Does profit depend on risk or ability?
Let's think about a question first. When investing, does the more profitable the investment, the greater the risk?
Suppose you are competing with another person in terms of investment performance, and your income is not as good as his. What should you do if you want to surpass his income as soon as possible?
The method is very simple, if you increase the risk, you can obtain possible high returns.
So how to increase the risk? It is enough to allocate assets in high-risk industries or concentrate investment. Assuming that the person you PK with has bought stocks, bonds, and bank deposits in his asset portfolio, and the risks are very dispersed, then you can just buy all stocks.
This is the basic principle of traditional finance - risk-benefit correspondence.
Traditional finance believes that there is no free lunch in the financial market, and all profits must come from risks. Therefore, if you want to increase your income, you can only increase your risk. But behavioral finance breaks this law by building strategies.
If the method of increasing the risk is used to increase the income, is it the investor's ability? Of course not. This is what the capital market should have given us. We have taken more risks, and of course we should get more returns.
So what is the situation, the improvement of investment performance is the ability of investors? The answer is that the risks have not increased, but the returns have.
Therefore, the essence of behavioral financial strategy is that we can find some ways to make us more profitable without increasing the risk.
Free Lunch - Visions
This phenomenon is equivalent to a "free lunch", and there is a special term in the academic field to describe it, which is called "vision". It refers to the abnormal phenomenon that violates the principle of risk-benefit correspondence in traditional finance.
In fact, behavioral finance trading strategies are looking for such anomalous opportunities.
Finding anomalous factors that can obtain excess returns is a top secret of various behavioral finance funds. They rely on these vision factors to make money, so if you ask, no one will really tell you what the vision factors they are using now.
It doesn't matter, let's take a look at how to find the vision and how to use it.
In fact, it is very easy to obtain anomalies, which often come from simple investment experience. It can be said that ordinary investors, as long as they have some investment experience, can discover anomalies based on intuition.
For example, some people may think that stocks with high dividend payouts have better returns. Then, high dividend payouts are a "feature" and may become anomalous factors. For another example, some people think that the stocks of listed companies are better in areas with less smog. Then, less smog is also a "feature" and may become an anomalous factor. Also, some people think that stocks in certain industries are better, so the industry is also a "feature" and may become an abnormal factor.
For example, LSV, an internationally renowned behavioral finance fund, used the momentum factor of short-term stock price inertia and the value factor of low stock valuation as strategies, and achieved very good returns.
So, where is the difficulty? The hard part is how to verify it's "true". Are these "features" really a profitable anomaly factor, or is it just our wishful thinking that this is the case, which needs to be tested.
In our previous article, we mentioned a cognitive bias called magical thinking, which means that people think that two things have a causal relationship, but in fact they have no relationship at all. These "characteristics" mentioned above are likely to be the case. I bought stocks with such characteristics many times and made money. It is thought that this feature can generate excess benefits. But chances are, it just took a risk, or just happened a few times.
Therefore, whether the "features" we have found can really be used to formulate a stable strategy must be tested by a certain method. The goal of the test is to see if the risks contained in the strategy are eliminated, and at the same time, a stable return can be guaranteed.
How to test for anomalous factors?
How should it be tested? Organizations generally use the following four steps to test:
The first step is to sort all the stocks on the market.
How to arrange it? Arrange according to the "features" observed by the institution that can obtain excess returns. For example, if an institution believes that "small company stocks have better returns", they can sort all stocks on the market according to the characteristic of "market value".
The second step is to divide the sorted stocks into ten equal parts.
Of course, it can also be divided into 20, 50, or even 100 equal parts according to the amount of funds.
The third step is to construct a hedging portfolio.
Buying is considered to be undervalued, that is, the group with good future returns, and shorting is considered to be overvalued, that is, the group with poor future returns. Taking the size of the company as an example, since you think that the stocks of small companies have better returns, you should buy 1/10 of the stocks of the smallest companies and short sell 1/10 of the stocks of the largest companies.
The fourth step is to check the portfolio risk.
Looking at the hedging portfolio constructed by sorting this "characteristic", whether the difference in returns between the buying end and the selling end is due to risk. Testing portfolio risk requires the use of factor models, which will not be expanded here, and will be introduced in later updated articles. In short, if it is not because of the benefits generated by risks, then the "feature" found by these institutions is a "true vision". You can use it to continuously invest and make profits.
No matter what kind of behavior combination strategy, the above steps are the most basic construction methods. Essentially all behavioral financial institutions test their observations in this way.
Let's think about the principle of the above steps.
