Financial theory tells us that to earn return, one needs to take risk. But how much risk is left to the individual making the decision. At this point, the inability of human beings to properly weigh their chances of success in low probability events makes all the difference.
In pursuit of quick riches, we sometimes turn to lottery-like stocks: companies that trade at outrageous valuations, have exciting stories, and have the potential to be wildly successful.
Possibility effect, tendency to overestimate the chance of occurring of a possible but not probable event, is the reason why investors (especially retail investors) are attracted to these highly volatile stocks, especially with negative news around them. Overoptimism of the human race goes against them for investment decisions in stocks (though it holds true across asset classes) with lottery-like characteristics. Investors irrationally overpay for lottery-like gambles, assuming their odds are higher than in reality.
We all love these stocks because we love innovation, new technologies, and revolutionary companies. We all are excited to that maybe at this very moment we can find the next Netflix … the next Tesla… the next Apple … the next Byjus or a pharma company which could possibly come up with a drug that might fight coronavirus. However, these stocks are like lottery tickets. They pay off BIG … or they eventually go to zero. It’s a gamble. These smaller, younger companies more often belong to sectors like Pharmaceuticals & Biotechnology, Technology Hardware & Equipment, and Software & Services. Penny stocks or financially distressed stocks that are either in or near bankruptcy also exhibit lottery like characteristics. Everyone knows the odds are terrible, but the prospect of great fortune has always been, and will always be, very seductive.
On the other hand, Warren Buffet swears on Low Volatility Investing – giving enough evidence in support of the Betting against Beta anomaly. A discussion on Buffet’s Alpha highlights the Buffett’s returns appear to be neither luck nor magic but, rather, a reward for leveraging cheap, safe, high-quality stocks over a long (very long) period of staying invested. Beta anomaly is regarded as one of the most puzzling phenomena in the history of finance as it negates the fundamental notion that a higher return can only be earned after taking more risk.
Betting against Beta or Low volatility is simply a way of buying stocks which rank low on standard deviation or volatility over a look back period of 6-12 months. Stocks that would rank high on this factor would be stocks where most investors under-react to information being fed to them on a regular basis, owing to the certainty bias. When an outcome is likely, people tend to underestimate its odds. This bias has been named the certainty effect.
As per financial theory, we would expect over a long period, high beta stocks should have done much better than low volatility and low beta stocks. However, when we see the returns of Nifty Low Volatility 50 Index (The least volatile security in the index gets the highest weight) and Nifty High Beta 50 Index (The security with the highest beta in the index is assigned the highest weight), the reverse holds true. Research studies also offer evidence in support of the existence of beta-anomaly (long leveraged low-beta assets and short high-beta assets) in the Indian equity market also.
The study titled “A Lottery-Demand-Based Explanation of the Beta Anomaly,” which appears in the December 2017 issue of the Journal of Financial and Quantitative Analysis explains: “Lottery investors generate demand for stocks with high probabilities of large short-term up moves in the stock price. Such up moves are partially generated by a stock’s sensitivity to the overall market—market beta. A disproportionately high (low) amount of lottery demand-based price pressure is therefore exerted on high-beta (low-beta) stocks, pushing the prices of such stocks up (down) and therefore decreasing (increasing) future returns.”
So, what does this really mean for us investors?
To formulate a strategy in the context, think of a barbell approach of investing. As per the barbell strategy, the optimal way is to strike a balance between reward and risk while investing. That is, to invest in the two extremes of high risk and no risk assets while avoiding middle-of-the-road choices. Some sectors are available at extremely discounted valuations – banking sector, consumer discretionary, energy and industrials, led by government spending and domestic consumption, a combination of both. Profit booking in safety/ comfort sectors like FMCG. One has to have defensive stocks to beat the volatility, but as you move to a full-blown recovery globally and in India, you need to be shifting towards cyclicals and the banking sector. The PSUs have been unloved for a long time and the valuations are compelling.
Happy Strategizing & Happy Investing!
Dr. Tarunika Jain Agarwal Ph.D.