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"The Boredom Discount": Why Greater Risk Does Not Lead To Greater Return

Tyler Durden's picture




 

In his latest piece, Dylan Grice comes very close to explaining some of the more irrational, manic, aspects of modern capital markets. Appropriately coming after the recent mania with the $640 million Mega Millions Jackpot (which as we described is nothing but the government taking advantage of personal gullibility and effectively acting as a tax on the poor), the SocGen strategists effectively succeeded in debunking some of the flawed assumptions embedded in the efficient risk frontier, and points out that just because something has greater risk, does not mean it will generate a higher return. Quite the contrary. After analyzing returns of low (boring) and high beta (big upside opportunity, big risk) stocks, he finds that "higher quality stocks carry the sort of lower risk which is supposed to attract a low return, we’ve consistently found them to be higher return. Quality stocks, in other words, seems to possess that attribute most desirable to the long-term investor: systematic undervaluation."

Reread the last quote as it has huge implications for all those who, self-professed, scramble after high beta momentum stock, and allegedly make gobs of money. Chances are most of them are lying. But how does one explain this fundamental discrepancy between textbook finance and reality? Simple - think lottery, and the fact that humans are inherently flawed, greedy animals, always seeking shortcuts to wealth, fame and power. In Grice's words, "Antti Iimanen's idea that 'high risk' securities attract a "lottery ticket" premium is closer to being right than wrong. We also think that the same psychological tendency that overvalues lottery tickets undervalues quality stocks, as their robust business models and solid balance sheets do tend to be quite boring. [Hence the boredom discount]. So our best guess at the moment is that the mispricing of quality is indeed systematic. It reflects something permanent (our psychological hardwiring) rather than something transient (the fads of macroeconomic theory)."

In other words, just like 3 people shared the winning prize from the Mega Millions jackpot and tens of millions ended up empty handed, so chasing after high beta will, over time, lead to ruin. And in this case, one can't blame the Fed or any other central planners. It also explains the exponential blow off mania phases so evident in every bubble... up until the realization that the latest fad is nothing but another get rich quick scheme with nothing backing it, and driven more by herd mentality than rational thought. To paraphrase Cassius: ""The fault, dear Brutus, is not in our stars, But in ourselves."

The one SocGen chart that proves Grice's point with clinical precision:

The implications of this finding also undermine the entire efficient markets hypothesis: in essence, the corollary is that "high risk" in the market is systematically overvalued by all those who assume that just because it is high risk, it will generate greater returns, when empirical evidence shows time and time again that it won't. The same as playing the lottery at 176 million to one odds. And yet people keep doing it. Until the risky stock blows up in your face. After all: it is risky for a reason! There are those who naturally benefit from this bias, such as all those who are willing to take advantage of the "lottery" mania to issue risky securities to a public which is inherently unable to distinguish inherent bias from objective observation, and overvalue risk, while undervaluing safety.

Grice explains further:

A common finding in experiments is that people prefer, say, a guaranteed $90 to a 95% chance of $100. In other words, a near-certain bet correctly valued $95 will tend to be worth significantly less to most people. We undervalue near-certain outcomes. Yet this is exactly the world in  which low beta/high quality stocks live. Cast your eyes down a screen of low beta stocks and you’ll find yourself looking at food retailers, tobacco companies and regulated utilities. Forget the possibility of outsized returns in a few months. Last year was pretty much the same as the one before, and this year will probably be much the same as next … probably

 

The next chart shows the difference between the objective probabilities and the decision weights from the previous chart. It shows the over-valuation of possibilities and the undervaluation of near-certainties. And if high beta/low quality stocks live in the world of possible triple-digit returns, attracting lottery ticket overvaluations, low beta/high quality stocks live in the world of near certainty, attracting the boredom discount.

Of course, for this thinking to be correct we, like the guys at GMO, are making the assumption that the lower quality elements of the stock market are effectively more speculative. They are vehicles for trading with, not investing in. If that’s close to the mark, therefore, we’d expect to see more activity in the high beta/lower quality names. The following chart shows exactly such a tendency, with estimated holding period for low beta (fifth quintile) portfolios to be almost three times higher than for high beta (top quintile) ones.