If you use the "characteristic" of size to sort, why do you need to short large companies while buying small companies? This is to control systemic risk. Just imagine, if you only buy the stocks of small companies, what if the prices of the stocks of small companies all fall? This is systemic risk. Remember the arbitrage we mentioned in the previous article.
In fact, we are not betting that the stocks of small companies will definitely rise. The original intention should be that the stocks of small companies will rise better than the stocks of large companies. Therefore, we buy small companies and sell short large companies at the same time. When the stock market is rising, small companies are better than big companies, and the strategy can be profitable; when the stock market is sideways, small companies are also better than big companies. , the strategy can still be profitable; when the stock market falls as a whole, small companies are still better than large companies, and the strategy can still be profitable.
Therefore, the advantage of this kind of buying and selling is to avoid systemic risks. No matter whether the whole market is rising or falling, the strategy can be profitable.
Why can many institutions make money regardless of whether the market is good or bad? This is because institutions have adopted the method above, and most individual investors immediately lost all their money when the market fell apart. In fact, they just don't know how to hedge risks in this way.
Having said that, let's think again, why does the behavioral portfolio strategy buy a group of small company stocks instead of just one? As we said earlier, each stock rises and falls differently, and the range is even more different. Buying a stock has unsystematic risk, then we need to spread this unsystematic risk by buying a few more stocks.
Therefore, the combination strategy constructed according to this method avoids systematic risk through one buy and one sale, that is, arbitrage; and avoids unsystematic risk by buying and selling a group instead of one, so that the entire combination has no systematic risk. There is no unsystematic risk and the total risk is very small.
If our intuition is correct, that is, the found "characteristic" can pass the risk test and prove that there is no risk, then the combination strategy is likely to obtain excess returns, then we can use this "differential" for a period of time Elephant to make money.
However, as a reminder, no vision works consistently, and as it becomes known to more and more people, its effectiveness also diminishes.
Therefore, it becomes particularly important to constantly look for new anomalies that can be profitable or to combine the original single profit factors.
The Size Premium: An Anomaly for Small Caps
Many investment "visions" come from our simple experience or feeling.
For example, do you feel that the stocks of small companies have better returns?
In the academic field, there is a special term "scale premium" to describe this phenomenon, and it is also the first "anomaly" discovered in behavioral finance.
In 1981, the financier Benz first discovered the abnormal phenomenon that the returns of stocks of small companies are always higher than those of stocks of large companies, referred to as the "small-cap anomaly".
The term "abnormal" refers to the "normal" of traditional finance. What is "normal"? Traditional finance believes that the best allocation for buying stocks is random, that is, buying a little of all stocks in the market, so that the risk is the most diversified and the return is the best.
The anomaly of small-cap stocks tells us that it is definitely better to only buy stocks of small companies than randomly buy stocks of both large and small companies.
If the small-cap anomaly really existed, then developing a strategy would be very simple.
According to the general steps of the construction strategy we introduced above, sort the stocks from small to large, buy the smallest 1/10 group of companies, and sell the largest 1/10 group, so that the entire portfolio is risk-free, but obtain excess returns.
Traditional financiers saw this result and thought, how is this possible? It must be because your sample is too small, or the calculation is biased. I'll have to do the math myself.
Therefore, the Nobel laureate Professor Fama of the University of Chicago and his collaborator Professor French re-examined the scale effect. They not only lengthened the research sample, from 1963 to 1990, nearly 30 years; the sample coverage Also increased, all stocks in the three US exchanges are included in the analysis.
What was the outcome? Very unexpectedly, not only did they not overthrow this conclusion, but they used such a large amount of data to verify this vision again! In their experiments, the simple strategy of buying small stocks and selling large stocks turned out to yield a monthly return of 0.74%, which translates to an annualized rate of return of over 8%!
In the mature market of the United States, it is not easy to obtain a stable return of about 2%, let alone such a simple method to obtain such a high return.
The risk-free portfolio can achieve such a high return. This result was calculated by the authoritative figure in traditional finance with such a large sample size. Therefore, the scale effect is recognized by everyone as an "anomaly" that is difficult to explain by traditional financial theory. ".
So does this vision only exist in the US market?
Not really. After Benz proposed the scale effect, it attracted widespread attention from scholars all over the world. Scholars have tested the stock markets of different countries and found that there are similar phenomena to varying degrees.
Companies with different sizes will indeed have different stock returns. This is the famous "scale effect", and it is also the earliest return anomaly discovered in the financial market.
The Value Premium: The Value Stock Anomaly
Let's move on to an older and more widely used strategy—the value stock strategy.
