Embracing Downside Risk

Embracing Downside Risk

By Larry Swedroe It has long been known that investors have asymmetric preferences when it comes to bearing downside risk versus participating in the upside. The term “loss aversion” refers to an investor’s tendency to prefer avoiding losses more strongly than acquiring gains. Most studies suggest a loss is twice as powerful, psychologically, as an equal-sized gain. This aversion helps explain why the equity risk premium has been so large; the risk of owning equities is highly correlated with the risks of the economic cycle. Thus, in recessions, investors who earn wages or own businesses are exposed to the double whammy of bear markets and either job layoffs or reduced business income (or even bankruptcy). Because investors are, on average, highly risk averse, it should be no surprise they have demanded a large equity premium as compensation for accepting the risks of this double whammy, especially when considering that the risk of unemployment or the loss of business income are basically uninsurable. Investors might be forced to sell stocks (because of the diminution of earned income) at the worst possible time. A Study On Accepting Risk Roni Israelov, Lars Nielsen and Daniel Villalon contribute to the literature on investors’ asymmetric preference for risk with their paper “Embracing Downside Risk,” which appears in the Winter 2017 issue of The Journal of Alternative Investments. Using equity index options prices, they showed that the vast majority of the equity risk premium derives from accepting downside risk versus seeking participation in the upside. They found that, over the period 1986 through 2014, greater than 80% of the equity risk premium was explained by...
The Link Between Four Seemingly Unrelated Factors

The Link Between Four Seemingly Unrelated Factors

By Larry Swedroe Among some of the most well-documented stock market anomalies are four apparently unrelated factors: profitability (firms with high expected profitability exhibit higher future returns), distress risk (limited liability produces skewness in returns), lotteryness (individual investors who exhibit lottery demand are willing to accept lower returns in exchange for a small chance to receive a big payoff) and idiosyncratic volatility. Turan Bali, Luca Del Viva, Neophytos Lambertides and Lenos Trigeorgis contribute to the literature on these anomalies through their May 2017 study, “Seemingly Unrelated Stock Market Anomalies: Profitability, Distress, Lotteryness and Volatility.” The authors explain: “Growth, distress, and lotteryness involve real options that might increase the idiosyncratic skewness of the distribution of the firm’s equity returns. If investors prefer stocks with embedded real options and have preferences for more positive idiosyncratic skewness, then high idiosyncratic skewness offered by firms with such real options might entice investors to accept lower expected returns.” Thus, they considered a measure of growth options and related measures of profitability—controlling for asset growth in interaction with volatility—as well as distress and lotteryness, as potential drivers of idiosyncratic skewness, and examined whether their impact is priced in the cross section of equity returns. The authors explain: “High-growth (and likely low current profitability) firms, which tend to belong in high skewness subsets, would benefit more from high convexity (being out-of-the-money options on the firm’s assets) in more volatile environments as they have more optionality to benefit and less (fixed scale) commitment to lose from demand variability.” Their study covered 12,709 U.S. listed firms during the period 1983 to 2015. Following is a summary of their...
5 Action Steps After the Equifax Breach

5 Action Steps After the Equifax Breach

By Joe Delaney There is a lot of information buzzing around in the wake of the cybersecurity breach of credit reporting agency Equifax, which put virtually all Americans’ personal and financial information at risk of theft. We want you to know what the consensus is in the financial services industry about the seriousness of this breach and what action you need to take. THIS IS A BIG DEAL As The Atlantic reported on September 7th, just after the company’s announcement that the breach had been ongoing since May and was discovered on July 29th, 143 million U.S. consumers were affected. As there are only about 125 million households in the U.S., the scope and sensitivity of the information is unprecedented. We’ve all been hearing about the importance of protecting ourselves from identity theft for years, even decades. It may seem to some like this is just another data hack and all we need to do is not give our Social Security numbers out to strangers and we’ll be fine. On the contrary, we must take this seriously, and we must take action. TAKE THESE 5 ACTION STEPS NOW 1. Check the Equifax website to see if your information was breached. Go to www.equifaxsecurity2017.com and click on “Potential Impact.” Simply enter your last name and last six digits of your Social Security number as instructed. If notified that you may have been impacted, take the recommendations below much more seriously. If not, stay vigilant and strongly consider them.  2. Sign up for the free Trust ID service. Equifax is offering this free of charge. You will be asked if you’d...
Why So Many Investors are Playing a Loser’s Game

Why So Many Investors are Playing a Loser’s Game

By Larry Swedroe The other day, one of my firm’s wealth advisors called me to relate his conversation with a prospective client who had questioned the academic basis of our evidence-based investment philosophy. Specifically, she doubted the validity of the statement that most active managers persistently underperform their risk-adjusted benchmark. Her response was: “Of course they outperform, that’s what they get paid for. If they didn’t, no one would pay them.” From her perspective, it might have seemed painfully obvious to believe this was the case. After all, investors are rational and would not pay for poor performance. Yet the evidence shows she could not have been more wrong. In 1998, when Charles Ellis’s book, “Winning the Loser’s Game,” was first published, only about 20% of actively managed funds were generating statistically significant alphas. About 80% were not. That’s why Ellis called active management a loser’s game—a game that’s possible to win, but with odds so poor that it’s not prudent to try. Thus, like all loser’s games (such as buying lottery tickets or playing slot machines), the surest way to win is to not play. With investing, that means using passively managed vehicles, such as index funds. If the poor odds that Ellis describes aren’t convincing enough, as my co-author Andrew Berkin and I demonstrate in our book, “The Incredible Shrinking Alpha,” today the percentage of actively managed funds generating statistically significant alpha is less than 2%. We explain why this trend, in which active managers experience a persistently declining ability to generate alpha (that is, to outperform risk-adjusted benchmarks), is virtually certain to continue. That, in turn,...
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