Popularity as a Bridge between Classical and Behavioral Finance
The title of this book refers to popularity as a bridge between classical and behavioral finance. Both approaches to finance rest on investor preferences, which we recast as popularity.
Classical finance is based on the following principles: rationality, equilibrium or risk-free arbitrage, and efficient markets with “fair” pricing. In this book, we took the equilibrium approach.
In classical finance, risk—in particular, systematic risk—is the primary aversion of investors. A single systematic risk is priced in the capital asset pricing model (CAPM), but some risks, including various types of stock or bond risks, can also be multidimensional. The specific structure of risk can also be priced, as in catastrophic risk.
Although classical finance usually assumes away market frictions, rational investors may have preferences for market liquidity, favorable tax treatments, or asset divisibility, making assets more or less valuable to the extent they embody these characteristics.
In behavioral finance, investors may not be completely rational. Thus, investors may have preferences that go beyond rational behavior.
We classified behavioral biases into two types, psychological and cognitive. Psychological desires cause some assets to be more popular than others, relative to their risk-adjusted expected cash flows and relative to such other rational characteristics as liquidity. Investors’ rationality is also limited because they make cognitive errors.
Neoclassical economics provides the rationality framework for efficient capital markets, CAPM, New Equilibrium Theory (NET), and so on. Behavioral economics assumes limited or “bounded” rationality and thus provides the framework for prospect theory, loss aversion, framing, mental accounting, overconfidence, and similar cognitive biases.
Popularity represents preferences, which can be rational or irrational. Thus, popularity provides a bridge between classical and behavioral finance.
Popularity as a Theory
The CAPM is an elegant and easy-to-use theory for describing investor expected returns in an equilibrium setting. We generalized the CAPM to include all types of preferences in the popularity asset pricing model (PAPM).
The CAPM assumes that investors are not only rational and risk averse but can also diversify away all unsystematic risk. Thus, only systematic (market) risk in securities is priced. Securities with high systematic risk have lower relative prices and, therefore, higher expected returns.
NET is a framework in which investors are rational but have preferences for or aversions to various security characteristics beyond undiversifiable market risk, as in the CAPM—even beyond the multiple dimensions of risk modeled in the arbitrage pricing theory.
In NET, in addition to systematic risk aversion, investors also have a rational aversion to assets that are difficult to diversify, lack liquidity, are highly taxed, and/or are not easily divisible. All these preferences affect the prices and expected returns of assets that embody these characteristics.
The PAPM provides a theory in a CAPM equilibrium framework by including both risk aversion and popularity preferences on the part of investors. These preferences can be rational, as in NET, or irrational, as in behavioral economics.
In the PAPM, the various securities have different systematic and unsystematic risks and differing popularity characteristics. Investors also have differing risk aversions and popularity preferences. The characteristics are priced according to the aggregate demand for each of the characteristics. The expected return of each security is determined by its risk and popularity characteristics.
In our PAPM illustration, one investor, having only risk aversion and no popularity preferences, was purely rational. Although this investor earned excess economic returns, he or she was only part of the equilibrium demand, so aggregate popularity was still a part of PAPM pricing. Securities are priced in this equilibrium framework, and no riskless arbitrage opportunities exist.
Empirical Evidence for Popularity
The concept of a negative return to popularity (what we have simply called “popularity”) has been shown to be consistent with the empirical premiums found in the stock market. But this explanation is after the fact. Direct tests involve trying to identify in advance what characteristics are likely to be popular and which ones are likely to be unpopular and then to test the relative performance of portfolios based on them. We did this test at the company level and at the common stock level.
We carried out analyses on five characteristics: (1) brand, (2) competitive advantage, (3) reputation, (4) tail risk, and (5) lottery-like stocks. In the analyses, we considered both equally weighted composites and market cap–weighted composites. Of these 10 different views, all 10 are highly consistent to moderately consistent with popularity whereas only 5 of 10 are consistent with the paradigm that more risk equals more return.
Companies with high brand values are popular. The quartile portfolios containing these companies ended up having significantly lower returns than the quartile portfolios with the lowest brand value over the April 2000–August 2017 period.
Companies with sustainable competitive advantages are said to have wide economic moats, making them more popular than low-moat or no-moat companies. Portfolios of companies with no moats outperformed portfolios of wide-moat companies over the July 2002–August 2017 period.
Quartile portfolios of companies with better reputations tended to underperform quartile portfolios of companies with less glowing reputations over the April 2000–August 2017 period.
Equities that have historically had negative tail-risk events (low or negative coskewness) are unpopular. Quartile portfolios of these stocks significantly outperformed those of stocks with high coskewness over the January 1996–August 2017 period.
Stocks with lottery-like payoffs are popular because they provide the apparent opportunity for outsized gains. Quartile portfolios of these stocks, specifically those with the highest average of their five best days’ returns, had the lowest risk-adjusted returns among the quartile portfolios based on this measure of lottery-like payoffs over the February 1991– December 2016 period.
We also examined the well-known premiums and anomalies for the 1972–2016 period by analyzing 10 applicable sets of factor-based quartile portfolios in Ibbotson and Kim (2017) through the popularity lens. Ibbotson and Kim found that quartile portfolios of low-beta, low-volatility, small-capitalization, value, less liquidity, and high-momentum stocks outperformed their opposites. Of the 10 factors that we analyzed, 7 are consistent with the popularity framework, whereas only 2 out of 10 are consistent with the classical risk–return view. Overall, we found that for most categories in the stock market, an inverse relationship exists between risk and return, counter to classical theory. Either risk is popular in some circumstances or other, nonrisk characteristics dominate returns. We believe that popularity reflects the demand that ultimately determines prices and returns.
Popularity is a framework that can be used to model asset values and expected returns. Most existing financial literature, whether classical or behavioral, is consistent with popularity. Our new research is also consistent with popularity. Thus, popularity is a bridge between classical and behavioral finance.
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