Certain investors have heard of Benjamin Graham, known as the "Godfather of Wall Street", and this strategy is related to him if it traces its origin. "Securities Analysis" written by Mr. Graham is a must-read for anyone who wants to be a stock investor, so he is also honored as the father of securities analysis by the world.
One of his most famous views is "holding high the banner of value investing". What does that mean? That is, value investing can get the best return.
So what is value investing? This is a word that we see every day in the major media, and it is also a word that we often talk about. Many people are actually not clear about it, and it is easy to misunderstand it. So what exactly does it mean?
In fact, value investing is buying value stocks, and value stocks are clearly defined and measurable.
Simply put, value stocks mean cheap stocks. Please think about which of the following is a cheap stock?
· In the first case, which one is cheaper, the 100 yuan stock or the 50 yuan stock?
· In the second case, which is cheaper, a stock with a price-earnings ratio of 20 times or a stock with a price-earnings ratio of 10 times? We have also introduced the price-earnings ratio in previous articles, which refers to the ratio of the market price to the company's fundamental earnings per share.
The answer is that in the former case, there is no comparison; in the latter case, stocks with a price-earnings ratio of 10 times are cheaper.
Did you get it right?
Cheap is a relative concept, which is relative to the fundamentals of the stock. Therefore, it is impossible to compare which is cheaper between a 100-yuan stock and a 50-yuan stock. The price-earnings ratio is the ratio of market price to earnings per share, so a stock with a price-earnings ratio of 10 times is cheaper than a stock with a price-earnings ratio of 20 times.
Following Graham, quite a few studies have revealed that buying value stocks or cheap stocks will increase more than buying growth stocks, which means higher returns. So what are growth stocks? It is the opposite of value stocks, expensive, or stocks with high price-to-earnings ratios.
This time, traditional finance quit. Because if value stocks are more profitable, then developing a strategy will be very simple.
As a result, in 1992, Fama and French retested the value stock vision with a larger sample, and history repeated itself again. They found that this strategy can actually achieve excess returns. Buy 1/10 value stock portfolio and sell 1/10 growth stock portfolio at the same time, you can get a monthly income of 1.53%, which translates to an annual rate of return of more than 10%!
How to explain the size premium and value premium?
The two tests by traditional financial scientists have proved that the anomaly does exist, which completely violates the basic principle of traditional finance: risk-benefit correspondence theory. How can this be explained?
Traditional finance and behavioral finance give very different reasons.
Traditional financiers believe that size and value may represent some kind of unknowable systemic risk. What exactly is the systemic risk, they did not clearly give.
But they took advantage of this test result. Fama and French incorporated the two anomalous factors of scale premium and value premium into the asset pricing model, emphasizing that these are two unknown risk factors, together with the CAPM model, which is the market factor representing macroeconomic risks, Proposed the famous three-factor pricing model. The three-factor model is also one of the most cited studies in the field of finance so far.
What about behavioral finance? They believe that this is due to the wrong behavior of investors. So use these two visions to construct a combination strategy for actual investment.
The small-cap premium, in the final analysis, is because investors miscalculate the value of small-cap stocks and don't like this type of stock. In the United States, the investor structure is dominated by institutions, and the liquidity of small-cap stocks is not enough. Only some closed-end foundations are willing to hold small-cap stocks, and large institutions are less likely to hold small-cap stocks with poor liquidity and poor performance. This creates a premium for small-cap stocks.
The value stock premium is also for a similar reason. Value stocks are those stocks with low price-earnings ratio or price-to-book ratio, that is, those stocks with poor growth.
Because investors tend to chase high-growth stocks, they undervalue value stocks. For example, under the same circumstances, a good company is worth 20 yuan, and a bad company is worth 10 yuan. A good company has better performance than a bad company, so the value is higher. Investors will chase after the stocks of good companies, causing the stock price of a good company to rise to 30 yuan, while no one cares about a bad company, and it is likely that the stock price has fallen to 5 yuan.
Therefore, the idea of value investment strategy is to buy value stocks of poor companies, because their prices are undervalued. In the future, when the price converges to value, value stocks will be able to achieve high returns.
So, is it the same for the Chinese investment market?
The basic principle behind the success of behavioral finance strategies is to operate in reverse—buy what no one else likes, and sell short what everyone else likes.
The Chinese market is not the same as the US market. Because China’s investment market is dominated by retail investors, investors’ preferences for large and small cap stocks are different from those in the United States. Guo Shuqing, then chairman of the China Securities Regulatory Commission, once said that Chinese investors like to speculate in new, small, and bad stocks. Among them, Small-cap speculation refers to speculation in small-cap stocks. Therefore, the small-cap stock strategy may not work well in China, but the value strategy is suitable because the environment is the same.
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