Value Risk and the Value Premium

[ESRBob]

The 11/04 Index Investor also discusses the existence/persistence of the value premium. *They come down on the side that the premium exists, but it is not a 'free lunch', but rather may only reflect the increased risk being taken on by investors in value stocks. *I confess I hadn't really thought of it this way, but am willing to be swayed by more evidence. *In any case, Intelligent Asset Allocators don't shy away from risks if the risks are 'new risks', less- or non- correlated with other asset classes. *So the 'value stock risk' with its attendant reward may be a useful thing to add into the portfolio to reduce the volatility of the overall portfolio.

Anybody have more sources/references who seem to be knowlegeably discussing this? *Fama French, I guess, seemed to imply the value premium was 'free' with no more or different risk than that of the rest of the stock universe. *Is the 'value stock risk' in fact a new type of uncorrelated risk, different from overall stock mkt? *Is it fairly rewarded?

ESRBob

[ats5g]

Hey Bob,

Actually F&F are the ones who have said that the small and value premiums are due to the higher risks of small stocks and value stocks. Here are some links:

From DFA's website: Explaining Stock Returns

Links for the 3 factor model and value.

A pro "free lunch" paper: Value and Growth Investing: A Review and Update

Questioning obtaining the value premium: Can Investors Capture the Value Premium?
Bogle has also questioned this, and shown that investors haven't really captured much of the value premium, especially after fees and taxes.

What if volatility is not the only measure or risk? If value is indeed riskier, then adding it to your portfolio may reduce the volatility of the portfolio, but still increase the risk of the portfolio.

Now, if you take into account something like a person's job, for example. A person that works in a growth industry, like technology. For him/her, value stocks may actually be less risky b/c value stocks are not correlated w/ him/her losing his/her job.

- Alec

So the 'value stock risk' with its attendant reward may be a useful thing to add into the portfolio to reduce the volatility of the overall portfolio.

Bob,

I certainly don't understand this in any exact formula type of way, but only from a - Forces you to " buy Low type of way." Stocks that no one else wants.

This was a rather Large topic in Berstein's 4 Pillars book. I have a value tilt on my portfolio that Vanguard's Portfolio Analyiser thinks is too much. 25% Large Cap Value and 20% Small Cap Value of my Stock portion of my portfolio.

As far as risk goes, I'm certain that a few companies may appear to have value before they File for Bankruptcy Protection before they go belly up. But, I think if you invest in enough companies via an index fund, you're bound to come up with a few winners to offset the losers.

[ESRBob]

What if volatility is not the only measure or risk? If value is indeed riskier, then adding it to your portfolio may reduce the volatility of the portfolio, but still increase the risk of the portfolio.

- Alec

Alec,
Thx for the papers and I will read them.

I'm scraping against the bottom of my barrel on formal knowledge on this Finance theory, but I thought volatility was basically synonomous with risk, or put another way, if the expected return on two assets was the same, the one with higher volatility would mean it was riskier.

If the expected return were lower, then you would expect that to be matched with lower risk than some other asset class.

Because if an asset class offered same or higher expected returns and lower volatility (risk of achieving that return) wouldn't we all pile in there until price got bid up?

Also, if I am able to add a 'risky asset' to my portfolio and in so doing reduce the overall volatility of the portfolio (while keeping expected returns even), isn't that the holy grail of Modern Portfolio Theory?

Now I'm getting myself confused again. I'll read your paper links and see if that helps.

Thx,
ESRBob

[Hyperborea]

I'm scraping against the bottom of my barrel on formal knowledge on this Finance theory, but I thought volatility was basically synonomous with risk, or put another way, if the expected return on two *assets was the same, the one with higher volatility would mean it was riskier.

Volatility can only measure what historical results have been. *What about an asset that has a 5% chance of completely disappearing and your money invested in it too? *Perhaps we haven't been "lucky" enough to witness that 5% chance in the data sequence that we have experienced but it still has that 5% chance. *Is it risky? *Yes. *Does it's volatility show it to be so? *Maybe not.

For a real world example of this just look at the whole Long Term Capital Management fiasco.

Also, if I am able to add a 'risky asset' to my portfolio and in so doing reduce the overall volatility of the portfolio (while keeping expected returns even), isn't that the holy grail of Modern Portfolio Theory?

Bob,

Bernstein also addresses this topic as well. Adding some International stocks will increase the return of the portfolio (risk), and also decrease the volatility.

[charlie]

If I remember correctly, Swedroe points out that
some of the "value premium" may actually be
due to the fact that growth stocks tend to be
assigned a higher than warranted P/E and suffer
more when expectations are not met. Value
stocks on the other hand have low expectations
and rebound faster when they do better than
expected. Individually, some value stocks
deserve low P/E multiples and go bankrupt or
merge with stronger companies. As a group,
however, I agree with cut-throat that over the
long term term investors in a value index fund will
be rewarded.

Swedroe goes into a lot of detail on this topic in
his book "The Successful Investor Today".

Cheers,

Charlie

[ats5g]

Hey Bob,

I'm probably going to butcher this, so here are two papers [fairly easy to read] by John Cochrane [finance guru from the University of Chicago] that should help explain finance theory and how it relates to investing/portfolios:

New Facts in Finance

Portfolio Advice for a Multi Factor World

The Capital Asset Pricing Model says assets can only earn a high rates of return if they have a high Beta. "Beta measures the tendency of an asset to move up or down with the market. Beta measures how adding a bit of an asset to a diversified portfolio increases the volatility of the portfolio." [first paper by Cochrane]. Hence, those assets that don't move up or down with the market much [or are uncorrelated], or move opposite the market, will have low expected rates or return or do not have to demand high expected rates of return. This is why insurance usually has a negative rates of return.

Also remember that the CAPM gets its measure of risk from Markowitz and MPT. I believe that Sharpe and Markowitz helped each other out on one or both. So, portfolio volatility is the only measure of risk in the CAPM.

Fama and French [and others I'm sure] said "Whoops, there are assets whose returns cannot be explained by their beta." E.g., value stocks and very small stocks [CRSP 9-10].

What if there are other risk factors that investors care about besides portfolio volatility? For example, if value stocks do a lot worse than growth stocks in massive depressions, and investors could lose their jobs during this time, then value stocks will pay higher rates of return. Covariation of assets with recessions.

If there are other risk factors that influence people's portfolio make-ups, then the two dimensional mean-variance graph of Markowitz becomes a three or four dimensional graph [see the second paper], with expected return, portfolio volatility, and one, two, or more other risk factors on other axes.

Because if an asset class offered same or higher expected returns and lower volatility (risk of achieving that return) wouldn't we all pile in there until price got bid up?

Not necessarily. If that asset had some characteristic - say very bad returns when we were losing our job, investors may not be willing to buy that assets until it's expected return was higher [than say the market] enough [and it's price lower enough] to compensate for this risk. Investors may have been scared to death of the bad returns of value, and perhaps particularly small value, in the beginning of the century and the great depression. What if the value premium, perhaps like the equity premium, is some historical anomaly?

The value premium is still quite hotly debated in finance today.

Think about this: Consider two scenarios:

1. Value premium is compensating some risk, which perhaps hasn't fully showed itself yet.

2. Value premiums is due to people's behavioral finance issues, and it is a free lunch.

If you subscribe to #2, what if your wrong?!

So many questions.

- Alec