(PUB) Investing 2015

The efficient-market hypothesis, or

EMH

, is largely

correct. The notion that the collective wisdom of all

market participants is very difficult to outsmart

cannot be questioned, as evidenced by

years’

worth of index fund performance.

However, stock-pricing models that accompany the

EMH

are problematic. The trouble is that people tend

to confuse the models with reality. They talk of

“anomalies” that the model cannot explain as if these

are investor mistakes. (One example of an anomaly:

In William Sharpe’s capital asset pricing model, or

CAPM

, where stock returns are attached to the

single indicator of beta, lower-beta stocks tend to

perform better than the model, and higher-beta

stocks perform worse.)

Such a claim is inconsistent with the spirit of the

EMH

, which states that investors are collectively

rational, not collectively error-prone. Why believe

that the people are wrong and the model is right?

The truth almost surely is the opposite.

A new, richer model of stock-pricing is needed—one

that can incorporate the many aspects that influence

investor decisions, not just a single factor (as

with

CAPM

) or four factors (as with the Fama-French-

Carhart model). Last year, Zebra Capital’s Roger

Ibbotson and Morningstar’s Tom Idzorek laid out such

a path in “Dimensions of Popularity,” published

in the

Journal of Portfolio Management

. The article

suggested that the anomalies mind-set be reversed.

Rather than mine data to find anomalies, and then

searching for reasons to explain those results,

researchers should be thinking about aspects

of popularity.

(This concept, as with most, follows in the footsteps

of other works; the ideas are not brand-new but

rather reworked and clarified from previous versions.

Indeed, Roger Ibbotson, Jeffrey Diermeier, and

Laurence Siegel articulated some of these ideas three

decades ago.)

A popular stock is a stock that has desirable character-

istics. On the whole, investors find such stocks easy

to own. As a result, they are willing to accept a lower

rate of return on those securities than they are with

unpopular stocks, which for various reasons may be

unpleasant holdings. The search for higher return

thus becomes the search for the unpopular—along

with a willingness to accept their warts.

The popularity concept, unlike that of the current

framework of expected model returns plus anomalies,

does not assume that the market functions in

mysterious ways. Nor does it necessarily posit investor

irrationality (although it can permit such a thing,

by offering a behavioral-finance explanation for a

source of unpopularity). By greatly expanding

the potential reasons that investors use when valuing

stocks, popularity provides a better framework

for thinking about ways to achieve higher returns.

Four Findings

Here are some examples from an unpublished draft

paper that Ibbotson, Idzorek, and Morningstar’s

James Xiong are now writing. Some are familiar,

others less so. At this stage, the list is highly prelimi-

nary; many other sources of popularity remain to be

cataloged. But it should give a flavor of the endeavor—

and perhaps even an idea or two for how you might

wish to tilt your portfolio:

Value

The historic outperformance of value stocks breaks

traditional pricing models. As the authors point

out in their new paper, “deep value is less risky than

deep growth,” as measured by volatility, yet deep-

value stocks have handily beaten deep-growth com-

panies over time. But a behavioral preference for

the apparent safety of growth companies, which tend

to be healthier businesses with stronger corporate

brands, can explain what the

CAPM

cannot.

How to Beat an Efficient Market

Morningstar Research

John Rekenthaler