IDEAS home Printed from https://ideas.repec.org/a/taf/quantf/v6y2006i6p481-494.html
   My bibliography  Save this article

Myopic loss aversion and margin of safety: the risk of value investing

Author

Listed:
  • Kuan Xu
  • Gordon Fisher

Abstract

This paper examines the risk of value investing from the point of view of a myopic loss-averse investor holding a diversified portfolio and relying on infrequent portfolio rebalancing. This closely resembles purchasing a large portfolio, such as those created by BARRA, and following a buy-and-hold investment strategy. In these circumstances, which portfolio, value or growth, is riskier to a myopic loss-averse investor? To facilitate analysis, a myopic loss ranking and a corresponding statistical procedure are developed and applied to investment-style data provided by BARRA. The paper qualifies the conditions under which value investing is more risky in North American financial markets.

Suggested Citation

  • Kuan Xu & Gordon Fisher, 2006. "Myopic loss aversion and margin of safety: the risk of value investing," Quantitative Finance, Taylor & Francis Journals, vol. 6(6), pages 481-494.
    • Handle: RePEc:taf:quantf:v:6:y:2006:i:6:p:481-494
    DOI: 10.1080/14697680600780934
    as

    Download full text from publisher

    File URL: http://www.tandfonline.com/doi/abs/10.1080/14697680600780934
    Download Restriction: Access to full text is restricted to subscribers.
    File URL: https://libkey.io/10.1080/14697680600780934?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Davidson, James, 1994. "Stochastic Limit Theory: An Introduction for Econometricians," OUP Catalogue, Oxford University Press, number 9780198774037.
    2. Richard H. Thaler & Amos Tversky & Daniel Kahneman & Alan Schwartz, 1997. "The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 112(2), pages 647-661.
    3. Valentino Dardanoni & Antonio Forcina, 1999. "Inference for Lorenz curve orderings," Econometrics Journal, Royal Economic Society, vol. 2(1), pages 49-75.
    4. Foster, James & Greer, Joel & Thorbecke, Erik, 1984. "A Class of Decomposable Poverty Measures," Econometrica, Econometric Society, vol. 52(3), pages 761-766, May.
    5. Amos Tversky & Daniel Kahneman, 1991. "Loss Aversion in Riskless Choice: A Reference-Dependent Model," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 106(4), pages 1039-1061.
    6. Fishburn, Peter C., 1976. "Continua of stochastic dominance relations for bounded probability distributions," Journal of Mathematical Economics, Elsevier, vol. 3(3), pages 295-311, December.
    7. Chen, Nai-fu & Zhang, Feng, 1998. "Risk and Return of Value Stocks," The Journal of Business, University of Chicago Press, vol. 71(4), pages 501-535, October.
    8. Murasawa, Yasutomo & Morimune, Kimio, 2004. "Distribution-free statistical inference for generalized Lorenz dominance based on grouped data," Mathematics and Computers in Simulation (MATCOM), Elsevier, vol. 64(1), pages 133-142.
    9. Fisher, Gordon & Willson, Douglas & Xu, Kuan, 1998. "An empirical analysis of term premiums using significance tests for stochastic dominance," Economics Letters, Elsevier, vol. 60(2), pages 195-203, August.
    10. Banz, Rolf W., 1981. "The relationship between return and market value of common stocks," Journal of Financial Economics, Elsevier, vol. 9(1), pages 3-18, March.
    11. Russell Davidson & Jean-Yves Duclos, 2000. "Statistical Inference for Stochastic Dominance and for the Measurement of Poverty and Inequality," Econometrica, Econometric Society, vol. 68(6), pages 1435-1464, November.
    12. Daniel Kahneman & Amos Tversky, 2013. "Prospect Theory: An Analysis of Decision Under Risk," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 6, pages 99-127, World Scientific Publishing Co. Pte. Ltd..
    13. MacKinlay, A. Craig, 1995. "Multifactor models do not explain deviations from the CAPM," Journal of Financial Economics, Elsevier, vol. 38(1), pages 3-28, May.
    14. De Bondt, Werner F M & Thaler, Richard, 1985. "Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
