Paul Kaplan: I'm Paul Kaplan, Director of Research at Morningstar Canada. Financial economics, like other fields, can be rife with controversy. Perhaps one of the greatest controversies has been that between classical and behavioural finance. Economists on both sides have made significant contributions to our understanding of how investors behave and how financial markets work. Leading thinkers from both schools have received the Nobel Prize in economics.
So, if both schools have something to contribute, is it possible to reconcile their theories and find a middle ground? I believe that the answer is yes. In fact, I co-authored a CFA Institute Research Foundation monograph with Yale's Roger Ibbotson and two of my colleagues at Morningstar, Thomas Idzorek and James Xiong that was published in 2018 called "Popularity: A Bridge between Classical and Behavioral Finance". Our approach, which we call 'Popularity', provides a bridge between the opposing camps.
Although I've been aware of behavioural finance for most of my career, especially as an explanation for the size and value effects and various other anomalies, I didn't give much thought to how its insights might affect my own work until I saw two articles by Roger Ibbotson and Thomas Idzorek titled "Dimensions of Popularity" and "Popularity and Asset Pricing".
Dimensions of Popularity starts: "we believe that most of the best-known market premiums and anomalies can be explained by an intuitive and naturally occurring social or behavioural phenomena observed in countless settings, popularity."
The idea of popularity is simple. Investors are willing to pay more for securities with popular characteristics and less for securities with unpopular characteristics. This causes popular stocks to have lower expected returns and unpopular stocks to have higher expected returns. Thus, investors who are willing to hold unpopular stocks well over the long run earn higher returns than other investors.
Since stocks of smaller companies are less popular than stocks of larger companies, there is a size premium. Similarly, stocks trading at low price to earnings ratios are less popular than stocks trading at high price to earnings ratios, often because they are out of favour, less well known, or operate in less glamorous industries. Hence, there is a value premium.
The beauty of the idea of popularity is that it applies to all security characteristics where the concern for them is rational or irrational. Thus, popularity encompasses both rational and behavioural explanations of market phenomena. This is how popularity serves as a bridge between the rational and behavioural schools of finance. My coauthors and I hope that our work on popularity will help tear down walls and build bridges between classical and behavioural camps.
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