Read more at location 2532
Of course such person could be making an error himself, which is why these choices produce anxiety;Read more at location 2533
Below are the several reasons that could explain this preference for highly risky assets.Read more at location 2540
The “wisdom of crowds” applies to the means,Read more at location 2542
In the 1950s, they came up with the term “winner’s curse” to describe the fact that for auctions of offshore oil fields, winners were generally cursed by winning.Read more at location 2545
If we assume that the average bid is accurate, then the highest bidder overestimates the item’s value. Thus the auction’s winner is likely to overpay.Read more at location 2547
Over time, Miller’s winner’s curse argument has become more popular for several reasons.Read more at location 2558
Interestingly, Ed Miller was the first to emphasize the efficacy of low-beta investing in a Journal of Portfolio Management article in 2001, noting that if the winner’s curse was responsible for the poor performance of high-beta stocks; the risk-reward ratio for low-beta stocks was obviously higher.Read more at location 2565
Perhaps the most celebrated overconfidence anecdote is Svenson’s (1981) finding that 93 percent of American drivers rate themselves as better than the median.Read more at location 2579
94 percent of college professors think they are above-average teachers;Read more at location 2581
90 percent of entrepreneurs think that their new business will be a success; 98 percent of students who take the SAT say they have average or above-average leadership skills.Read more at location 2582
Barber and Odean (1999) used overconfidence to explain why men, who psychological studies show are more overconfident than women, trade too much.Read more at location 2584
People who think they are better than average at stock picking or picking mutual funds, will necessarily focus on the highly volatile stocks that generate better rewards for their prescience:Read more at location 2586
This involves constantly inflating our achievements and abilities and rationalizing our mistakes. For example, he noted that children not only lie, but lie more the higher their IQ.Read more at location 2593
Economist and Psychologist Danny Kahneman states this is the one bias he most wants his children to have because of its myriad benefits.Read more at location 2601
Friedman and Savage (1948) were the first to really apply utility functions to financial decision making, and, interestingly, it was not the concept risk aversion that they concentrated upon but rather the paradox that people liked to gamble and buy insurance.Read more at location 2609
Stocks with higher volatility generate more news than less volatile firms.Read more at location 2641
Stocks that are in the news generate lots of information that fiduciaries can use to sell their ideas to clients.Read more at location 2642
to see if an investor is able to generate a superior return. That is, does she have alpha? Many people believe they have an ability to pick stocks successfully.Read more at location 2660
if people believe that their short-run performance signals alpha, that information would be considered valuable regardless.Read more at location 2662
the ease to which some anecdotes are recalled.Read more at location 2669
Almost by definition, any stock that rose tenfold was highly volatile over much of its meteoric rise.Read more at location 2671
This is implied in the saying, “To get rich, you have to take risk.”Read more at location 2671
The flow of investor funds is a highly convex function of fund performance: really high for the top decile but then evening out to almost indifference below the 50th percentile, rather like a call option.Read more at location 2684
Bloomberg Magazine actually highlights analysts by their most profitable picks,Read more at location 2695
Those uncertain choices we make with incomplete information are not confined to finance, and indeed surveys show that the most prominent regrets in people’s lives are not portfolio choices but choices about careers, romance, and parenting.Read more at location 2703
CHAPTER 8 Why This Bad Theory Is So PopularRead more at location 2713
Note: fatto: se nei modelli dei mercati finanziari sostutuiamo l invidia i all egoio e. spighiamo più dati. perchè i ricercatori sono tanto lenti ad aggiustare il loro paradigma lap. fallacia naturalistica: è giusto ciò che è fallacia moralistica fm quel che è giusto è il lap si spiega con la f.m postulare l egoismo ci dice cosa fare: modellistica paretiana. ma postulare l invidia nn ci dice nulla l invidia fa saltare un postulato del decisore razionale: l indifferenza delle alternative irrilevanti. il postulato dell egoismo genera xsino l altrusmo in un gioco ripetuto. quindi: la teoria c è è bella (l economista aspira ad essere uno scienziato) implica ricchezza e altruismo... quindi deve essere vera. le utilità relative rendono i modelli meno stabili e più incerti. l etere il flogisto il comportamentismo il marxismo la psicanalisi... tutte teorie false. solo quelle della fisica sono state abbandonate. prchè? xchè è difficile confutare le scienze umane. l accademia è