The one strategy that all investors should know prior to buying or selling shares
This interview is based on research by Luca Del Viva
Being an investor is a challenging job – knowing the right time to buy or sell shares is always a balancing act that involves a trade-off between risk and return. Typically, investors are reluctant to take risks, especially when the risk is concentrated in the possibility of losing much or all of their investment. In this respect, some features of an investment are desirable, like having a high upside potential (positive returns) while being protected from downside losses (negative returns).
Detecting such assets with a positive-asymmetric pay-off is far from easy. Esade Assistant Professor Luca Del Viva has found evidence that can help investors ease this process and improve their decisions. Published in the Journal of Financial and Quantitative Analysis, his research provides clues for investors to help them identify equities with this desirable pay-off structure.
Do Better: What have you revealed in your research?
Luca Del Viva: There are several factors that influence an investor's behaviour and thus the price of shares. Our starting point was the hypothesis that part of an investor's decision to buy shares from a specific company clearly depends on the firm's growth potential. If a firm shows future growth potential – for instance, a successful product launch – investors will notice that and reward this behaviour. What we found in our research is that there is a positive relationship between a firm's potential for growth and the asymmetric pay-off structure of the returns of its shares.
What type of positive relationship?
We observed that the value of a firm's shares is affected by the implied growth potential. The higher a company's potential for growth, the higher the asymmetry of its shares' return will be. So investors seeking this desirable asymmetric feature need to keep in mind that the shares' return distribution is not symmetric and this asymmetry is positively determined by the growth potential.
A firm with a higher concentration of growth options will exhibit more positively skewed returns, increasing the probability of high positive returns while reducing the likelihood of big losses.
Investors like high positive returns while keeping low the chances of losing all the money
How can investors make the most of this asymmetric behaviour?
Investors like high positive returns while keeping low the chances of losing all the money. If a firm's growth potential can produce such a pay-off structure, investors could be interested in determining what easily observable characteristics of a firm imply higher future growth potential.
If you are offered two lottery tickets at the same cost and same likelihood of winning, you will prefer the ticket with the larger associated jackpot. Well, a firm's growth potential works in a similar way, with the difference that it is harder to detect a priori which firm will grow more. In our research, we also provide some guidance on this.
The traditional view is that investors prefer to reduce risks by diversifying more
But this asymmetry means higher risks?
It all depends on how we define risk. Traditionally, risk is defined as the volatility of equity returns. The traditional view is that investors prefer to reduce these risks by diversifying more. Under the traditional view, investors are mainly interested in two aspects: the expected return and the potential risk (volatility) of their investment. If we take into account these two factors only, investors who are only interested in reducing risk will clearly obtain the maximum benefits from diversifying.
Investors who are willing to have a slightly higher risk could increase their return potential
But if we add a new dimension, the one that comes from this asymmetry, investors who are willing to have a slightly higher risk (volatility) could benefit from the asymmetry of this type of shares and so increase their return potential. It is intuitive to understand that as an investor I am more concerned about high volatility when returns are negative rather than when they are positive.
What's your advice for investors?
Our advice derived from our research would be for investors to identify firms that have higher potential for growth, because this will allow them to have this asymmetric pay-off distribution, which will yield higher returns in the long run. The reason why an investor may prefer skewness could be based on behavioural motivation.
There are investors who may be willing to lose a very small amount of money because although the probability of winning is very small, the fact that it may happen can yield a fortune. Alternatively, we could argue that an investor might prefer positive asymmetric returns because although initially the probability of loss can be a bit higher, these losses are very small compared to the probability of future gains. In both cases, investors would benefit from better performances over the long run.
Join the Do Better community
Become a member and enjoy our free benefits. Get recommendations, receive personalised content in your inbox and save your favourite articles to read later.