(September 11, 2012) – Sophisticated investors can be seduced by the same risk-return fallacies as lottery ticket customers, argues Societe Generale investment analyst Dylan Grice.
“The same psychological tendency that overvalues lottery tickets undervalues quality stocks, as their robust business models and solid balance sheets do tend to be quite boring,” writes Grice in his blog Popular Delusions. “So our best guess at the moment is that the mispricing of quality is indeed systematic. It reflects something permanent (our psychological hardwiring) rather than something transient (the fads of macroeconomic theory).”
After pouring through decades of stock market data, Grice and his colleagues found a persistant pattern: On average, returns from high risk investments don’t compensate for the risk an investor takes on. Conversely, very low risk equities tend to pay off disproportionally well.
Statistical reasoning is like a magnetic compass: When probabilities approach polarity–if an outcome is extremely unlikely or near-certain–our perception of risk goes haywire, he argues. That’s why people buy lottery tickets and penny stocks, despite the outsized chance of losing their investment.
In Grice’s view, people value certainty so highly—100% is vastly more comfortable than 95%—that near-certainty can be had for cheap: “We undervalue near-certain outcomes. Yet this is exactly the world in which low beta/high quality stocks live…And if high beta/low quality stocks live in the world of possible triple-digit returns, attracting lottery ticket overvaluations, low beta/high quality stocks live in the world of near certainty, attracting the boredom discount.”
This theory dovetails with the low-volatility investment anomaly: “All ‘true’ low volatility portfolios should earn a premium return of about 2% in the United States and do so with 25% less absolute risk than the benchmark,” says one leading strategist. “Even something as simple as screening out high volatility stocks and weighting by the inverse of volatility (i.e., allocating more to low volatility stocks) will produce a comparable result.”
While penny-stock traders pay a premium for the thrill of a slim chance, what’s the converse—the psychological effect of near-certainty that investors are eager to buy their way out of? “Slightly anxious boredom,” says Grice.
Read Grice’s whole paper here.