    15. Haim Levy, 1992. "Stochastic Dominance and Expected Utility: Survey and Analysis," Management Science, INFORMS, vol. 38(4), pages 555-593, April.
    16. Foster, James E & Shorrocks, Anthony F, 1988. "Poverty Orderings," Econometrica, Econometric Society, vol. 56(1), pages 173-177, January.
    17. Kodde, David A & Palm, Franz C, 1986. "Wald Criteria for Jointly Testing Equality and Inequality Restriction s," Econometrica, Econometric Society, vol. 54(5), pages 1243-1248, September.
    18. Anderson, James H. & Korsun, Georges & Murrell, Peter, 2003. "Glamour and value in the land of Chingis Khan," Journal of Comparative Economics, Elsevier, vol. 31(1), pages 34-57, March.
    19. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 110(1), pages 73-92.
    20. Fama, Eugene F & French, Kenneth R, 1996. "Multifactor Explanations of Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 51(1), pages 55-84, March.
    21. Lakonishok, Josef & Shleifer, Andrei & Vishny, Robert W, 1994. "Contrarian Investment, Extrapolation, and Risk," Journal of Finance, American Finance Association, vol. 49(5), pages 1541-1578, December.
    22. Kaur, Amarjot & Prakasa Rao, B.L.S. & Singh, Harshinder, 1994. "Testing for Second-Order Stochastic Dominance of Two Distributions," Econometric Theory, Cambridge University Press, vol. 10(5), pages 849-866, December.
    23. Fama, Eugene F & French, Kenneth R, 1992. "The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-465, June.
    24. Chan, Louis K C & Hamao, Yasushi & Lakonishok, Josef, 1991. "Fundamentals and Stock Returns in Japan," Journal of Finance, American Finance Association, vol. 46(5), pages 1739-1764, December.
    25. Garry F. Barrett & Stephen G. Donald, 2003. "Consistent Tests for Stochastic Dominance," Econometrica, Econometric Society, vol. 71(1), pages 71-104, January.
    26. G. Hanoch & H. Levy, 1969. "The Efficiency Analysis of Choices Involving Risk," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 36(3), pages 335-346.
    27. Kuan Xu & L. Osberg, 1998. "A distribution-free test for deprivation dominance," Econometric Reviews, Taylor & Francis Journals, vol. 17(4), pages 415-429.
    28. Hadar, Josef & Russell, William R, 1969. "Rules for Ordering Uncertain Prospects," American Economic Review, American Economic Association, vol. 59(1), pages 25-34, March.
    29. Wolak, Frank A, 1991. "The Local Nature of Hypothesis Tests Involving Inequality Constraints in Nonlinear Models," Econometrica, Econometric Society, vol. 59(4), pages 981-995, July.
    30. Bawa, Vijay S., 1975. "Optimal rules for ordering uncertain prospects," Journal of Financial Economics, Elsevier, vol. 2(1), pages 95-121, March.
    31. Anderson, Gordon, 1996. "Nonparametric Tests of Stochastic Dominance in Income Distributions," Econometrica, Econometric Society, vol. 64(5), pages 1183-1193, September.
    32. Levy, Haim & Kroll, Yoram, 1978. "Ordering Uncertain Options with Borrowing and Lending," Journal of Finance, American Finance Association, vol. 33(2), pages 553-574, May.
    33. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
    34. repec:bla:jfinan:v:53:y:1998:i:3:p:1131-1147 is not listed on IDEAS
    35. H. Dennis Tolley & Rulon D. Pope, 1988. "Testing for Stochastic Dominance," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 70(3), pages 693-700.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Marc Jeannin & Giulia Iori & David Samuel, 2008. "Modeling stock pinning," Quantitative Finance, Taylor & Francis Journals, vol. 8(8), pages 823-831.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Kwame Addae-Dapaah & James Webb & Kim Ho & Yan Tan, 2010. "Industrial Real Estate Investment: Does the Contrarian Strategy Work?," The Journal of Real Estate Finance and Economics, Springer, vol. 41(2), pages 193-227, August.
    2. Hooi Hooi Lean & Michael McAleer & Wing-Keung Wong, 2010. "Market Efficiency of Oil Spot and Futures: A Stochastic Dominance Approach," CIRJE F-Series CIRJE-F-705, CIRJE, Faculty of Economics, University of Tokyo.