The most common question we get when we recommend quality is whether or not its past outperformance has been simply because it started out cheap, or because there’s something more going on. The possibility effect creates excitement. The near-certainty effect is a slightly anxious boredom. And we’re hardwired to overvalue excitement and undervalue boredom. So I think it’s the latter – because there is something more going on.

 

So we still have a bias towards quality in the stock market, and we think you should too.

And while we all know that Grice is 100% right, and in the long run risk does not pay off, that animalistic, irrational part of the brain will keep on telling you to buy AAPL call options at $500, $600, $1,000, $10,000 etc, because "it may make you rich." Sure: so can the Mega Millions. Realistically, will it? Absolutely not.

 

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Wed, 04/04/2012 - 14:32 | 2317202 mayhem_korner
mayhem_korner's picture

 

 

tortoise > hare

Wed, 04/04/2012 - 14:32 | 2317205 GeneMarchbanks
Wed, 04/04/2012 - 14:32 | 2317212 SDRII
SDRII's picture

only thing that matters this year is the SPX-Gold return spread

Wed, 04/04/2012 - 14:33 | 2317214 ekm
ekm's picture

I love that kind of boredom.

Wed, 04/04/2012 - 14:39 | 2317224 Zola
Zola's picture

Grice should be happy about it because thats the only reason why SG stock price is still > 0 .

Wed, 04/04/2012 - 14:42 | 2317238 techstrategy
techstrategy's picture

The systematic undervaluation now is amplified by stockholders writing calls and realizing transaction gains instead of price appreciation.  The opposite is true for many high beta names.  I will explore and publish much more on this later, but it all relates to the concentration of institutional control of float and effective collusion of many players.  More importantly, it highlights that the markets have become purely a vehicle for trading (gambling) and not investing.

 

Wed, 04/04/2012 - 17:39 | 2317688 Umh
Umh's picture

In a seven handed poker game 1-3 win big, 2-4 lose big and the rest more or less break even. It's almost always the same big winners and big losers. That's not gambling; that's peoples nature.

Wed, 04/04/2012 - 14:43 | 2317241 disabledvet
disabledvet's picture

"what do you recommend we do Mr Rockefeller now that the Federal Government has broken up your company?"
"Buy."
That was 1912 or something. "'twas good advice" as they say. Even now as "the monopolies reconstitute themselves." Remember sheeple "the Riders are always trying to get back to their Master" (the Ring.)

Wed, 04/04/2012 - 14:51 | 2317265 Aunty Christ
Aunty Christ's picture

Notorious B.I.G.G.S' double down call earlier this week seems to be the top...

Wed, 04/04/2012 - 15:10 | 2317309 azzhatter
azzhatter's picture

In other news Bob Pissonme was just on CNBC with some bulltard spew

Wed, 04/04/2012 - 15:22 | 2317338 arkel
arkel's picture

Great article. Thanks for posting ZH.

Wed, 04/04/2012 - 15:24 | 2317350 Haddock
Haddock's picture

Or rather, egomaniac coke head gamblers often overvalue excitement and undervalue bordom...

Wed, 04/04/2012 - 15:36 | 2317378 one_fell_swoop
Wed, 04/04/2012 - 15:41 | 2317395 slewie the pi-rat
slewie the pi-rat's picture

very few people, especially in the current accounting and "reporting" climate are able to determine if a stock is "higher quality" or not

insiders working w/ the accountants may have the best view of the "quality" involved with the line items on the financial statements, themselves an "accepted fiction"

at the risk of repeating myself:  with PM coins, prices and values will go up and down too;  sometimes even "like crazy"

with PM coinage:  there is a never any discussion except over "genuine?";  and if so, what legalTenderPrice/value, if any, is gonna get a-GREED upon, here, to make a (probably reportable)  trade involving two principals, no one esle, and no counterparties to the PM coinage and very likely anything else, either

beyond that, no one can separate fools from their follies;  just ask cassius, BiCheZ!

