Knowledge that Transforms

We are delighted to announce that the winner of the 2011 Spängler IQAM Best Paper Prize is: “Operating Leverage” by Robert Novy-Marx, The two runners-up for the award are: “Inside Debt” by Alex Edmans and Qi Liu and “Fear of the Unknown: Familiarity and Economic Decisions” by Henry Cao, Bing Han, David Hirshleifer, and Harold Zhang, The awards were presented at the 2011 annual meeting of the European Finance Association in Stockholm on August 19. We are grateful to Spängler IQAM Invest for sponsoring this award.

We develop an analytical solution to the dynamic portfolio choice problem of an investor with power utility defined over wealth at a finite horizon, who faces a time-varying investment opportunity set, parameterized using a flexible vector autoregression. We apply this framework to study the horizon effects in the allocations of equity-only investors, who hold a mix of value and growth indices, and a more general investor, who also has access to Treasury bills and bonds. We find that the mean allocation of equity-only investors is heavily tilted towards value stocks at short-horizons, but the magnitude of this tilt declines dramatically with the investment horizon, implying that growth is less risky than value at long horizons. Investors with access to bills and bonds exhibit similar behavior, when value and growth tilts are computed relative to the total equity allocation of the portfolio. However, after accounting for the propensity of these investors to increase their total equity allocation as the horizon increases, the mean value tilt of the optimal allocation is shown to be positive and stable across time.

I derive and test implications of the operating leverage hypothesis for the cross-section of expected returns. Using a novel measure of operating leverage, I document that operating leverage predicts returns in the cross-section, and that strategies formed by sorting on operating leverage earn significant excess returns. Operating leverage also explains why the value premium is weak and non-monotonic across industries, but strong and monotonic within industries. Intra-industry differences in book-to-market are driven by differences in operating leverage, giving rise to expected return differences. Industry differences in book-to-market are driven by differences in the capital intensity of production unrelated to returns.

Owners of private companies often invest a substantial share of their net worth in one company, which exposes them to idiosyncratic risk. We investigate whether owners of US companies require compensation for lack of diversification in the form of higher returns on equity. Exposure to idiosyncratic risk is measured as the share of the owner’s net worth invested in the company. Equity returns are measured as the earnings rate and as capital gains. For both returns measures we find a positive and significant influence of exposure to idiosyncratic risk. This paper improves our understanding of returns on private equity.

Can investors with irrational beliefs be neglected as long as they are rational on average? Do their trades cancel out with no consequences on prices, as implicitly assumed by traditional models? We consider a model with irrational investors, who are rational on average. We obtain waves of pessimism and optimism that lead to countercyclical market prices of risk and procyclical risk-free rates. The variance of the state price density is greatly increased. The long run risk-return relation is modified; in particular, the long run market price of risk might be higher than both the instantaneous and the rational ones.

This paper considers a stock market with ambiguity-averse informed investors under the CARA-normal setting, and studies the relationship between limited market participation and the equity premium which is decomposed into the risk premium and the ambiguity premium. In a rational expectations equilibrium, limited market participation arises if the largest deviation of investors’ ambiguity increases sufficiently or if the variance of the stock return decreases sufficiently. In each case, a change in the risk premium and a change in the ambiguity premium may have opposite signs. This paper identifies conditions under which a change with the plus sign dominates and thus the equity premium increases when fewer investors participate in the stock market.

Evidence indicates that people fear change and the unknown. We model this behavior as familiarity bias in which individuals focus on adverse scenarios in evaluating defections from the status quo. The model explains portfolio underdiversification, home and local biases. More importantly, equilibrium stock prices reflect an unfamiliarity premium. In an international setting, our model predicts that while the standard CAPM fails to hold with respect to the world market portfolio, a modified CAPM holds wherein the market portfolio is replaced with a portfolio of the stock holdings of investors not subject to familiarity bias.

We develop a simple theoretical argument that generates testable predictions about how disagreement affects corporate investment and find strong empirical support for these predictions. Investment is negatively related to a proxy for disagreement, after controlling for Tobin’s q, and after dealing with the fact that Tobin’s q and our disagreement proxy contain measurement error. This proxy is unrelated to traditional indicators of asymmetric information. We also find that variation in disagreement is an important component of the portion of the variation in Tobin’s q that matters for investment, and that disagreement affects investment and Tobin’s q more if the firm has greater financial flexibility.

Brokerage houses usually organize their research activities by country or economic sector. We evaluate which research structure provides most value to investors. To do so, we study the relative information content of recommendations issued by country-specialized analysts and sector-specialized analysts. Our findings show that the former issue more valuable recommendations. The strength of country-specific commonalities and institutional factors explain at least part of the better performance of country-specialized financial analysts. Although analysts’ geographic location has been shown in the literature to be a significant determinant of earnings forecast accuracy, its relevance is more subtle when it comes to stock recommendations.

If an individual with expected utility and a reasonable level of wealth rejects a small actuarially favorable gamble, it implies a very high degree of risk aversion. It also predicts (counterfactually) the rejection of more sizable and very attractive bets. If additional background uncertainty affects wealth, this result also applies to non-expected utilities. The authors describe a set of reasonable conditions under which an individual may reject the small bet but accept the large bet, even in the presence of background uncertainty. The two critical assumptions that the authors use are rank-dependent utility and a discrete distribution for background risk. Plausible calibrations can reconcile large/small bet risk attitudes and the empirical evidence on limited stock market participation in the presence of labor income risk.