Investment Approach for Positive and Negative Skewness - Coursework Example

Investment Approach for Positive and Negative Skewness Name Institution Introduction It is well established that when individuals are considering prospects for investments, they prefer opportunities that are more positively skewed. Prior research has shown that investors have a preference for positively skewed stocks than negatively or less positively skewed stocks. The basic intuition in investors is that any increase in Skewness leads to a decrease in the chances of low or negative returns (Eichner & Wagener, 2015). As a result, investors apply a higher valuation to such stocks. The investors are willing to pay a premium due to the opportunity of gaining a higher return. This paper looks at the literature supporting the position that investors have a preference for stocks which are positively skewed compared to those that are negatively skewed. Further, the paper looks at the investment approach that an institutional investor would take when investing on behalf of a client who do not have the preference for positively skewed stocks or investments. Investors Preference for Positive Skewness Skewness is considered as the third moment of returns. It refers to the measurement of the extent to which return distribution of stocks is asymmetric. This is done through a comparison of a normal distribution that has zero skewness (Omed &Song, 2014). Skewness can either be positive or negative. Positive skewness refers to a situation where the distribution has a longer right tail showing probability for extremely high gains. Negative skewness, on the other hand, refers to a distribution that has a longer left tail, meaning that there is a probability of high losses. Research has shown that investors have a preference for investments that have positive skewness. As a result of this preference, investors tend to overinvest in the securities or assets that are highly skewed (Lazos et al., 2016). According to Kumar (2009), there is a potential role of gambling in investment decisions. The overemphasis on stocks that have positive skewness by investors is likened to the gambling experience where gamblers take large chances of a small loss of a small opportunity for a large gain. The markets have always been associated with risks and uncertainties. As a result, investors tend to prefer situations where there is a higher likelihood that there will be gains. Though the stock markets are volatile and unpredictable, the volatility of the markets is more associated with the investors rather than the market itself. Emotions and perceptions of investors, which are the drivers of greed and fear in the financial system, govern the concept of returns in the market. These factors make the markets more unpredictable leading to the emphasis by investors on securities that seem to have a high probability of returns (Bogle, 2008). The preference for positively skewed stocks by investors can be explained by the fact that human beings believe in what makes them happy and, therefore, are driven to make decisions that may give them good outcomes in the future (Guidolin & Timmermann, 2007). Investors are more concerned about the future utility flows that are expected. As a result, they will are inclined to overestimate the probabilities for their investments giving them higher returns. The preference for positively skewed stocks is also associated with lotteries which explain why investors would take the chance to invest in a small opportunity for very large gains (Omed &Song, 2014). The pursuit for stocks with a positive skewness by investors also arises from the need to maintain positively skewed portfolios. Investors prefer those assets that give them high returns even in volatile markets because they also make their portfolios more positively skewed. Due to this characteristic of such assets, investors will, therefore, be willing to pay more for them (Ilmanen, 2012). Proposed Investment Approach As stated above, investors prefer stocks that are right-skewed as opposed to those that are left-skewed because they portray a positive portfolio. This means that assets that have the effect of decreasing a portfolio’s skewness are less desirable to investors. However, such assets that are less desirable command higher expected returns than those that have positive skewness. The assets that increase a portfolio’s skewness, on the other hand, have lower expected returns (Harvey & Siddique, 2000). According to Ilmanen (2012), financial markets have certain strategies employed by investors that resemble insurance or lotteries. Investors who prefer opportunities that have a positive skewness are considered to follow a pattern of over-weighting of low-probability events. Investors are attracted to investment opportunities that are lottery-like with positively skewed returns because there is a chance for a large pay-off irrespective of the small probability that exists for such a payoff. Investors over-weight such probability leading to an increased demand for the assets. As a result, the assets become overpriced making it likely that the investors will earn low returns. There is evidence that suggests that a negative relationship exists between skewness and investment returns (Ilmanen, 2012). Investors that seek positive skewness are likely to have poor returns as is similar to most lottery tickets. Though the investments with positive skewness have a potentially