Date of Award

11-1-2013

Document Type

Masters Thesis

Degree Name

M.A.

Organizational Unit

College of Arts Humanities and Social Sciences

First Advisor

Tracy Mott, Ph.D.

Second Advisor

Roscoe Hill

Third Advisor

Markus Schneider

Fourth Advisor

Robert Urquhart

Keywords

Behaviorial economics, Beta, Efficient market theory, Risk, Stock market, Stock price volatility

Abstract

Modern portfolio theory states that investments with greater beta, a common measure of risk, require greater returns from investors in order to compensate them for taking greater risk. Therefore, under the premise that market participants act rationally and therefore markets run efficiently, investments with higher beta should generate higher returns vis-à-vis investments with lower beta over the long run. In fact, many studies suggest that investments with lower beta actually generate equal to or higher returns relative to investments with higher beta. In looking at data for the S&P 500 going back 22 years between 1990 and 2012, this study found that there was very low correlation between beta and returns. In fact, portfolios with very low risk generated commensurate to better returns versus portfolios with very high beta. Therefore, we find that beta appears to be a poor measure of risk as it relates to the stock market.

In addition to beta and returns, this study looked at the fundamental characteristics of each company specifically corporate profitability and balance sheet leverage which are commonly used by investors in assessing the underlying quality of a company. We find that companies with higher levels of return on equity combined with lower levels of balance sheet leverage tend to outperform companies with lower levels of profitability and higher balance sheet leverage. As a result, we find a high correlation between balance sheet leverage, ROE and stock returns. This paper suggests that in fact, fundamental factors such as leverage and ROE tend to be better measures of risk vis-à-vis beta. One important final observation is the fact that while in general, companies with high ROEs and low leverage tend to outperform companies with low profitability and high leverage, portfolios of those companies with the highest ROE and lowest leverage and portfolios of those companies with the lowest ROE and highest leverage actually underperform on the whole other portfolios. In other words, portfolios of companies that exhibit the most extreme of characteristics in terms of ROE and leverage underperform portfolios of companies with more moderate characteristics.

One plausible explanation for these observations is rooted in behavioral economic theory known as the favorite long shot bias and the opposite favorite long shot bias. The opposite favorite long shot bias suggests that market participants tend to "over-bet" an asset and/or an investment with high probability of a payoff but low overall return if the payoff occurs (ie the sure bet). In fact, market participants go so far to secure a payoff that they actually place a higher bet on the probability of success than the actual odds would suggest. In stock market terms, investors will tend to over-value the least-riskiest stocks to the point where risk and return is no longer favorable. Similar phenomenon can be observed in horse race betting and sports drafts. The favorite long shot bias is the inverse of the opposite favorite longshot bias. This theory suggests that market participants actually "over bet" an asset and/or an investment with the lowest probability of a payoff but with significant overall returns if the payoff occurs. Similar phenomenon takes place in the purchase of insurance to insure against large potential losses with small probabilities as well as lottery ticket purchases.

We see the most striking evidence of this when looking at the returns of stocks with the highest ROEs and the lowest levels of debt/capital as of 1990. In that year, investors would have based their investments in stocks using current attributes at that time. We can see that stocks with the highest ROEs and lowest levels of debt/capital garner higher valuations relative to the broad stock market. We also see that stocks with the lowest ROEs and highest debt/capital also command premium valuations to the market as a whole. Therefore, risk-averse investors will tend to overvalue companies with the least risky prospects while risk loving investors will tend to overvalue companies with the riskiest prospects at the same time. As a result, we can see from looking at the future returns that companies that exhibit extreme characteristics in terms of ROE and debt/capital tend to underperform the broad market. Similar to high profile athletes and horse track betting, we find that investors tend to over-bet sure shot investments while simultaneously over-betting long shot investments.

Publication Statement

Copyright is held by the author. User is responsible for all copyright compliance.

Rights Holder

Munish Malhotra

Provenance

Received from ProQuest

File Format

application/pdf

Language

en

File Size

92 p.

Discipline

Economic theory, Behavioral sciences, Finance

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