It’s enough to make even the most risk-loving
investor quake in fear. Portfolio managers recently were reportedly
giving technology stocks a longer look, betting that a war in Iraq
will fuel a short-term rally in the sector.
Technology stocks? They were largely responsible for the burst of
the market bubble in early 2000 that set off the current decline.
The balance of financial investments in portfolios has become even
more delicate in the current unstable economic climate. Market conditions
aside, how investors should combine financial investments in an
overall portfolio to maximize objectives is a popular theme in investment
analysis. A so-called efficient portfolio has as high a level of
expected return as possible for the given level of risk and uses
the minimum risk needed to achieve that expected return. But how
to get there?
The appropriate composition of an efficient portfolio is far from
obvious, noted Jay Shanken, Dean’s Distinguished Professor
of Finance in the Goizueta Business School. Shanken, along with
coauthor S.P. Kothari of MIT’s Sloan School of Management,
recently had a monograph published by the Association for Investment
Management and Research (AIMR), the organization that administers
the chartered financial analyst exam and publishes the Financial
The study, titled “Anomalies and Efficient Portfolio Formation,”
analyzes the properties of efficient stock portfolios that exploit
the most prominent market anomalies related to company size or market
capitalization, company book-to-market ratios and past-year momentum.
While empirical literature has touched on these anomalies—phenomena
observed in the stock market that deviate from classic risk-and-return
theories—it has not examined how they relate to creating the
“We’ve got this very simple theory that says everybody
should just hold index funds—this market portfolio idea,”
Shanken said. “But there’s plenty of evidence that that
would not be the best portfolio to hold. It’s not efficient.
The anomalies show that other things affect expected returns besides
what the theory says should work. We analyze the properties of efficient
portfolios that take into account these anomalies.”
Shanken’s analysis focuses on the three most prominent stock
market anomalies: the tendency for the stocks of smaller firms,
for those of firms with high book-to-market ratios (value stocks)
or for those with high past-year returns (momentum stocks) to have
high average future returns.
“These anomalies represent deviations from a theory called
the ‘capital asset pricing model,’ which predicts that
expected stock returns are determined only by a particular risk
measure called ‘beta’ and not by these other stock characteristics,”
For each anomaly, the authors estimate the amount that investors
should tilt their portfolios away from the market index—toward
the anomaly-based portfolio—to exploit the gains of efficiency.
The analysis looks at stock return data from 1963 to 2000, as well
as data on firms’ book-to-market ratios.
In doing the actual statistical analysis, Shanken and Kothari considered
portfolios that were combinations of a broad stock market index,
Treasury bills—a riskless investment—and the three anomaly
portfolios of small firms, value stocks and high momentum stocks.
They allowed for the possibility that the positive “alphas”
(a standard measure of performance) of the three anomaly portfolios
might not be as large in the future as they appeared to be in the
“We found that even if they are expected to be just a quarter
of the size they were in the past, an optimal portfolio would invest
more than half in value stocks and about one-third in momentum stocks,”
Shanken said. “This would increase the annual expected return
by about 0.6 percent, relative to the market index, holding risk
constant. With alphas half the historical level, the increase in
expected return is more substantial, almost 2 percent per year.”
The authors say they expected value and momentum to play an important
role in optimal portfolio decisions based upon past literature about
anomalies. They were surprised, however, by the extent to which
aggressive investment in these anomalies seems to be called for.
Investors should take heed of the risk-and-return characteristics
of anomaly-based investment strategies, Shanken advised. “In
broad terms,” he said, “we would continue to want to
exploit these anomalies and invest more in higher book-to-market
stocks and more in stocks that have high momentum in the previous
year, even if we’re somewhat skeptical that the effect would
be as strong in the future.”
article first appeared in Knowledge@Emory and is reprinted with