una tribù e ha bisogno dei suoi sacramenti. la psicologia conta: siamo maestri nel razionalizzare i ns pregiudizi. effeto dotazione. molti lavori sofisticati si sono basati su un paradigma fallace. ammetterlo è duro. come venivano liquidati gli studi fastidiosi: si sottolineavano le inaccuratezze (tanto ce ne sono sempre) trascurando di soppesarle. le riviste accademiche sono troppo specialistiche e nn colgono i fenomeni più vasti. la dimensione storica sfugge. ricordo xsonale di f., la sua tesi: i rendimenti dei titoli rischiosi sono più bassi. xchè la gente preferisce quei titoli. l accdemia nn apprezza e quindi si dà al trading applicando le sue idee che mirano a titoli low volatily. i fund manager e le banche nn apprezzano la strategia low volatile. la strategia dà buoni esiti patrimoniali ma spunta una denuncia xchè xicolosa. conclusione: toccata con mano l inconsistenza dell epistemologia popperiana. Edit
the fact that low-volatility stocks outperform the basic indices.Read more at location 2720
“’for every debate in science there is an isomorphic debate in the methodology of science.”Read more at location 2722
why academics have been so slow to adjust their failed paradigm,Read more at location 2724
While the naturalistic fallacy presumes that nature is what ought to be, the moralistic fallacy is the reverse: what ought to be, is.Read more at location 2728
If everyone’s utility is relative, it is difficult to talk about what societies should do. Economics loses a lot of its ability to objectively determine what to doRead more at location 2729
With relative utility, aggregate wealth has no obvious implication for general welfare.Read more at location 2733
The assumption of individual optimizers was initially seen as a cynical assumption, but Adam Smith and Friedrich Hayek highlighted how such narrow self interest can aggregate to counterintuitive socially beneficial outcomesRead more at location 2734
Robert Axelrod and evolutionary biologists such as Robert Trivers showed that altruism is consistent with self-interest in repeated interactions.Read more at location 2737
If individual utility were dependent of others, economic models would be a lot less tractable,Read more at location 2744
Phlogiston, aether, Skinner’s behaviorism, psychoanalysis, and Marxism are all wrong,Read more at location 2747
you can never conclusively disprove a social theory.Read more at location 2748
As Jonathan Haidt notes about politics, there’s a tendency to build a motivated ring of ignorance around sacred assumptions, those assumptions that simultaneously bind and blindRead more at location 2756
we see what we believe, and it is more important to have the correct biases than an objective and meticulous methodology.Read more at location 2776
Everyone knows that a little inaccuracy can save a lot of explanation,Read more at location 2807
Yet all it took was a simple cross-tabbing of beta with size, presented by credible insiders, to convince most people the standard CAPM model was untenable.Read more at location 2817
the data I present here is a good example of evidence that is too unwieldy for a refereed journal. Academics like rigorous tests using a small set of econometric tests on single asset classes, so the error structure needs to be very particularRead more at location 2820
stocks—are so simple, extended analysis would only obscure them,Read more at location 2825
A major problem is that as most of the active and esteemed researchers have built their careers extending or modifying the current framework, it would be very costly to classify work built on bad assumptions as irrelevant,Read more at location 2836
Yet the problem in asset pricing theory is not some second-order refinement, some inconsistency that occurs at extremes; rather, the entire framework is based on a profound mistakeRead more at location 2838
My 1994 dissertation centered on the low returns to highly volatile equities, which then I argued was related to the incentives and preferences individuals had toward buying highly volatile stocks.Read more at location 2844
Naively, I thought it was better that academia did not appreciate the insight because I could then apply my insight as a fund managerRead more at location 2853
I took a job as an economist with a regional bank in Cleveland mainly because it offered the potential to collaborate with the bank’s assetRead more at location 2855
when I approached several funds for some real capital, there was no interest.Read more at location 2862
Every year or so I would send an academic version of my papers highlighting the low return to high-risk stocks to well-known academics, and the usual response was silence,Read more at location 2865
Eventually, I did become an equity long-short portfolio manager at a hedge fund.Read more at location 2875
The bottom line is that this insight has generated successful out-of-sample results to me personally,Read more at location 2882
I have seen first-hand how data and theory are treated differently the model of science proffered by Karl Popper,Read more at location 2883
The truth will eventually be accepted for a variety of reasons, but it takes a while.Read more at location 2887
