Financial markets are full of pricing anomalies, and their existence is often explained by human behavior. Behavioral finance postulates that cognitive irrationality is manifested in biases like the disposition effect (the tendency of people to sell assets that have increased in value, but keeping assets that have dropped in value in portfolio) or overconfidence bias (the tendency of people to be more confident in their own abilities). There are some papers which directly link investment decision making caused by these biases to actual physiology of investors (for example, a known impact of testosterone on investment performance). A new research paper written by Nofsinger, Patterson, and Shank examines not only testosterone but also cortisol levels of testing subjects and then compares their performance in a mock investment contest. Both hormones are strongly related to higher portfolio turnover and inability to accept losses, with cortisol levels even more significant than testosterone.

Author: Nofsinger, Patterson, Shank

Title: On the Physiology of Investment Biases: The Role of Cortisol and Testosterone

In many academic fields like physics, chemistry or natural sciences in general, laws do not change. While economics and theory of investing try to find rules that would be true and always applicable, it is not that simple, there is a “complication“ – human. Psychology of humans is very complex. In the one hand, it creates anomalies in the market, that academics study and practitioners use. On the other hand, after an anomaly is discovered, often, the strategy becomes less profitable.

While for academics, it is just another research question, investors may be worried that the anomaly is arbitraged away, and it will become unprofitable in their portfolios. In this article, we will look deeper on whether the anomaly can be arbitraged away, if the profits are lower for the specific strategy once the strategy becomes well-known, and even if the strategies can be timed. Quantpedia‘s readers are often interested in these common topics, and we will try to shed some light on them.

Mirror, mirror on the wall, what’s the best factor model of them all? We at Quantpedia are probably not the only one asking this question. A lot of competing factor models are described in the academic literature and used in practice. That’s the reason why we consider a new research paper written by Matthias Hanauer really valuable. He compared several commonly employed factor models across non-U.S. developed and emerging market countries and answered the question from the beginning of this paragraph. Which model seems the winner? The six-factor model proposed in Barillas et al. (2019) that substitutes the classic value factor in the Fama and French (2018) six-factor model for a monthly updated value factor …

Authors: Hanauer

Title: A Comparison of Global Factor Models

Our society teaches us, that it is good to be different. That our trading strategy must be always unique, creative and individualistic. It is boring and unprofitable to be the “average”, to do what the others do. And then, there is a research paper written by Bollen, Hutchinson and O’Brian which offers the opposite view. Their analysis explains there exist one hedge fund style where everything is the other way round – trend-following CTAs funds. Their interesting (but for some maybe controversial) paper shows that CTAs with returns that correlate more strongly with those of peers have higher performance. It appears that CTA strategy conformity is a signal of managerial skill. Now, that is an eccentric idea 🙂

Authors: Bollen, Hutchinson and O’Brian

Title: When It Pays to Follow the Crowd: Strategy Conformity and CTA Performance

The end of the year is a good time for a short recapitulation. Apart from other things we do (which we will summarize in our next blog in a few days), we have published around 50 short blog posts / recherches of academic papers on this blog during the last year. We want to use this opportunity to summarize 10 of them, which were the most popular (based on Google Analytics tool). Maybe you will be able to find something you have not read yet …

Professor Roger Ibbotson is one of the most respected and influential researchers of the current era. His book “Stocks, Bonds, Bills, and Inflation” is a classic and often serves as a reference for information about capital market returns. Therefore we always pay attention to his publications. His actual work, “Popularity – A Bridge between Classical and Behavioral Finance”, which is written with Thomas M. Idzorek, Paul D. Kaplan, and James X. Xiong, is now available on SSRN.

In their work, authors explain the term “Popularity” from an asset pricing point and show how “Popularity” can be a broad umbrella under which nearly all market premiums and anomalies (including the traditional value and small-cap) can fall. They develop a formal asset pricing model that incorporates the central idea of “Popularity”, which they call the “popularity asset pricing model” (PAPM). Based on this model, they predict characteristics as a company’s brand, reputation, and perceived competitive advantage to be new equity factors.

It’s a long read, but we at Quantpedia really recommended it for all equity portfolio managers …

Authors: Ibbotson, Idzorek, Kaplan, Xiong

Title: Popularity: A Bridge between Classical and Behavioral Finance