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New Pricing Phenomenon in Equity Markets Discovered

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Turan Bali, Robert S. Parker Chair and Professor of Finance at Georgetown University’s McDonough School of Business, has discovered a new pricing phenomenon in equity markets. Based on the preferences and trading behaviors of individual investors, Bali recommends a new investment strategy that buys stocks with high tail covariance risk and short sells stocks with low high tail covariance risk, which produces a 9 percent average return for investors, which is a significant increase compared with traditional strategies that average between 3 and 6 percent return rates.

“Our results from newly proposed measure of downside risk show that hybrid tail risk matters beyond the standard risk measurements of market beta and standard deviation,” Bali said. “No one has showed this before. Most investors expect higher return from stocks that have higher tail risk.”

In the paper “Hybrid Tail Risk and Expected Stock Returns: When Does the Tail Wag the Dog?,” Bali and his co-authors (Nusret Cakici, Fordham; and Robert Whitelaw, NYU) generate a new risk measurement that is relevant to individual investors holding a portfolio of small number of stocks and an index fund with large undiversifiable tail risk that can create big losses.

Their research, forthcoming in The Review of Asset Pricing Studies, evaluates risk and return preferences of individual investors who hold an average of only three to five stocks. These private investors don’t have time to monitor stocks or the technical ability to manage the return and risk characteristics of those stocks. Because of this, individuals tend to invest in stocks that receive a lot of media coverage and analyst attention, as well as those in a specific business sector that personally interests the private investor.

This means that in addition to having a small number of stocks, those few stocks are not diversified across a variety of industries. Without a diversified portfolio, investors are particularly susceptible to systematic market risk. If the market moves in either direction, or some macro fundamentals move, such as low economic growth, high unemployment rates, high inflation rates, or high interest rates, it creates a big loss in their portfolio. There is not much anyone can do about systematic risk, but diversification can greatly minimize firm specific risk.

Bali’s research shows that the under-diversified nature of portfolios of individual investors matters for the pricing of tail risk. Investors care about big negative price moves more than they do in standard models. Large falls in the market and large falls in individual stock returns are important to measure hybrid tail risk. Their key innovation is that systematic risk of stocks is measured across the left tail states of the individual stock return distribution and not across those of the market return as in standard systematic risk measures.

Better understanding these characteristics allows professional fund managers to develop better product designs and assists them in advising and educating their clients. It can be particularly difficult to measure tail risk for private investors because they are not holding fully diversified portfolios.

The individual investor should try to increase the number of stocks in their portfolio, ideally 30 stocks or more to fully diversify and minimize firm specific risk. Additionally, they should choose stocks that are in a variety of industries, and stay away from very small and very illiquid, or difficult to sell, stocks, according to Bali.

Institutional investors holding a large number of stocks in their portfolios can use this research to identify the tail covariance risk measure. Professional fund managers should short sell stocks that have a low tail covariance risk and use the proceeds to buy stocks with high tail covariance risk.