Must-Read: Robert F. Stambaugh and Yu Yuan: Mispricing Factors
Must-Read: it is, I think, worth stepping back to recognize how very little is left of the original efficient market hypothesis project, and how far the finance community has drifted–nay, galloped–away from it, all the while claiming that it has not done so.
The original EMH claim was this: You–if your von Neumann-Morgenstern psychological rate of time preference and your von Neumann-Morgenstern psychological rate of declining marginal utility of wealth are close to that of the average–cannot expect to beat the market. The best you can do is diversify, hold the market portfolio, and hunker down. You can expect to earn higher average returns, but only by taking on unwarranted systematic risks that place you at a lower expected utility.
But finance today has given up any pretense of a claim that the–widely fluctuating over time–risk-free rate at any horizon has anything to do with von-Neumann Morgenstern patience-or-impatience psychology. It is very possible for the average person to beat the market in a utility sense by trading on the difference between the average rate of time preference and that priced in by the market. Finance today has given up any preference that the–widely fluctuating over time–expected systematic risk premium has anything to do with von Neumann-Morgenstern declining marginal utility of wealth. It is very, very possible for the average person to beat the market in a utility sense and quite probably in a money sense by trading in systematic risk on the difference between their risk tolerance and the (usually abnormally low) risk tolerance priced in by the market. And now, in addition to the–mispriced from a von Neumann-Morgenstern psychological perspective–wrong risk-free rates and wrong systematic risk premium are joined by two additional “misplacing” factors that the market has not managed to arbitrage away.
So what is left? All that is left of the EMH project is the American question: If this deal is good for you, why is it good for me? All that is left is the insight that if you there is neither a difference-in-patience, a difference-in-risk-tolerance, a diversification, mor an alignment-of-incentives-for-agents reason for a trade to be win-win, at least one of the parties in it is making a mistake. That is a powerful insight–but a very limited one. And it is not what the EMH is–or, rather, it is not what the EMH was back before it was redefined to “save the hypothesis”:
: Mispricing Factors: “A four-factor model with two ‘mispricing’ factors…
…in addition to market and size factors, accommodates a large set of anomalies better than notable four- and five-factor alternative models. Moreover, our size factor reveals a small-firm premium nearly twice usual estimates. The mispricing factors aggregate information across 11 prominent anomalies by averaging rankings within two clusters exhibiting the greatest co-movement in long-short returns. Investor sentiment predicts the mispricing factors, especially their short legs, consistent with a mispricing interpretation and the asymmetry in ease of buying versus shorting. Replacing book-to-market with a single composite mispricing factor produces a better-performing three-factor model.