small likelihood for large gains, the investor may lose more before achieving the “great win.” Investors who display a direct preference for positive skewness are willing to sacrifice the mean-variance efficiency to ensure that they gain skewness. Such investors, therefore, deliberately under-diversify because diversification reduces skewness (Ilmanen, 2012). The pursuit for positive skewness has been associated more with individual investors as compared to institutional investors. In situations where the client for an institutional investor does not have the positive or negative preferences, the investor can choose to follow diversification as an investment approach. Investors who have a preference for positive skewness will usually hold portfolios that have fewer securities to eliminate the occurrence of risks. Research has shown that a considerable number of investors have not more than five stocks in their portfolios. Some of these investors have only one stock in their portfolios (Mitton & Vorkink, 2004). This is despite the fact that standard portfolio theory states that such underdiversified investors accept unnecessary high return volatility without any compensation. One of the benefits of a diversification approach to investment is the fact that the approach reduces unsystematic risk. This method is, however, not compatible with the focus on skewness for investors. Though diversification has the ability to reduce the risks involved in investment opportunities, it also has the effect of reducing skewness. This means that since the client, in this case, does not favor a preference for positive skewness; the diversification approach would be appropriate. When the size of the portfolio increases as a result of the application of the diversification approach, the portfolio variance reduces, and the expected losses become smaller (Hueng & Yau, 2006). The choice of the diversification approach to investment would ensure that the chances of losses from the stocks that the institutional investor would invest in are minimal. The goal of an investor who needs to decrease variance and extreme losses would be to have a diversified portfolio. Since the client does not have a preference for positive skewness, the investor can ensure that the risk of extreme losses is eliminated by adopting the diversification approach. The preference for positive skewness by investors arises from the desire to increase the upside potential of the investment. However, most investors are not able to effectively weigh the downside risks of an investment with the upside potential. Though the upside potential for skewness is higher than that of a diversified portfolio, the risk of loss is also larger (Hueng & Yau, 2006). One of the disadvantages of a diversified portfolio is the fact that there are a higher transaction and information cost due to the many stocks involved. However, this disadvantage is experienced by individual investors. Institutional investors have the personnel and the funds to handle large portfolios hence the diversification portfolio would be best suited. Conclusion Investors have a preference for positive skewness as compared to negative skewness. Human beings are more comfortable in situations that assure them of some future benefit or gains as opposed to situations where there is a great likelihood for losses. The preference for positive skewness arises from the fact that such investments have the potential, though small, for large gains. The fact that these investors insist on skewness means that the number of stocks in their portfolios is also low. An investor who desires higher skewness has to choose to have a less-diversified portfolio which assures them of a large payout. In instances where a client of an institutional investor does not have the preference for positive skewness, the investor can choose the diversification approach. This investment approach allows him/her to reduce the variance and also reduce the instances of loss. The investor can have more stocks in the portfolio. References Bogle, J.C., (2008), ‘Black Monday and Black Swans’, Financial Analysts Journal, Vol. 64, No. 2, March / April, pp. 30-40. Harvey, C. and A. Siddique, (2000), ‘Conditional Skewness in Asset Pricing Tests’, Journal of Finance, Vol. 55, No. 3, June, pp. 1263 –1296. Ilmanen, A., (2012), ‘Do Financial Markets Reward Buying or Selling Insurance and Lottery Tickets?’ Financial Analysts Journal, Vol. 68, No. 5, pp. 26-36. Kumar, A., (2009), ‘Who Gambles in the Stock Market?’ Journal of Finance, Vol. 64, No. 4, August, pp. 1889-1933. Mitton, T. & Vorkink, K. (2004). Equilibrium under diversification and the preference for skewness. Brigham Young University. Eichner, T. & Wagener, A. (2015). Increases in skewness and three-moment preferences. Institute of Social Policy, University of Hannover. Hueng, J. & Yau, R. (2006). Investor preferences and portfolio selection: Is diversification an appropriate strategy? Department of Economics, Western Michigan University. Omed, A. & Song, J. (2014). Investors’ pursuit of positive skewness in stock returns. University of Gothenburg. Lazos, A., Coakley, J. & Liu, X. (2016). Investor heterogeneity, sentiment and skewness preference in the options market. Essex Business School, University of Essex. Guidolin, M. & Timmermann, A. (2007). International asset allocation under regime switching, skew and kurtosis preferences. 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