Research challenges long-held assumptions about the relationship between risk and return; proposes new paradigm for understanding investment performance.
The Journal of Portfolio Management has selected "Dimensions of Popularity" by Roger Ibbotson and Thomas Idzorek for its prestigious 40th anniversary issue. Ibbotson, Ph.D., is founder of Ibbotson Associates, chairman and chief investment officer of Zebra Capital Management, and professor of finance at the Yale School of Management and Idzorek, CFA, is head of the Morningstar Investment Management group, a unit of Morningstar, Inc. Morningstar acquired Ibbotson Associates in 2006.
“Investors have long viewed the world through the risk-reward paradigm. They recognized that with greater risk comes greater return. This holds true when examining asset class performance—stocks are riskier than bonds and, on average over time, produce higher returns; small capitalization stocks are more volatile than large capitalization stocks, but outperform in the long run,” Idzorek said. “At the individual security level, however, this truism of investing—that with more risk comes more return—isn’t supported by historical data. The risk-reward paradigm also doesn’t explain many of the other premiums and anomalies we see in the market.”
In “Dimensions of Popularity,” Ibbotson and Idzorek identify the most common market premiums and anomalies, such as:
- Small cap—Smaller capitalization stocks outperform larger capitalization stocks
- Valuation—Value companies beat growth companies
- Liquidity—Less liquid stocks best those with more liquidity
- Momentum—Stocks trending up will continue to trend up
Because the risk-return framework does not explain all these premiums and anomalies seen in the market, the researchers propose the unifying “theory of popularity.” They explain that the most common market premiums and anomalies are associated with a stock’s popularity or unpopularity. For example, if investors “vote with their dollars,” small cap companies have gotten fewer votes. Value companies commonly have something wrong with them, which makes them unpopular.
If an asset has characteristics that investors really dislike, such as low liquidity, little name recognition, or high volatility, its price will be lower and therefore its expected future returns will be higher, all other things being equal. According to the theory of popularity, if an investor were to rank stocks by popularity, he or she could buy a basket of unpopular stocks and systematically rebalance as the stocks become more popular by buying a new portfolio of relatively less popular stocks. As some of the stocks in the portfolio become more popular over time, they become more valuable and the investor will see appreciation.
Ibbotson and Idzorek test this theory by sorting the universe of stocks by popularity, as defined by share turnover, and dividing them into quartiles each year from 1972 through 2013. They find that stocks in the lowest quartile of share turnover—the least popular stocks—outperformed the highest quartile by more than 7 percentage points per year over the period studied.
“Risk has become a catch-all for all of the attributes that investors do not like, but riskiness does not explain all the anomalies we see in the market. Value premiums are a perfect example. Stocks with low market-to-book ratios or low price-earnings ratios are not necessarily more volatile or less liquid, but we know that over time value stocks beat growth stocks. We need a new model for explaining investment performance that goes beyond risk and return. Popularity may be a better lens through which to view investment behavior,” Ibbotson said. “Many of the well-known market premiums are associated with unpopular stocks. Unpopular stocks tend to be smaller, less liquid, and perceived as lacking growth potential. These stocks, with their low relative prices, may offer investors better future performance as they move along the spectrum toward popularity.”