Chapter 6 Perceptions about Risk and Return

Learning Objectives
 Identify managers’ perceptions about the characteristics that underlie risk and return.
 Analyze how representativeness leads managers, investors, and market strategists to
form biased judgments about the market risk premium.
 Present evidence that firms’ managers rely on the heuristic “one discount rate fits all,”
which according to the traditional approach to corporate finance, leads to the
destruction of value.
Traditional Treatment
 Corporate managers make judgments about risk and return in order to estimate the
cost of capital for the purpose of making decisions about investment and capital
structure.
 The typical starting point for the analysis of risk and return is the CAPM.
 Managers are urged to discount expected cash flows of projects with higher-than-
average risk at a rate higher than the cost of capital, and expected cash flows of
projects with lower-than-average risk at a rate lower than the cost of capital.
Market Risk Premium
 Between 1926 and 2015, stocks returned about 10% per year, 6.5% more than the
return on investing in one-month treasury bills.
 The 6.5% figure has served as a reasonable starting point for estimating the
market risk premium.
 In 2015, academics in the United States provided a mean estimate of 5.5% for the
market risk premium, and a mean estimate of 2.4% for the risk-free rate.
Psychological Issues Estimating The Market Risk Premium
 The S&P 500 featured a positive return in exactly two out of three years during the
period 1926–2015.
 Two-thirds of the time an up-year followed an up-year.
 Similarly, two-thirds of the time, actually 65.5%, an up-year followed a down-year.
 For annual returns, the S&P 500 did not experience hot and cold periods, even though
it did give rise to bull markets and bear markets.
Some Vocabulary
 Base rate information is information pertaining to the general environment. A
historical statistic is an example.
 Singular information is unique information directly related to a situation or object.
 Extrapolation bias, or the “hot-hand fallacy” features unwarranted extrapolation of
past trends in forming forecasts. 主张因为某件事发生了很多次，所以很可能再次
发生。
S&P 500 & the Die Rolling Game
  When the true environment is like the die-rolling game, people who are prone to
extrapolation bias will make biased forecasts.
 In regard to the S&P 500 up- and down-years, people who are prone to extrapolation
bias will be excessively optimistic during bull markets and excessively pessimistic
during bear markets.
Gambler’s Fallacy 赌徒谬误
 Whereas hot hand fallacy pertains to predictions of unwarranted continuation,
gambler’s fallacy predicts unwarranted reversals.主张由于某事发生了很多次，因
此接下来不太可能发生；或者由于某事很久没发生，因此接下来很可能会发生
 Representativeness leads people to view three-year outcomes featuring two up-years
and one down-year as being more likely than they actually are.
 People who commit hot hand fallacy tend to draw inferences about how unknown
probabilities might be changing over time from their observations.
 In contrast, people who commit gambler’s fallacy tend to believe they already know
the probabilities.
Financial Executives’ Judgments of the Market Risk Premium
 Survey evidence from the Duke/CFO study suggests that financial executives
generally succumb to extrapolation bias when estimating the market risk premium.
 The higher the market return has been in the prior quarter, the higher their forecasts of
the equity premium over the subsequent year.
Overconfidence
 Survey evidence also suggests that financial executives surveyed are overconfident in
respect to risk.
 Typical market estimates for volatility are in the neighborhood of 10 to 20%.
 Financial executives’ forecasts of volatility tend to be in the neighborhood of 6 to 7%.
One-Year Horizon Forecasts
 The mean estimate of the CFOs’ risk premium over the sample is 3.8%.
 Regression analysis reveals that the CFOs’ expected return for the S&P 500 is
positively and significantly related both to the risk-free rate and the prior year’s
return.
 The contribution of the prior return suggests that CFOs exhibit a touch of hot hand
fallacy.
 The most striking feature of the CFOs’ forecasts is their estimates of volatility, which
feature extreme overconfidence.
10-Year Horizon Forecasts
 The mean risk premium is 3.6%.
 Mean forecasted return for the one-year horizon is 5.7% and for the 10-year horizon is
7.2%.
  The associated forecasted returns are roughly in line with the historical averages for
the S&P 500, which for the period 1927 through 2015 featured a 7.7% arithmetic
mean and a 5.8% geometric mean.
Differences
 The most notable differences between the one-year forecasts and 10-year forecasts
involve the relationship between the risk premium and volatility.
 While the relationship is not statistically significant for the one-year horizon, it is for
the 10-year horizon.
