Collective Brain

Popularity: An Elegant New Paradigm for Understanding Risk and Return

Collective Brain

The recently published 40th anniversary issue of the Journal of Portfolio Management features an article titled "Dimensions of Popularity" by Roger Ibbotson and Thomas Idzorek. Ibbotson is perhaps best known for his iconic Stocks, Bonds, Bills, and Inflation which he originally co-produced with Rex Sinquefield in 1977. Ibbotson and Sinquefield, a co-founder and retired director of Dimensional Fund Advisors, wrote the two journal articles and four books upon which Stocks, Bonds, Bills, and Inflation is based and formulated much of the philosophy and methodology. Dimensional Fund Advisors also has provided the small stock returns, as it has since 1982. It is also quite common in the investment advisory industry to see an "Ibbotson chart" posted somewhere in the office (here is IFA's version). Idzorek is president of Morningstar Investment Management in Chicago.

Ibbotson and Idzorek propose popularity as a unifying concept of all the commonly identified market premiums and anomalies such as:

  • Size—Smaller capitalization stocks outperform larger capitalization stocks
  • Relative Price—Value stocks outperform growth stocks
  • Liquidity—Less liquid stocks outperform highly liquid stocks
  • Momentum—Stocks trending up will continue to trend up

Popularity can explain many of these observations that may or may not be understood in a simple reward/risk framework. Size, for example, is readily explainable as a risk factor, and from a popularity perspective, if investors vote with their dollars, then small cap companies have garnered fewer votes. Relative price is less explainable as a risk factor, but the authors note that value companies commonly have something wrong with them, rendering them unpopular. It is also clear that less liquid stocks which trade infrequently must be less popular than heavily-traded stocks. The authors do not attempt to explain momentum in the popularity framework but note that the momentum premium has been erratic over recent periods and it lacks a widely accepted explanation for how and why it seems to have worked. The quantitative measure that the authors chose as a proxy for popularity is share turnover, which scales the number of traded shares to the total shares outstanding.

If investors in unpopular stocks demand a higher return as compensation for holding those companies instead of the ones that make for good cocktail party conversation, then we should see it in the long-term data. As the chart below indicates, they have indeed gotten that higher return and perhaps surprisingly, they got it with lower volatility.

Normally, we expect higher risk (or volatility) to be associated with higher return, and certainly riskier stocks should be less popular than more stable stocks. One way we could understand this unusual result is that highly popular stocks are the most widely followed and highly reported in the news. For example, When Apple misses its quarterly earnings estimate by a penny, everybody knows about it and its stock gets taken to the woodshed. The market may be more forgiving of a micro-cap stock that is only known to a much smaller group of investors. An additional important point brought up by the authors is that while the positive relationship between risk (or volatility) and return is observed between asset classes such as U.S. Large Cap vs. U.S. Small Cap or U.S. Equities vs. Emerging Markets Equities, the relationship does not appear to hold within an asset class. For example, within U.S. equities, lower volatility stocks have shown higher risk-adjusted returns than higher volatility stocks. We addressed that specific issue in this article.

The authors make an interesting claim that popularity offers an explanation of historical returns data that is consistent with both equilibrium market efficiency and behavioral economics. They contend that the joint awarding of the 2013 Nobel Prize in Economic Sciences to Eugene Fama and Robert Shiller constituted an endorsement of both approaches. They find support for a unifying theory in Graham and Dodd's Security Analysis which states, "...the market is not a weighing machine, in which the value of each is registered by an exact and impersonal mechanism, in accordance with its specific qualities. Rather we should say that the market is a voting machine, whereon countless individuals register choices which are partly the product of reason and partly the product of emotion."

While we at IFA don't think that popularity should be a basis for portfolio construction, we do find this result to be interesting and helpful to our understanding of returns data, especially with regard to value (i.e. unpopular) companies vs. growth companies. 

Follow-Up

In the Wall Street Journal of 11/29/2014 (page B7), Liam Pleven cites Morningstar data showing that the year-to-date return of the 20 most popular stocks (as measured by % share turnover) as of 11/25/2014 was -8.48% vs. 13.91% for the S&P 500 Index.