Popularity: A Bridge between Classical and Behavioral Finance
163 Pages Posted: 23 Oct 2019
Date Written: December 10, 2018
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.
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