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