    3. David Hirshleifer, 2001. "Investor Psychology and Asset Pricing," Journal of Finance, American Finance Association, vol. 56(4), pages 1533-1597, August.
    4. Russell Davidson & Jean-Yves Duclos, 2013. "Testing for Restricted Stochastic Dominance," Econometric Reviews, Taylor & Francis Journals, vol. 32(1), pages 84-125, January.
    5. Christodoulakis, George & Mohamed, Abdulkadir & Topaloglou, Nikolas, 2018. "Optimal privatization portfolios in the presence of arbitrary risk aversion," European Journal of Operational Research, Elsevier, vol. 265(3), pages 1172-1191.
    6. Oliver Linton & Esfandiar Maasoumi & Yoon-Jae Wang, 2002. "Consistent testing for stochastic dominance: a subsampling approach," CeMMAP working papers 03/02, Institute for Fiscal Studies.
    7. Hooi Hooi Lean & Michael McAleer & Wing-Keung Wong, 2013. "Risk-averse and Risk-seeking Investor Preferences for Oil Spot and Futures," Documentos de Trabajo del ICAE 2013-31, Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico, revised Aug 2013.
    8. Stengos, Thanasis & Thompson, Brennan S., 2012. "Testing for bivariate stochastic dominance using inequality restrictions," Economics Letters, Elsevier, vol. 115(1), pages 60-62.
    9. Lean, Hooi Hooi & McAleer, Michael & Wong, Wing-Keung, 2010. "Market efficiency of oil spot and futures: A mean-variance and stochastic dominance approach," Energy Economics, Elsevier, vol. 32(5), pages 979-986, September.
    10. John Y. Campbell, 2000. "Asset Pricing at the Millennium," Journal of Finance, American Finance Association, vol. 55(4), pages 1515-1567, August.
    11. Levy, Haim & Levy, Moshe, 2021. "Stocks versus bonds for the long run when a riskless asset is available," Journal of Banking & Finance, Elsevier, vol. 133(C).
    12. M. Eskandar Shah & Sourafel Girm & R. Hudson, 2012. "Rationalizing the Value Premium under Economic Fundamentals in an Emerging Market," Working Papers 12010, Bangor Business School, Prifysgol Bangor University (Cymru / Wales).
    13. Abhay Abhyankar & Keng-Yu Ho & Huainan Zhao, 2009. "International value versus growth: evidence from stochastic dominance analysis," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 14(3), pages 222-232.
    14. Clark, Ephraim & Qiao, Zhuo, 2020. "The value premium puzzle, behavior versus risk: New evidence from China," The Quarterly Review of Economics and Finance, Elsevier, vol. 76(C), pages 12-21.
    15. Lean, Hooi Hooi & McAleer, Michael & Wong, Wing-Keung, 2015. "Preferences of risk-averse and risk-seeking investors for oil spot and futures before, during and after the Global Financial Crisis," International Review of Economics & Finance, Elsevier, vol. 40(C), pages 204-216.
    16. Wang, Ming-Hui & Ke, Mei-Chu & Liang Liao, Tung & Chiang, Yi-Chein & Hsu, Chuan-Hao, 2020. "Alternative estimation method of earnings growth rate for PEGR strategy," The North American Journal of Economics and Finance, Elsevier, vol. 53(C).
    17. Chung, Yi-Tsai & Hsu, Chuan-Hao & Ke, Mei-Chu & Liao, Tung Liang & Chiang, Yi-Chein, 2016. "The weakening value premium in the Australian and New Zealand stock markets," Pacific-Basin Finance Journal, Elsevier, vol. 36(C), pages 123-133.
    18. Al-Khazali, Osamah & Lean, Hooi Hooi & Samet, Anis, 2014. "Do Islamic stock indexes outperform conventional stock indexes? A stochastic dominance approach," Pacific-Basin Finance Journal, Elsevier, vol. 28(C), pages 29-46.
    19. Wen-Hao Chen & Jean-Yves Duclos, 2011. "Testing for poverty dominance: an application to Canada," Canadian Journal of Economics, Canadian Economics Association, vol. 44(3), pages 781-803, August.
    20. Daniel, Kent & Hirshleifer, David & Teoh, Siew Hong, 2002. "Investor psychology in capital markets: evidence and policy implications," Journal of Monetary Economics, Elsevier, vol. 49(1), pages 139-209, January.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:taf:quantf:v:6:y:2006:i:6:p:481-494. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Chris Longhurst (email available below). General contact details of provider: http://www.tandfonline.com/RQUF20 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.