Be careful before acting on what is considered to be conventional wisdom. Make sure it’s supported by empirical evidence. In this case, the evidence makes clear that “cut your losses and let your profits run” should not be conventional wisdom.
Making a bet on biotech/pharma firms that have not yet achieved significant revenue is the equivalent of buying a lottery ticket—with the same poor risk/return relationship.
While analysts underwrite high growth for companies that have grown quickly and slow growth for companies that have grown slowly in the past, a large body of evidence demonstrates that reversion to the mean of both positive and negative abnormal earnings growth is the norm.
Advisors and investors should be aware that fund families that invest systematically have found ways to incorporate the research findings on the limits to arbitrage and the evolving changes we have discussed to improve returns over those of a pure index replication strategy. It seems likely this will become increasingly important, as the markets have become less liquid, increasing the limits to arbitrage and allowing for more overpricing.
While the evidence makes clear that active management is a loser’s game (one that it is possible to win but so unlikely you should not try), we don’t want active managers to disappear. Hope should continue to triumph over evidence, wisdom, and experience because active managers help eliminate market anomalies and inefficiencies created by the misbehavior of investors (such as noise traders). That helps to ensure that capital is allocated efficiently.
For investors that use trend-following strategies, Avramov, Kaplanski, and Subrhmanyam provided new evidence supporting momentum strategies and showed that the distance between short- and longer-term momentum signals provides additional explanatory power in the cross-section of equity returns.
Antonello Cirulli and Patrick Walker, authors of the December 2023 study “Outperforming Equal Weighting,” examined whether equally weighted portfolios could be enhanced by avoiding negative exposure to some of the most prominent factor anomalies documented in asset pricing literature.
The risk-based explanation provided by a peer-based review is a necessary ingredient for considering investment, but it is not a sufficient ingredient.
Crowded equity positions in anomalies remain and have significant impacts in terms of risk and return dynamics.
The empirical research findings demonstrate that the return premium generated by being long low-distress risk stocks and short high-distress risk stocks is persistent and that the capital asset pricing model (CAPM) and the Fama-French three-factor models cannot explain it. Hence, we have the distress puzzle, or anomaly.
The timing of equity factor premiums has a strong allure for investors because academic research has found that factor premiums are both time-varying and dependent on the economic cycle.
Ignoring the impact of taxes on the returns of taxable accounts is one of the biggest mistakes that can be made.
Covered calls implemented to deliver higher derivative income should be expected to have (1) lower total returns, (2) higher tax realizations along the path, and (3) a more negatively skewed return profile. Investors who allocate to these strategies for their income alone, without accounting for these other considerations, might have made a devil’s bargain
When a small subset of companies makes up a large portion of a portfolio, for better or worse their returns will have a greater impact on overall portfolio results.
The claims of superior risk-adjusted performance by the PE industry are exaggerated. Given their lack of liquidity, opaqueness, and greater use of leverage, it seems logical that investors should demand something like a 3-4% IRR premium. Yet, there is no evidence that the industry overall has been able to deliver that.
The timelier adoption of new technology and the higher likelihood of large-scale technology adoption make the risk associated with technological innovation more systematic, which in turn increases returns required by investors for technology spillover recipients.
Idiosyncratic volatility (IVOL) is the volatility of a security that cannot be explained by overall market volatility—it is the risk unique to a particular security. IVOL contrasts with systematic risk, which is the risk that affects all securities in a market (such as changes in interest rates or inflation) and, therefore cannot be diversified away. On the other hand, the risks of high IVOL stocks can at least be reduced through diversification.
Over the very long term, while value stocks have been less profitable and have had slower growth in earnings than growth stocks, they have provided higher returns.
While ESG investors can express their values through their investments, they should expect lower returns from their portfolios—though they also will be taking less investment risk.
The higher returns to high R&D stocks represent compensation for heightened systematic risk not captured in standard asset pricing models.
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