For the 10-Year Horizon Forecasts
 CFOs do not simply add the risk premium to the risk-free rate to compute expected
return.
 CFOs’ forecasts suggest that they believe that the risk premium is negatively related
to the risk-free rate.
 Third, the impact of past returns on forecasts reflects gambler’s fallacy.
 The estimated risk premium and prior-year returns are negatively correlated.
 Forecasted returns and forecasted volatility are negatively related.
Insider Trading
 Executives engaging in legal insider trading exhibit gambler's fallacy.
 Financial executives tend to sell the stocks of their own firms when those stocks have
featured high positive appreciation in the previous year.
Growth and Value
 In contrast, executives hold, or even purchase, the stocks of their firms when those
stocks have featured low price appreciation in the previous year.
 Executives appeared to engage in insider selling when the stocks of their firms are
growth stocks and engage in holding or insider buying when the stocks of their firms
are value stocks.
Estimating the Cost of Capital
 Approximately three-quarters of financial executives report that they rely on the
CAPM to estimate the cost of equity for their firms, which in theory they use to
compute the associated cost of capital.
 At the same time, according to the Duke/FEI survey, between 30 and 40% use their
firm’s historical average arithmetic stock return.
 Between 30 and 40% also report that they take other factors into account, and use a
multifactor approach.
Factors
 The factors in question are varied but book-to-market equity and momentum, the
variables that academics emphasize, are rated at the bottom.
 Almost two-thirds of survey participants report that they judge idiosyncratic risk as
being somewhat or very important in determining their firm’s cost of capital.
One Size Fits All
 Managers generally use a single discount rate for all projects, but are less inclined to
rely on a single discount rate when the costs of doing so are high.
 The survey found that 59% of CFOs use the discount rate for the entire company, that
is, a “one size fits all” heuristic.
 51% indicated that they would use a risk-matched discount rate, which was the second
highest rated item.
 Large firms are more likely to use risk-matched discount rates than are smaller firms.
 Fewer than 10% vary the discount rate across component cash flows.
Not the WACC
 Survey evidence indicates the tendency for firms to use a much higher discount rate,
on average 15% instead of the average WACC of 8%.
 Firms set discount rates above the cost of capital when they ration capital, thereby
refraining from undertaking all projects that have a positive net present value (NPV).
 Why they do so involves a combination of financial constraints, operational
constraints, and consideration of idiosyncratic risk.
Constrained Behavior
 More than half of responding CFOs indicate that their firms do not invest in all
positive NPV projects, even during normal economic times.
 Of the reasons provided, operational constraints outnumber financial constraints by
about two-to-one.
 The evidence indicates that firms that set high hurdle rates have higher cash holdings.
 Such firms might be holding higher levels of cash to take advantage of future
opportunities, also known as growth options.
Corporate Nudge?
 Some managers set high hurdle rates to compensate for excessively optimistic project
cash flow forecasts.
 Just under 10% of survey respondents strongly agree that they adjust their discount
rates upward for this reason.
 The evidence suggests the strong presence of optimism among entrepreneurs, a
feature that is important because historically, the returns to entrepreneurial activity
have been inferior.
Value Expressive Benefits
 Nonpecuniary benefits can compensate for inferior financial benefits.
 One benefit pertains to value expressive activities, which allow entrepreneurs to
express their personal values such as working on “clean technology.”
Corporate Nudges
 To relate risk to expected return, carefully identify both the base rate information and
the singular information.
  Use statistical forecasting techniques, and contrast the outcomes with forecasts based
on intuitive judgments.
 Based on the contrast, ascertain whether the intuitive judgments fail to make
appropriate use of either the base rate information or the singular information.
Summary
 The influence of representativeness can be discerned in managers’ judgments on risk
and return, both at the aggregate level and the individual level.
 CFOs exhibit hot hand fallacy for a one-year forecast horizon but gambler’s fallacy
for a 10-year forecast horizon.
 CFOs’ judgments of the market risk premium are positively related to market
sentiment.
 However, long-term realized returns are negatively related to market
sentiment, not positively related.
 The relationship between CFOs’ mean 10-year forecast of the market risk premium
and future volatility is weak, but positive.
 The relation between 10-year forecasted returns and volatility is negative.
 CFOs state that they largely rely on the CAPM, and do not take into account factors
associated with book-to-market equity and momentum.
 The majority of CFOs indicate that they do not adjust project discount rates to reflect
risk, which runs counter to the prescriptions of the CAPM.
 Discount rates are often chosen to be higher than the firm’s cost of capital.