Wed, 04/04/2012 - 16:27 | 2317499 juggalo1
juggalo1's picture

You missed the meaning of the term "high-quality".  The author meant it to mean "low beta"

Wed, 04/04/2012 - 21:17 | 2318139 slewie the pi-rat
slewie the pi-rat's picture

oh, bullshit

my comment did not mention beta

i purposely did not use the word

so, you may be hallucinating...

Wed, 04/04/2012 - 15:56 | 2317422 riphowardkatz
riphowardkatz's picture

This "the fact that humans are inherently flawed, greedy animals, always seeking shortcuts to wealth, fame and power."

Not true. People would never have children, they wouldn't donate billions and billions to charity, they wouldn't make reductions in their quality of life while waiting for the CHANCE  for  longer term values to come to furitition. 

The mega millions analysis is so flawed. It was entertainment for 99% of people. It was nothing more. Reading more into it is just wrong.

Yes, some people have a short term and irrational mentality that does not mean it is human nature to be that way. The nature of humans is to live for 80 plus years. The nature of humans requires reason to live those years with the chance of earning happiness. The nature of humans is to work towards happiness.

Nearterism (as Einhorn calls it) or range of the moment thinking is an irrational mentality and value system that has always existed in SOME people. Its cause is the lack of a proper philosophy. Humans unlike the other animals you equate them with are not born with values. They must learn and choose their values. The world suffers today from people not choosing rational values that proceed from a rational philosophy. There is nothing inherent about it. Or is it F' free will it's all your genes?

Your whole essay reads like a crappy ode to animal spirits and Keynes.

Sad, sad, sad. Didn't realize you were a misanthrope. You can join the elite company of other misantrhopes like Hillary Clinton, Keynes, Krugman and Bernanke. 

 

Wed, 04/04/2012 - 16:26 | 2317495 juggalo1
juggalo1's picture

The nature of humans is not to live to 80 years old.  It is to live to be 35 years old.  These eighty-year olds are a phenomenon of modern culture.

Wed, 04/04/2012 - 18:12 | 2317771 riphowardkatz
riphowardkatz's picture

Without war 80 or close to it would be very realistic. The reason the age has increased over the last 100 years is due not as much to medical advancments but the reduction of war. 

It is very much natural for humans to live to 80 lots have throughout history and in all parts of the world.

 

Wed, 04/04/2012 - 22:35 | 2318319 Umh
Umh's picture

Mostly due to a reduction in early childhood death. Measles, mumps, flu....

Wed, 04/04/2012 - 22:42 | 2318314 Umh
Umh's picture

There were always a fair number of older folks. The average age of death being 35 was because so many people died very young. George Washington, Thomas Jefferson, Benjamin Franklin were old, but not exceptional for their era.

Mon, 04/09/2012 - 16:35 | 2329265 stoverny
stoverny's picture

"The mega millions analysis is so flawed. It was entertainment for 99% of people. It was nothing more. Reading more into it is just wrong."

 

They showed lines 6-hours long on the news of people waiting to piss their money away.

Looks can be deceiving but MOST of these people did not appear to be flush with disposable income.

Now ask yourself: how many of these people who drove across state lines and stood in a desert for 6 hours, only bought a dollar or 2's worth of tickets when they finally reached the counter?

This is not entertainment like a movie ticket.  That may hold true for the wealthy person who buys 5 bucks worth.  Not for the bread-and-butter lottery consumer, though.  For them it's a retirement plan.

Wed, 04/04/2012 - 16:24 | 2317490 juggalo1
juggalo1's picture

The mega-millions is not a tax on the poor.  It's a tax on the stupid, like the basketball player who bought 10k in tickets instead of blowing it at the strip club.

Thu, 04/05/2012 - 02:41 | 2318689 Common_Cents22
Common_Cents22's picture

10,000 AAPL shares a day keeps the redemption bears away!

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