Part III: The New Investment Technology

Many academics agree that to beat the market, one needs to assume greater risk - as opposed to trying to predict the market.

Defining Risk: The Dispersion of Returns

$$ \mathbb{E}[R] = \frac{1}{3}(.10) + \frac{1}{3}(.30) + \frac{1}{3}(-0.10) = 0.10 $$ $$ Var(R) = \frac{1}{3}(0.30–0.10)^2 + \frac{1}{3}(0.10–0.10)^2 + \frac{1}{3}(–0.10–0.10)^2 = 0.0267 $$

The mystical perfect risk measure is still beyond our grasp. That said, here are some common ones:

Beta and Systematic Risk

Systematic risk of a security arises from the variability of the general stock market. Diversification does not reduce this risk.

Unsystematic risk is the remaining variability that is due to a company’s particular factors, e.g. a strike. Diversification reduces this risk. There is no reason for extra compensation.

Beta is a measure of the systematic risk. The broad market index is assigned a beta of 1. If a stock has a \( \beta = 2 \), then on average, it swings twice as far as the market.

Behavioralists believe that:

• Investors are not rational in present and future valuations of securities.
• There are substantial barriers to efficient arbitrage.

The Irrational Behavior of Individual Investors

Overconfidence

People tend to be overconfident, e.g. in a survey, 94% of male respondents believed that their athleticism was above average.

Hindsight bias makes the world seem predictable. Investors might think they can beat the market.

The tendency of “growth” stocks to underperform “value” stocks shows how overoptimistic growth forecasts are.

Smart Beta

Using relatively passive-rule based strategies to gain greater than market returns without assuming more risk than investing in a low-cost total stock market index fund.

The Sharpe Ratio: (excess return over the risk-free rate) / (risk of the strategy). The risk-free rate is usually the return from a 3-month treasury bill. Higher Sharpe Ratios are better.

Smart beta argues that pure indexing (weighting by market cap) is not optimal. The portfolio should be tilted in some direction.