Morningstar Magazine - April/May 2018 - 9

My Introduction to Behavioral Finance

After graduate school, I went to work for
a Chicago-based consulting firm called Ibbotson
Associates.2 We began creating risk-tolerance
questionnaires to guide investors into assetallocation portfolios that were right for their levels
of risk capacity and risk preference-collectively
risk tolerance-and soon realized that the
complexities of investor behavior made this harder
than it sounded. So, we obtained the help of
behavioral economist and future Nobel laureate
Daniel Kahneman, who helped us design the
questions to take investor behavior into account.
Kahneman and my then colleague Mark Riepe
published an excellent article on "beliefs,
preferences, and biases investment advisors
should know about." (Kahneman and Riepe, 1998).
In time, I learned that behavioral finance provides
explanations for many of the various market
anomalies that had been discovered empirically.
However, the classical camp did not cede to the
behavioral camp, but rather interpreted the
anomalies as "risk premiums" that represent fair
compensation for taking risk that is not captured
by the CAPM. (My coauthors on the monograph
and I don't find that plausible because some of the
premiums are associated with less risk, not more.)
This illustrates the wall between the two camps.
Introduction to the Popularity Bridge

While aware of it, especially as an explanation
for the various anomalies, I didn't give much
thought to how the insights of behavioral finance
might affect my own work until I read "Dimensions
of Popularity" by Ibbotson and Idzorek (2014) and
"Popularity and Asset Pricing" by Idzorek and
Ibbotson (2017). "Dimensions of Popularity" starts:
"We believe that most of the best-known market
premiums and anomalies can be explained
by an intuitive and naturally occurring (social or
behavioral) phenomenon observed in countless
settings: popularity."
The idea of popularity is simple. Investors are
willing to pay more for securities with popular
characteristics and less for securities with

unpopular characteristics. This causes popular
stocks to have lower returns and unpopular
stocks higher returns. Thus, investors who are
willing to hold unpopular stocks will, over the long
run, earn higher returns than other investors.
Because stocks of smaller companies are less
popular than stocks of larger companies, there
is a size premium. Similarly, stocks trading at low
price/earnings ratios are less popular than stocks
trading at high price/earnings ratios, often
because they are out of favor, less well-known, or
operate in less glamorous industries. Hence, there
is a value premium.

premiums, which are aggregations of the
preferences of the investors regarding the nonrisk
characteristics. In this way, the market
aggregates investor preferences in determining
the influence of security characteristics on
the expected returns and prices of the securities.
2 In the CAPM, the market portfolio is optimal

for the average investor, so indexing is an optimal
strategy. In the PAPM, the market portfolio
may not be optimal for any investor, so the case for
indexing is diminished.
3 In the CAPM, each investor holds the market

The beauty of the idea of popularity is that
it applies to all security characteristics, whether
concern for them is rational or irrational. Thus,
popularity encompasses both rational and
behavioral explanations of market phenomena,
and serves as a bridge between the rational and
behavioral schools of finance.
From Popularity to the Popularity Asset
Pricing Model

portfolio in combination with the risk-free
asset (long or short), based on the investor's risk
aversion. In the PAPM, each investor forms
a customized portfolio of the risky assets that
reflects his or her attitudes toward security
characteristics, and combines that with the
risk-free asset (long or short). Hence, each
investor's portfolio of risky assets is not available
in any index fund.

In "Popularity and Asset Pricing," Idzorek and
Ibbotson seek to express the insights of popularity
in an equation for the expected return of a
security as a linear function of its risk and nonrisk
characteristics. What they lacked was a formal
theory as to why this would be true. This is where
I came in. Making use of my training in
microeconomics, I extended the utility function
of the CAPM to include preferences for security
characteristics other than risk and expected
return. I interpret this extension to be the
dimensions of popularity discussed by Ibbotson
and Idzorek (2014). I dubbed the resulting model
the popularity asset pricing model (PAPM).

The forthcoming monograph will include
everything from our previous work (Ibbotson and
Idzorek, 2014; Idzorek and Ibbotson, 2017), the
PAPM, and new material including empirical work
(thanks to James Xiong). We hope that this
work will help tear down walls and build bridges
between the classical and behavioral camps. K

The PAPM has striking differences from the CAPM:

Ibbotson, R.G. & Idzorek, T.M. 2014. "Dimensions of
Popularity." Journal of Portfolio Management, Special 40th
Anniversary Issue, pp. 68-74.

1 The expected excess return of each security

is a linear function of not only its beta, but also
of what I call popularity loadings, which
measure the popularity of the security based on
its characteristics relative to those of the
beta-adjusted market portfolio. The popularity
loadings are multiplied by marketwide popularity

Paul D. Kaplan, Ph.D., CFA, is director of research with
Morningstar Canada. He is a member of the editorial board
of Morningstar magazine.
References
Fama, E.F. 1970. "Efficient Capital Markets: A Review of
Theory and Empirical Work." Journal of Finance, Vol. 25,
Issue 2 (May), pp. 383-417.

Idzorek, T.M. & Ibbotson, R.G. 2017. "Popularity and Asset
Pricing." Journal of Investing, Vol. 26, No. 1 (Spring), pp.
46-56.
Kahneman, D. & Riepe, M.W. 1998. "Aspects of Investor
Psychology." Journal of Portfolio Management, Vol. 24, No.
4 (Summer), pp. 52-65.

2 Morningstar acquired Ibbotson Associates in 2006, but I had moved to Morningstar before that in 1999.

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