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Build Bridges, Not Walls

How popularity connects classical and behavioral finance.

Financial economics, like other fields, can be rife with controversy. Perhaps one of the greatest controversies has been that between classical and behavioral finance. Clearly, economists on both sides have made significant contributions to our understanding of how investors behave and how financial markets work, as is evident in that leading thinkers from both schools have received the Nobel Memorial Prize in Economic Sciences.

So, if both schools have something to contribute, is it possible to reconcile their theories and find a middle ground? I believe that the answer is yes. In fact, I am working with an academic (Yale’s Roger Ibbotson) and two of my colleagues at Morningstar (Thomas Idzorek and James Xiong) on a monograph to be published by the CFA Institute Research Foundation called “Popularity: A Bridge Between Classical and Behavioral Finance.” As the title says, we think that our approach, which we call popularity, provides a bridge between the opposing camps.[1] Below, I outline what we cover in the monograph. But before I do, I first explain my own journey from neoclassical economics to developing the theoretical basis for popularity, which incorporates elements of both classical and behavioral finance.

Learning Economics My first exposure to economics came in high school. In New York City, economics was a required class, and I was fortunate to have an inspiring teacher. We covered topics including the stock market, and some basic microeconomics, such as supply-and-demand curves. In college, when I took a more advanced course in microeconomics, I learned how to graphically derive demand curves from the assumption that consumers maximize their utility and supply curves from the assumption that firms maximize profits.

In graduate school, I learned the neoclassical mathematical models of consumer and producer behavior and general equilibrium. In these models, economic agents are completely rational and operate in purely competitive markets. Taking prices as given, neoclassical economics assumes that economic agents not only know their objective functions and constraints but can solve their optimization problems as if each person were a computer. This is the assumption of rationality that behavioral economists find so objectionable.

Learning Classical Finance Eventually, my interests shifted from general economics to finance. My economics training laid the foundation for understanding the capital asset pricing model, the intertemporal capital asset pricing model, and arbitrage pricing theory. I wrote my dissertation on asset-pricing theory and estimating asset-pricing models.

In these classical asset-pricing models, agents are rational and have rational expectations. Furthermore, active portfolio management is futile if the efficient-market hypothesis—proposed by Eugene Fama (1970), who would go on to win a Nobel prize—holds. According to the EMH, all information relevant to security prices is already reflected in those prices, so there is no point in trading based on any given piece of information.

As elegant, or perhaps simplistic, as the CAPM and the EMH are, empirical regularities cast doubt on them. According to the CAPM, the expected return of each security should depend on its systematic risk with respect to the market as a whole—its beta. But a large body of research shows that several other factors, such as market capitalization, valuation ratios, and return volatility, are related to expected return.

My Introduction to Behavioral Finance After graduate school, I went to work for a Chicago-based consulting firm called Ibbotson Associates.[2] We began creating risk-tolerance questionnaires to guide investors into asset-allocation portfolios that were right for their levels of risk capacity and risk preference—collectively risk tolerance—and soon realized that the complexities of investor behavior made this harder than it sounded. So, we obtained the help of behavioral economist and future Nobel laureate Daniel Kahneman, who helped us design the questions to take investor behavior into account. Kahneman and my then colleague Mark Riepe published an excellent article on "beliefs, preferences, and biases investment advisors should know about." (Kahneman and Riepe, 1998).

In time, I learned that behavioral finance provides explanations for many of the various market anomalies that had been discovered empirically. However, the classical camp did not cede to the behavioral camp, but rather interpreted the anomalies as “risk premiums” that represent fair compensation for taking risk that is not captured by the CAPM. (My coauthors on the monograph and I don’t find that plausible because some of the premiums are associated with less risk, not more.) This illustrates the wall between the two camps.

