A Lesson From The Powerball

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The record Powerball jackpot captured the nation's attention last week while markets gyrated.

Preferences for lottery-like payoffs may also skew investor preferences in the stock market.

This article theorizes how investor behavior may create opportunities for patient investors who avoid the higher beta, high upside investments.

Two news stories dominated the headlines last week - the vacillating U.S. stock market, which saw four consecutive back-and-forth triple digit moves for the Dow (NYSEARCA:DIA), including two declines of nearly 400 points - and the record Powerball jackpot.

While these two things might not seem related, they most certainly are important to understanding investor behavior. The discussion of the Powerball was everywhere - water cooler banter, the nightly news, social media, long queues at your local convenience store. People tried to rationalize the moon-shot gamble as having positive expected value given the size of the potential payout (a claim that still seems dubious given the realization of multiple winners and large cut taking by the government's who administer the lottery). Across the country, people ponied up a couple bucks for a ticket (or sometimes much more) just to dream for a moment what they would do with that life-changing windfall.

This preference for lotteries, society's hunt for asymmetric payoffs, is the link back to the broader capital markets. In any introductory finance class, students are taught that higher risk investments should be compensated with higher expected average returns. This makes intuitive sense, who would enter into a high risk investment with a higher probability of downside if the same return could be made with much lower risk of loss?

This theory is canonized by the Capital Asset Pricing Model, a mathematical model used to determine an expected return of an asset added to a well-diversified portfolio, given that asset's beta, or non-diversifiable risk. If that sounds like a lot of financial mumbo jumbo, it can be boiled down to the rather simple idea that in this framework high (low) beta assets should be characterized by higher (lower) expected returns.

Of course, if you look back over long-time intervals, higher beta stocks have not realized higher average returns than lower beta stocks. I harbor a belief that this long-run underperformance can be linked to the behavioral biases of the "Powerball craze", but first let's look at the data. Below is a graph of the benchmark S&P 500 Index (NYSEARCA:SPY) versus indices replicating its one-hundred lowest volatility (NYSEARCA:SPLV) and highest volatility constituents (NYSEARCA:SPHB). Over the quarter-century dataset, the lower volatility components have meaningfully outperformed (with lower variability of returns) and the higher volatility components have meaningfully lagged as depicted below.

This relationship continued in 2015...

... and has carried into the early part of 2016 as high beta stocks have weakened during the market selloff.

What does this have to do with the Powerball? In the aforementioned Capital Asset Pricing Model (CAPM), one of the underpinning assumptions is that investors are rational and risk averse. Over the last two generations, a new field of study, behavioral economics, has sought to demonstrate how individuals' cognitive biases impact decision making. The studies of these cognitive biases have their roots in the seminal work of Nobel Prize-winning psychologist Daniel Kahneman and frequent collaborator Amos Tversky. The bias described herein - preference for skewness - is both well documented in finance literature and likely contributes to the demonstrable investor preference for high volatility stocks that has in turn created the Low Volatility Anomaly, or why lower risk stocks have outperformed across markets and long time intervals.

Investors with a strong preference for skewness will not hold the market portfolio because their upside potential from idiosyncratic bets has been diversified away. Every time someone pulls a slot machine handle, buys a Powerball ticket, and often when they buy high beta stocks, people are demonstrating a preference for high-upside bets. People don't want to be a little better off, they want life-changing gains. The long-run underperformance of high-beta stocks is perhaps driven by an irrational bid from investors seeking lottery-like payoffs that have driven those securities to levels consistent with lower realized forward returns. This behavior could contribute to the boom-bust nature of the returns of riskier stocks.

If higher beta stocks are characterized by lower expected returns, then lower beta stocks have to be characterized by higher expected returns. If investors' preferences for high upside payoffs make those securities relatively expensive, I will gladly buy the lower risk stocks these investors shun for relatively inexpensive prices and earn higher risk-adjusted returns over time. I didn't buy a Powerball ticket last week, but I did buy some low volatility index funds during the market weakness.

This article will not generate even a whisper of conversation compared to the din of the Powerball clamor, and that is likely welcome news to the patient practitioners of strategies that profit from taking the other side of trades from irrational lottery-seeking market participants.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long SPLV, SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.