Introduction
Investors prefer safer to riskier stocks since it provides a perceived security and there alternative to a risky investment or stock is the incentive in form of higher returns. In depth, the market prices are to be set such that investors expect riskier stocks to deliver higher returns although the higher returns are not to be viewed as dependable since if the risky stocks are to be counted on to deliver higher returns than the safer investments or stocks then they are to be considered not risky like demonstrated (LAOPODIS 2012). This expected high returns are valuated so as to attract capital.
The principle of `the higher the risk the higher the return is embodied in both the core concepts of the capital market line and the security market line which have graphs that are positively sloping as highlighted (FABOZZI & MARKOWITZ 2011). Therefore, this report intends to analyze the extent to which investors would expect higher returns on safer stocks than on riskier stocks and this determination would be depended on the following;
- The evidence there is for the investors to judge the risk and return to be inversely proportional or negatively related.
- The psychological forces that would force investors to form such judgments about risk and return.
- The extent to which investors are consciously aware of the manner in which they form their judgments about risk and return.
- The reliability of the evidence on risk and return presented.
- The implications of higher expectation hold for the broad debate between proponents of market efficiency and proponents of behavioral finance.
- The robust nature of the judgments about the risk and return to judgment about the anticipated equity premium
In traditional finance, the underlying principle has been that the expected return is positively related to the risk of stocks and not inversely proportional or negatively related. Therefore, the reason that compels investors to form a negative association between risk and return is because of their reliance on the behavioral empirical representativeness as explained (LAOPODIS 2013). This representativeness embroils the over-reliance on the casts. Consider the tendency hypothesis that investors normally rely on the representativeness based heuristic that the stock of a good company is a representative of a good stock. For the purposes of testing this hypothesis, Statman and Shefrin (1995) used the information from the yearly reputation survey that was conducted by Fortune magazine.
Most importantly of the eight question survey, Fortune Company had its survey contain two questions that are important; the goodness of a company`s stock, and the goodness of a company. The survey had more consideration on the company`s quality, management`s quality, financial soundness, and quality of products and the rating of the company`s stock in terms of long term value by the respondents as advised (QUINN 2010). The suggestion that the value as a long term investment seemed likely to be a decent deputation for the quality of a company`s stock, and that the management`s quality seemed likely to be a decent proxy for the company`s quality. The hypothesis tested was to ascertain the judgment of investors that the stocks which are good are for good companies and the response was bias on the support of this evidence highlighted in (EHRMAN 2006).
On the other hand, take consideration on the investors dependent on the representativeness might expect the returns to safer stocks to be higher than the returns to the riskier stocks. In that regard, it was found that investors judge that good companies are safe companies and that the financially sound companies are the ones with the good stocks. The relationship between the company`s financial soundness and the perceived risk of its stock is that they are inversely proportional and that investors identify with the companies that are financially sound and are well run which is explained (SCHOENFELD 2004). The aspect of representativeness makes investors associate high expected returns to the stocks of companies properly managed, and the low risk to companies that are financially sound. In this regard, investors judge properly run companies as financially sound and, representativeness forces them to expect high returns from safe stocks.
There is the general concurring on the fact that expected returns have an across the board structure involving aspects such as the book to market equity, size, past sales growth, and past two year returns. The argument between the market efficiency proponents and those of behavioral finance is based on the overall structure of the realized returns. The proponents of market efficiency argue that these characteristics are deputations for risk while a contrasting view is by the proponents of behavioral finance who argue that these characteristics depict mispricing arising from investor partiality, in particular their overreaction, as is discussed (SHELTON 1997).
In the efficient market perspective, the inverse relationship between realized returns and book to market equity deputations for the relationship between true risk and expected returns. In accordance to this, the mean realized returns correspond with expected returns, and book market equity deputations for the risk associated with financial distress (KEEN 2011).
On ascertaining the validity of the implicit assumption in treating mean realized returns as expected returns, there is a major difference between these two in the overall relationship among the two are inversely proportional. For instance, realized return is positively related to book to market equity but inversely proportional to expected returns whereas the size is inversely proportional to realized returns, but directly proportional to expected returns as described (FLANNERY, HOUSTON & VENKATARAMAN 1993).
Therefore, perceived risk is positively proportional to book-to-market equity and is inversely proportional with the size. These characteristics are consistent with the efficient market position hence investors make erroneous judgments with their perception that risks and expected returns are inversely proportional as defined (TAYLOR & WEERAPANA 2010).
In the aspect of time varying equity premium, the overall return expectations remain steady in cases of volatile expectations about the return to the overall market. The beliefs of Wall Street strategists` about the magnitude of total returns to the market are volatile. Articles appearing in the Wall Street journals of December 2000 and January 2001, describe the expectations for the S&P 500 by eleven of the strategists. In the year 1999, the S&P 500 had a return of 18.4% and therefore making strategists to expect it to return to 9.6 % in 2000. In the year ending 2000, after the S&P returned -7% they expected it to return to 17% in 2001 hence these strategists give in to `gamblers fallacy` whereas the individual investors yield to extrapolation partiality. This depicts strategists as those who predict reversals quickly, while the individual investor project recent tendencies too readily.
The volatile beliefs about the equity premium are also held by economists on the amount of stocks which is expected to return over and above the risk free rate. In a report conducted on a survey on financial economists in 1997 – 1998, he found that majority expected equity premium to be 5.8%. A twist in their expectation fell to 3.75% later in August 2001. It is questionable if that volatility in the expected premium is consistent with rational expectations. In the case of higher returns there will be a high dividend and earnings growth pay out unlike when the expected return is low a low dividend and earnings growth payout is realized as discussed (KOCHIS 2007).
