As they say, what happens at the Society of Actuaries annual meeting, stays there. It was a pretty good conference, one with literally a dozen streams, so it's pretty easy to find some talk that's interesting at any time (it's actually continuing until Thursday). My talk (see pdf of presentation here), was pretty well received. That is, I had a lot of people telling me it's interesting, thoughtful questions, etc. This is in contrast to academics, who either tell me I'm stupid or crazy, though usually just ignoring me. I have not met an active finance professor who thinks my 'no risk premium due to relative status' is interesting, let alone true.
As mentioned, some professors have even been quite defensive, which is understandable. It doesn't bother me because it's fun to have the facts on your side. They'll come around, as they did on the low return to high volatility stocks and distressed stocks.
5 comments:
Why do HY indexes overstate returns? I find this to be absolutely true. There are great HY managers out there, yet they consistently underperform the index. I realize transactions costs are higher in the space so it makes a little sense, but it is chronic and hefty.
Eric your delivery was great. You plowed through examples from an enormous number of asset classes while keeping it lively, humorous, and entertaining.
Eric, great to meet you yesterday. Did they give you an official SOA pocket protector? Alas, but being an actuary is too exciting -- I had to give it up because of a heart condition. ;)
Perhaps decoupling the "no risk premium" story, which is fact-based, from the "due to relative status" story, which is faith-based as far as I can tell, would make it easier to sell.
Bundling mysticism with science is bound to be confusing. The risk premium story is good enough to stand on its own, and you could let the world try and find an explanation.
What we see is influenced by our theories, which is why most financial academics do not see a vast failure of the risk premium that I do: most admit only exceptions to the rule, puzzles, not the general failure I do. I think its impossible to see the data accurately without a theory, and a theory where people are generally risk-averse, but parochiall risk-loving, is simply untenable: we should see a general risk premium that we don't.
To recap, my proposition is as follows:
1) Standard economic theory implies a risk premium should be present in asset returns, all based on the standard utility function. Risk started as volatility, moved to covariance with the market, now is covariance with something that proxies our aggregate sense of well-being (Stochastic Discount Ftor).
2) Empirically, asset returns are not positively correlated with metrics of volatility, covariance with the market, and uncertainty. This is true over 26 asset classes.
3) In many cases, really high volatility portions of asset classes have lower-than-average returns
4) A theory consistent with this data would be having a relative utility function. This would generate a generally absent risk premium. Also, given a preference for 'high volatility' due to signaling/overconfidence/riskloving/etc, a negative volatility-return correlation would be implied (see page 94 of my SSRN paper, especially equation 3.64).
5) My theory is consistent with other data, such as the Easterlin Paradox, that everyone benchmarks, the Home Bias, and the general absence of a risk premium in other areas:
- in distressed debt, seniors easily beat subordinated;
- in reinsurance, a rebalanced portfolio beats a peak-peril portfolio;
- in convertibles, high-moneyness bonds beat more speculative low-moneyness bonds; and
- in merger arb, more defensive stock-financed acquisitions give better risk-adjusted returns than cash-financed ones.
It truly seems to be a matter of "wherever we look at..."
Post a Comment