larryswedroe wrote: ↑
Sun Jun 16, 2019 5:53 pm
Ben, the problem I believe is that volatility (market beta) is only one measure of risk and not the only one people care about. Investors also care about skewness and kurtosis (and overpay for assets that have positive skew and excess kurtosis, partly explaining value premium) and also WHEN risks shows up, not just volatility. So assets that tend to do poorly when labor capital is risky will have higher costs of capital even if have same beta as investors demand a larger premium for asset that do poorly in bad times (which value does because of more irreversible capital for example).
Thanks for putting it in terms of the return distribution--this is a much clearer statement. I think I understand what you meant to say, but I do want to clarify for those who may not know that market beta isn't a measure of volatility, but rather a measure of when the payouts occur--whether the asset pays out when the market does well (high beta) or when the market does badly (low beta). That said, it's possible that the value premium is capturing something about payout timing that isn't being captured by beta. Relaxing the assumptions of mean variance preferences would readily allow for this. The default general model in my mind is something like this (not the CAPM, which requires strong assumptions on preferences). But it's a little hard to see how the value premium would work into this. The labor risk story sounds like value would have to do badly when people lose their jobs but while the market is still doing well
. That's one scenario where value could add information over and above beta. And investors will need to know this and price these assets at a discount. I'm skeptical, but open to the possibility. if your book has a summary of the evidence on this, I will try to read it. I'm assuming the book you're referring to is Your Complete Guide to Factor Based Investing
The alternate hypothesis here is market inefficiency and mispricing. We know that the vast majority of people make terrible financial decisions. They live paycheck to paycheck, save too little, take out payday loans and credit card debt at insanely high interest, pay unforgivably high fees for investment managers to trail the market, chase recent performance, and so on. Most people are not simply not very good at the game of saving and investing. So the possibility that the prices of risky assets are a bit out of whack isn't that much of a stretch to begin with (since there are limits to arbitrage with risky assets). We also know that bubbles have been around for a long time--history gives us dramatic examples stretching back centuries. So it's not unlikely that there would be smaller scale bubbles simmering in our stock markets on an ongoing basis. How would these small scale bubbles manifest themselves in asset prices? Popular assets inside the bubble will have high valuations and low expected return. These would be the growth firms. Unpopular assets outside the bubble will have low valuations and high expected return. These would be the value firms.
There's also a simple story for small vs big: people like to stick with what's familiar. This could be what's behind home bias as well. One explanation for two phenomena--that's something.
It seems to me that these sorts of of inefficiency stories are less complicated and more compelling than the possibility that small, value, quality and momentum are all capturing higher order aspects of the return distribution that are not being captured by beta.
larryswedroe wrote: ↑
Sun Jun 16, 2019 5:53 pm
Ben, The CAPM simply isnt' complex enough. Things need to be as simple as possible, but not simpler (:-)) It's why the CAPM isn't used as the standard asset pricing model in finance--nice and elegant theory that just doesn't work as well as a more complex model. If the data doesn't confirm to your theory, throw out your theory
I'm not saying that we stick with the theory and throw out the data. CAPM is partially right, which is pretty darn good for a model in social science (which, in case anyone forgets, is what finance is). It doesn't get everything exactly right, and we have to address its deficiencies. The question is whether to modify the basic CAPM story by bringing in inefficient markets, or to modify it with other rational risk factors.
One thing to note here is that under the view that the excess returns for factors are fair compensation for risk, people on the right side of the equation--the large growth investors--are also making rational choices in line with their risk preferences. This raises the question--why are factorheads usually on the left side of the equation and not on the right? Most people interested in factors seem to be tilting towards small value and not towards large growth. Shouldn't risk preferences be more evenly distributed among factorheads? To me it looks more like a group of people crowding around the free lunch that is small value, than like a group of people locating themselves evenly along a risk return frontier between small value and large growth. Isn't this odd if factors are about risk and not about mispriced assets?