Should Good Stocks Have High Prices or High Returns?

Using a design involving a between-subjects experimental manipulation, this study surveyed 742 Finnish financial advisers about requiring a risk premium in one mode and about expected returns in the other mode. Company-level risk factors (e.g., leverage) caused an increased return requirement in the first mode but led to lower return expectations in the second mode. Sensitivity to the form of the question revealed an inconsistency in the advisers’ perception of risk and return. Advisers seemed to associate safe stocks with relatively lower discount rates (and thus higher valuations) but also with higher return expectations. This inconsistency may contribute to the overpricing and subsequent inferior performance of glamour stocks. Giving consistent advice is a necessary condition for providing valuable client service. Investors often expect “good” companies to deliver above average returns (where “good” can be variously defined). Asset-pricing theory, however, says that any “good” characteristic that is priced by the market (e.g., low leverage) is associated with lower, not higher, return expectations. Empirically, stocks commonly deemed good do not seem to provide superior returns and, indeed, may provide inferior returns.Do market participants rationally choose to hold beliefs that go against both asset-pricing theory and empirical evidence? Or are they confused by the logic of risk and return? In the latter case, their preferences and expectations might be unstable and could reverse as a result of manipulating the way that the question is posed.To test our hypothesis of labile expectations, we studied financial advisers’ perceptions of company characteristics and expected returns. We sent an online survey to Finnish professional investment advisers and obtained 742 responses (representing a 68 percent response rate). We used a between-subjects experimental manipulation. In one experimental mode (the expected returns mode), we asked about the impact of a set of company characteristics on return expectations. In the other mode (the required returns mode), we asked whether the respondents would require higher returns given a particular company characteristic: leverage, growth prospects, stock liquidity, or analyst following.We found that the advisers expected poor stocks to provide low returns and good stocks to provide high returns. At the same time, in the other experimental mode, the majority of advisers associated all the poor stock characteristics with risk and required higher returns for bearing that risk. For example, 86 percent of the advisers in the required returns mode required a risk premium for investing in highly leveraged companies but only 13 percent of the advisers in the expected returns mode expected such companies to provide higher returns. Furthermore, an overwhelming 68 percent of the advisers in the expected returns mode expected such companies to provide lower returns. These results show that advisers expect good stocks to have high prices (low discount rates) and high future returns at the same time.These inconsistent expectations may contribute to the overpricing and subsequent inferior performance of glamour stocks: Requiring less of a risk premium for such stocks boosts current prices; but at the same time, expecting higher returns sets the stage for future disappointments. More generally, the value added from advice may be compromised if the advisers are subject to the same biases as the individual investors. Giving consistent advice is a necessary condition for providing valuable client service.