Little Pirates

This chart is a nice simple illustration as to why an investment advisor might be drawn into pitching a higher risk portfolio.  All you need to do is offer him a bonus if the portfolio performs particularly well.  This creates an incentive for him to offer you investments drawn from the blue portfolio v.s. the green portfolio.

This chart is lifted from this provocative paper: “Low Risk Stocks Outperform within All Observable Markets.”  It’s role in the paper is to argue that this incentive, the tendency of advisors to prefer the blue to the green portfolios, leads to high prices for the blue stocks.  Thus they become overvalued and lousy investments.

What I find interesting about that is how complementary it is to my theory of Capitalism as the direct decedent of Piracy.  E.g. here we have agency effects creating an incentive for the investment advisor to put his client into more volatile (riskier?) investments, but thru the wonders of agency (aka limited liability) he bears on downside for that.

ht: Bob Wyman.

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