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Volatility Effects

Reward goes with risk, and volatility represents risk. Therefore, volatility means reward; investors/traders get paid for riding roller coasters. Right? These blog entries relate to volatility effects.

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Why Highly Volatile Stocks Tend to Underperform

Conventional wisdom holds that: (1) risk begets reward; and, (2) volatility is a manifestation of risk. Exceptionally high volatility in individual stock prices should, therefore, indicate future excess returns in those stocks. In their May 2006 paper entitled “The Relation between Time-Series and Cross-Sectional Effects of Idiosyncratic Variance on Stock Returns in G7 Countries”, Hui Guo and Robert Savickas investigate why the realized idiosyncratic volatility (beta) of individual stocks correlates negatively with future returns — why there is a penalty instead of a reward for this apparent risk. Using two sets of U.S. data (1926-2005 and 1963-2005) and one set of international data (1973-2003), they conclude that: Keep Reading

VIX as an Indicator for Different Kinds of Portfolios

Implied volatility, represented by the CBOE Volatility Index (VIX), incorporates the bets of speculators on future stock market behavior. In the April 2006 revision of their paper entitled “Implied Volatility and Future Portfolio Returns”, Prithviraj Banerjee, James Doran and David Peterson examine whether the predictive power of VIX applies to specific portfolio characteristics (value versus growth, small versus large and beta) and whether variations in VIX with respect to its short-term mean are predictive. Using data from June 1986 through June 2005 and future return periods of 22 and 44 trading days, they find that: Keep Reading

Predicting Stock Returns Not with Volatility, But Volatilities

Conventional wisdom holds that high (low) overall stock market volatility forecasts high (low) stock returns, as a fundamental reward-for-risk phenomenon. In their March 2006 paper entitled “Understanding Stock Return Predictability”, Hui Guo and Robert Savickas investigate a refinement to volatility-based prediction of stock market returns by combining the effects of realized overall market volatility and the average realized idiosyncratic volatility of individual stocks. They theorize that: (1) overall stock market volatility reflects the volatilities of both cash flow shocks and discount rate shocks; (2) overall stock market volatility overstates discount rate shock volatility; and, (3) average idiosyncratic volatility, which reflects the volatility of discount rate shocks only, corrects this overstatement. Using quarterly overall and idiosyncratic volatilities from 1927 through 2005, they conclude that: Keep Reading

Classic Research: Embrace Risk, But Take Profits

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the February 1999 paper entitled “Daily Momentum And Contrarian Behavior Of Index Fund Investors” (download count almost 1,900) by William Goetzmann and Massimo Massa. The authors investigate the existence and profitability of momentum and contrarian behaviors for stock index trading. They classify return momentum investors (trend followers) as those who buy (sell) when the market rises (drops) in the previous trading session, and return contrarian investors as “profit takers” who sell (buy) when the market rises (drops). They also examine investor response to changes in market volatility, defining both volatility momentum traders (risk chasers) and volatility contrarian traders (risk avoiders). Using daily activity records for 91,000 accounts trading an S&P 500 index during 1997 and 1998, the authors find that: Keep Reading

No Reward for Risk?

The market rewards investors for taking risk. Right? High volatility means high risk. Right? High volatility therefore means excess return. Right? In their January 2006 paper entitled “High Idiosyncratic Volatility and Low Returns: International and Further U.S. Evidence”, Andrew Ang, Robert Hodrick, Yuhang Xing and Xiaoyan Zhang test the relationship between past idiosyncratic volatility and future returns for stocks in developed markets around the world. Using data from 23 countries mostly over the period January 1980 through December 2003, they find that: Keep Reading

Recognition: Is That a Good Thing?

In the September 2005 version of their paper entitled “Investor Recognition and Stock Returns”, Reuven LeHavy and Richard Sloan analyze the relation between how widely a stock is recognized and its returns (past and future). They use change in the proportion of quarterly SEC Form 13-F filers (institutional investment managers who exercise investment discretion over $100 million) holding a stock to represent the change in investor recognition of that stock. Using Form 13-F and stock price data over the period 1982-2004, they find that: Keep Reading

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