Tuesday's column outlined a fresh hypothesis for how stock markets are priced. Popularity: A Bridge Between Classical and Behavioral Finance by Roger Ibbotson and Morningstar's Thomas Idzorek, Paul Kaplan, and James Xiong upends the usual perspective. In the authors' framework, as in classical finance, securities receive higher expected returns for shouldering more risk, all else being equal. However, risk is only one dimension of popularity (or unpopularity since risk is unpopular). In general, securities with desirable characteristics receive lower expected returns, and those with undesirable characteristics receive higher expected returns. The Popularity scheme counts down, not up.
(It may seem strange to treat popular stocks as being less profitable than others. Wouldn't their reputation boost their prices? To answer the rhetorical question, yes it would. However, stock market models assume that the effect has already occurred, which leaves the owners of costly dividend-paying stocks--the story is different for firms that retain all their earnings--in the same boat as the owners of costly bonds: facing lower expected returns because of their lower ongoing yields.)
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John Rekenthaler has a position in the following securities mentioned above: MORN. Find out about Morningstar’s editorial policies.