Avoiding Unpriced Risk Using a Probability-Based Approach to Security Selection

36 Pages Posted: 25 Jun 2013 Last revised: 11 Sep 2013

See all articles by Dan W. French

Dan W. French

Lamar University; University of Missouri at Columbia

David Javakhadze

Florida Atlantic University

Date Written: August 29, 2013

Abstract

We examine an approach to portfolio construction that that uses probability-based security analysis and find considerable evidence that the approach produces abnormal returns. High-minus-low value weighted portfolio returns are 0.50% per month and are monotonically increasing across probability quintiles. We argue that much of the information impounded in to prices is based on assumption and is unverifiable and that this, in turn, exposes prices to investor biases. Investors are therefore assuming risk of which they are unaware and for which they are not compensated. The approach we examine is able to identify this unpriced risk and thus produce abnormal returns with lower total risk.

Keywords: Required growth probability, stock selection, Fama French factors

JEL Classification: G10, G11, G14

Suggested Citation

French, Dan W. and Javakhadze, David, Avoiding Unpriced Risk Using a Probability-Based Approach to Security Selection (August 29, 2013). Available at SSRN: https://ssrn.com/abstract=2284586 or http://dx.doi.org/10.2139/ssrn.2284586

Dan W. French

Lamar University ( email )

PO Box 10745
Beaumont, TX 77710
United States
409-880-8603 (Phone)

University of Missouri at Columbia ( email )

Columbia, MO Columbia 65211
United States

David Javakhadze (Contact Author)

Florida Atlantic University ( email )

College of Busines
777 Glades Road
Boca Raton, FL 33433
United States
561-297-2914 (Phone)

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