Introduction to the Popularity Bridge While aware of it, especially as an explanation for the various anomalies, I didn't give much thought to how the insights of behavioral finance might affect my own work until I read "Dimensions of Popularity" by Ibbotson and Idzorek (2014) and "Popularity and Asset Pricing" by Idzorek and Ibbotson (2017). "Dimensions of Popularity" starts:

“We believe that most of the best-known market premiums and anomalies can be explained by an intuitive and naturally occurring (social or behavioral) phenomenon observed in countless settings: popularity.”

The idea of popularity is simple. Investors are willing to pay more for securities with popular characteristics and less for securities with unpopular characteristics. This causes popular stocks to have lower returns and unpopular stocks higher returns. Thus, investors who are willing to hold unpopular stocks will, over the long run, earn higher returns than other investors. Because stocks of smaller companies are less popular than stocks of larger companies, there is a size premium. Similarly, stocks trading at low price/earnings ratios are less popular than stocks trading at high price/earnings ratios, often because they are out of favor, less well-known, or operate in less glamorous industries. Hence, there is a value premium.

The beauty of the idea of popularity is that it applies to all security characteristics, whether concern for them is rational or irrational. Thus, popularity encompasses both rational and behavioral explanations of market phenomena, and serves as a bridge between the rational and behavioral schools of finance.

From Popularity to the Popularity Asset Pricing Model In "Popularity and Asset Pricing," Idzorek and Ibbotson seek to express the insights of popularity in an equation for the expected return of a security as a linear function of its risk and nonrisk characteristics. What they lacked was a formal theory as to why this would be true. This is where I came in. Making use of my training in microeconomics, I extended the utility function of the CAPM to include preferences for security characteristics other than risk and expected return. I interpret this extension to be the dimensions of popularity discussed by Ibbotson and Idzorek (2014). I dubbed the resulting model the popularity asset pricing model (PAPM).

The PAPM has striking differences from the CAPM:

  1. The expected excess return of each security is a linear function of not only its beta, but also of what I call popularity loadings, which measure the popularity of the security based on its characteristics relative to those of the beta-adjusted market portfolio. The popularity loadings are multiplied by marketwide popularity premiums, which are aggregations of the preferences of the investors regarding the nonrisk characteristics. In this way, the market aggregates investor preferences in determining the influence of security characteristics on the expected returns and prices of the securities.
  2. In the CAPM, the market portfolio is optimal for the average investor, so indexing is an optimal strategy. In the PAPM, the market portfolio may not be optimal for any investor, so the case for indexing is diminished.
  3. In the CAPM, each investor holds the market portfolio in combination with the risk-free asset (long or short), based on the investor's risk aversion. In the PAPM, each investor forms a customized portfolio of the risky assets that reflects his or her attitudes toward security characteristics, and combines that with the risk-free asset (long or short). Hence, each investor's portfolio of risky assets is not available in any index fund.

The forthcoming monograph will include everything from our previous work (Ibbotson and Idzorek, 2014; Idzorek and Ibbotson, 2017), the PAPM, and new material including empirical work (thanks to James Xiong). We hope that this work will help tear down walls and build bridges between the classical and behavioral camps.

[1] Ibbotson and Idzorek (2014) introduced the concept of popularity. [2] Morningstar acquired Ibbotson Associates in 2006, but I had moved to Morningstar before that in 1999.

References Fama, E.F. 1970. "Efficient Capital Markets: A Review of Theory and Empirical Work." Journal of Finance, Vol. 25, Issue 2 (May), pp. 383–417.

Ibbotson, R.G. & Idzorek, T.M. 2014. “Dimensions of Popularity.” Journal of Portfolio Management, Special 40th Anniversary Issue, pp. 68–74.

Idzorek, T.M. & Ibbotson, R.G. 2017. “Popularity and Asset Pricing.” Journal of Investing, Vol. 26, No. 1 (Spring), pp. 46–56.

Kahneman, D. & Riepe, M.W. 1998. “Aspects of Investor Psychology.” Journal of Portfolio Management, Vol. 24, No. 4 (Summer), pp. 52–65.

This article originally appeared in the April/May 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.

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