A Recipe For Overpaying

On the Gestalt University podcast, Chris Schindler has an intuitive explanation for the CAPM-defying empirical result that says higher volatility assets actually exhibit lower forward returns. Very simply explained — a large dispersion of opinion leads to overpaying. He points to private markets where you cannot short a company. The most optimistic opinion of a company’s prospects will set the price.

Options markets don’t care about CAPM. They model geometric returns. Higher volatility explicitly maps to lower expected geometric returns. I’ve referred to this idea as a “volatility drain” before. But here’s another way to see this. If you hold the price of an asset constant and raise the volatility the median expected outcome is necessarily more negative. Why? Because a stock is bounded by zero, so increasing the volatility should seemingly make the expected value of the asset higher. But if the market thinks the stock price is worth the same despite the higher volatility, that implies the probability of the asset declining must be higher.

(In reality, markets are constantly voting on the price, the volatility, and the left and right skew which allows an inclined observer to impute a continuous distribution.)

Back to Schindler’s point, if you want to fetch a high price for an asset, you want its value to be highly uncertain. Then sell it in an un-shortable auction with many bidders.

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