Also, investors will tend to hold on to portfolios that are of homogeneous stocks with respect to volatility and according to the preferred risk habitat hypothesis concerns trading in that when the investors sell the stocks present in their portfolios, they are replaced with the stocks that have the same volatility as those that they sell (GRAHAM, SMART & MEGGINSON 2012).
Even though there has been a correlation between characteristics such as; book to market equity, past returns, and past sales growth with return expectations, investors do not take consciously these factors while making their investment decisions despite the availability of the information. Other scholars and academic professionals also make implicit judgments about risk and return expecting higher returns from safer stocks accepting that risk and return is directly or positively related which is in contrast to the underlying principle of the risk and return being inversely proportional (HEBNER 2007).
Investors tend to use the perception of negative relationship between risk and return in making their judgments about a good company which is an error based on the empirical representativeness based assumptions together with framing effects. The difference in the predictions between strategists and individual investors arises from the different historical periods upon which their decisions are bias. These investors are influenced by perceived negative relation between the risk and return and the sway of imagery as explained (KOCHIS 2007).
Different investors will select stocks with different volatilities since actual portfolios contain concerted volatilities in relationship with the dispersion of volatilities available from the population of stocks. For the portfolios that the investors select they tend to be more persistent in there volatilities. The investors risk posture as a relatively personal trait is suggested by the temporal stability of the average component volatility. The more risk-averse inverse investors will pick docile stocks whereas less risk-averse investors will gravitate towards volatile stocks as discussed (TAYLOR & WEERAPANA 2009).
For instance; a survey of Consumer Finances indicated that investors with lowest risk aversion are those who are willing to bear high risks in exchange for high returns, the investors unwilling to bear or not at all willing to bear high risk in exchange for high expected returns are the highest risk aversion investors. Investors who are more risk averse have a stronger tendency to invest in mutual funds hence a correlation between the tendency to invest in funds and aversion to risk as conferred (HART 2005).
In addition, the investors who are unwilling to trade off high risk and high expected returns holds a portfolio with an average component volatility that is at a level 20% that of a peer of the realm who indicates to be very willing the trade off and hence in a normal circumstance less risk averse investors tend to choose more volatile stocks (MORRIS & MORRIS 2012). This therefore has it that the measure of a stock`s risk is it return volatility.
According to the preferred risk habitat which is more profound with Shefrin and Statman (2000) who envisage stock choices of people who overlook return correlations between entire asset classes. Here, it is noted that investors will keep a portfolio with stocks that contain volatilities within narrow ranges and that the more risk-averse individuals will tend to choose stocks that have lower volatility and also they tend to make heavier use of mutual funds. This leaves the investors who are more risk-averse under the preferred risk habitat as those who will not invest in stocks if the volatilities of the stocks are extremely high conveyed in resources finance (APPEL 2010).
An investor may choose to have his stock portion diversified in his portfolio and have his measure of risk aversion correlate with portfolio`s average component volatility and HHI (Herfindahl-Hirschmann Index which is a proxy for portfolio risk and a natural measure of portfolio diversification) and the portfolio volatility (KOCHIS 2007). Therefore, the portfolio`s volatility is dependent on the number of stocks the portfolio holds, their weights, correlations of the returns of the stocks, and the volatilities of the portfolio stocks as communicated (MORRIS & MORRIS 2012).
In Shefrin (1999), it is noted that the return expectations of survey respondents are consistently inversely correlated with their risk perceptions referring to investors being expectant that riskier stocks will deliver lower returns than safer stocks and the research findings are extensive having the similar sentiments being shared.
Shefrin and Statman (2001) analyze the overall structure of the Fortune variable VLTI (value as a long term investment) and the resultant relationship found was that the relationship between VLTI and firms` or investor`s characteristics is concurrent or parallel to the relationship between the expected returns and characteristics. Most evident is the Fortune reputation survey that covers quite a number of stocks and they survey has been conducted for a good number of years. The resultant of these surveys has been the deductions that expected returns are always directly proportional or positively correlated with value as a long term investment as conversed (BODIE & CLOWES 2003).
Conclusion
It is reasonably arguable that an investor will apply his heuristic judgments in the selection of his stock and this stock selection is based on the stocks tendency to attract risk and gain returns meaning he pay attention to the stock`s overall. This volatility of the choice of stock is dispersed as in the preferred risk habitat and the holders of less volatile stocks tend to be individuals who are more risk averse.
Although scholars of modern finance argue that the relationship between the risk and return of a stock is positive, investors tend to hold a contrary perspective. My suggestion relies on the fact that investors` reliance on the representativeness heuristic is the main reason that causes them to expect high returns from safe stocks. Those investors who judge that good stocks are stocks of good companies tend to associate good stocks with those safe stocks and high future returns as elaborated (TAYLOR & WEERAPANA 2009).
If the arguments of the proponents of market efficiency were to be followed then the mean realized returns would coincide with the expected returns thereby affecting the realized returns and the expected returns in an equal measure. There is a negative correlation between the book to market equity or value equity to expected returns. The investors` decision based on the heuristic based representativeness that illustrates that good stocks are those of good companies because these companies are associated with low book to market equity or value equity, and hence investors are induced by this representativeness in expecting higher returns from the stocks of good companies that are considered safe.
Finally, the tendency of biasness in the judgments of investors about the risk and returns of stocks occur as stout even in the wake of a highly volatile time varying equity premium.
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