Popularity: A Bridge between Classical and Behavioral Finance

163 Pages Posted: 23 Oct 2019

See all articles by Roger G. Ibbotson

Roger G. Ibbotson

Yale School of Management; Zebra Capital Management, LLC

Thomas M. Idzorek

Morningstar Investment Management

Paul D. Kaplan

Morningstar Canada

James X. Xiong

Morningstar Investment Management

Date Written: December 10, 2018

Abstract

Popularity is a word that embraces how much anything is liked, recognized, or desired. Popularity drives demand. In this book, we apply this concept to assets and securities to explain the premiums and so-called anomalies in security markets, especially the stock market.

Most assets and securities have a relatively fixed supply over the short or intermediate term. Popularity represents the demand for a security — or perhaps the set of reasons why a security is demanded to the extent that it is — and thus is an important determinant of prices for a given set of expected cash flows.

A common belief in the finance literature is that premiums in the market are payoffs for the risk of securities — that is, they are “risk” premiums. In classical finance, investors are risk averse, and market frictions are usually assumed away. In the broadest context, risk is unpopular. The largest risk premium is the equity risk premium (i.e., the extra expected return for investing in equities rather than bonds or risk-free assets). Other risk premiums include, for example, the interest rate term premium (because of the greater risk of longer-term bonds) and the default risk premium in bond markets.

There are many premiums in the market that may or may not be related to risk, but all are related to investing in something that is unpopular in some way. We consider premiums to be the result of characteristics that are systematically unpopular — that is, popularity makes the price of a security higher and the expected return lower, all other things being equal. Preferences that influence relative popularity can and do change over time. These premiums include the size premium, the value premium, the liquidity premium, the severe downside premium, low volatility and low beta premiums, ESG premiums and discounts, competitive advantage, brand, and reputation. In general, any type of security with characteristics that tend to be overlooked or unwanted can have a premium.

The title of this book refers to a bridge between classical and behavioral finance. Both approaches to finance rest on investor preferences, which we cast as popularity.

Suggested Citation

Ibbotson, Roger G. and Idzorek, Thomas and Kaplan, Paul D. and Xiong, James X., Popularity: A Bridge between Classical and Behavioral Finance (December 10, 2018). CFA Institute Research Foundation Publications, December 2018, ISBN 978-1-944960-60-5, Available at SSRN: https://ssrn.com/abstract=3474546 or http://dx.doi.org/10.2139/ssrn.3474546

Roger G. Ibbotson (Contact Author)

Yale School of Management ( email )

165 Whitney Avenue
P.O. Box 208200
New Haven, CT 06520-8200
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203-432-6021 (Phone)
203-432-6970 (Fax)

Zebra Capital Management, LLC ( email )

2187 Atlantic Street
Stamford, CT 06902
United States
203 701 5900 (Phone)

Thomas Idzorek

Morningstar Investment Management ( email )

22 W Washington Street
Chicago, IL 60602
United States

Paul D. Kaplan

Morningstar Canada ( email )

1 Toronto Street
Suite 500
Toronto, Ontario M5C 2W4
Canada

James X. Xiong

Morningstar Investment Management ( email )

22 W Washington
Chicago, IL 60602
United States

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