Join        Login             Stock Quote

Ego and the Low Vol Premium

 October 16, 2012 05:21 PM

(By Eric Falkenstein) In my book The Missing Risk Premium, I have a chapter on why if anything there appears a negative risk premium: more risk, higher return. It's obvious in lotteries and gambling, where the most improbable events have the lowest expected returns, but true in less trivial areas such as options and stocks. One of the causes is signaling, that investors tend to want to show others how awesome they are by trading frequently just like a real alpha generator would.

 It's interesting to note that in games there's a profound dichotomy between the optimal tactics for beginners and experts. For example, Simon Ramo notes that among the very best tennis players, to win you need good winning shots; to be a good average player, you need to merely lower your failure rate. In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: beginners should focus on avoiding mistakes, experts on making great moves.

[Related -Amazon.com, Inc. (AMZN) Q4 Earnings Preview: Will Amazon's EPS Top Street?]

Yet if the distinguishing characteristic of an expert investor is whether they are being aggressive, then any aspiring expert is forced to be aggressive because this signals to others that he truly is an expert, and finance is all about getting other people to give you money to manage. Thus it should come as no surprise that if you give people advise to invest is simple index funds or to focus on low volatility stocks because you can do little damage, and save a couple percent a year, far too many will dismiss this advice. The favorites of aspiring financial moguls are volatile, because one isn't going to hit a 'ten-bagger' on Coca-Cola (KO) (vol of 15%), but rather Netflix (NFLX) (vol of 70%).

[Related -9 Stocks That Have Paid Dividends For Over 100 Years]

 An example of how investors think about the perceptions of others was nicely demonstrated by Baumeister, Heatherton and Tice in their 1993 article, When ego threats lead to self-regulation failure: negative consequences of high self esteem. They gave subjects a video game involving flying a plane through obstacles, and after 20 minutes of practice (and secret recording), they were told they would receive $2 if they matched a time set to just below their actual average time, but $4 if they did some bit better than their average time. Subjects didn't realize this criterion for payout was scaled to their individual prior performance, but rather, thought they were from population averages (ie, those dopey other guys).

Half the subjects were randomly assigned to the ego-threat condition. For these subjects, the experimenter added the following remark: "Now, if you are worried that you might choke under pressure or if you don't think you have what it takes to beat the target, then you might want to play it safe and just go for the two dollars. But it's up to you."

 When that little statement added, more then took the gambit and did worse on average.

 Our desire to impress others causes us to take too much risk. On the bright side, this implies some rather simple strategies like low volatility investing, because I don't see it going away.



Post Comment -- Login is required to post message
Alert for new comments:
Your email:
Your Website:

rss feed

Latest Stories

article imageAutomating Ourselves To Unemployment

In this current era of central planning, malincentives abound. We raced to frack as fast we could for the read on...

article imageFed: Waiting For June… Or Godot?

The Federal Reserve left interest rates unchanged yesterday, as widely expected. But the possibility of a read on...

article imageThe Single Best Place To Invest Your Money For Retirement

It was never supposed to be this daunting. At least that's what we were read on...

article imageNegative Blowback From Negative Interest Rates

The Federal Reserve is widely expected to leave interest rates unchanged today. But perhaps standing pat read on...

Popular Articles

Daily Sector Scan
Partner Center

Fundamental data is provided by Zacks Investment Research, and Commentary, news and Press Releases provided by YellowBrix and Quotemedia.
All information provided "as is" for informational purposes only, not intended for trading purposes or advice. iStockAnalyst.com is not an investment adviser and does not provide, endorse or review any information or data contained herein.
The blog articles are opinions by respective blogger. By using this site you are agreeing to terms and conditions posted on respective bloggers' website.
The postings/comments on the site may or may not be from reliable sources. Neither iStockAnalyst nor any of its independent providers is liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. You are solely responsible for the investment decisions made by you and the consequences resulting therefrom. By accessing the iStockAnalyst.com site, you agree not to redistribute the information found therein.
The sector scan is based on 15-30 minutes delayed data. The Pattern scan is based on EOD data.