Diversification, Adaptation, and Stock Market Valuation

It’s always worth reflecting on the most fundamental part of investment: risks and returns. Where do they come from? Why different assets have different risks and returns profile? This article explains the rationale behind these questions using the concept of “Lotto Shares”, and shows its implications on cost of capital and investments.

The observed hierarchy represents a puzzle for the efficient market hypothesis.  If markets are efficient, why do some asset classes end up being priced to deliver such large excess returns over others?  An efficient market is not supposed to allow investors to generate outsized returns by doing easy things.  Yet, historically, the market allowed investors to earn an extra 4% simply by choosing equities over long-term bonds, and an extra 2% simply by choosing small caps inside the equity space.  What was the rationale for that?

The usual answer given is risk.  Different types of assets expose investors to different levels of risk.  Risk requires compensation, which is paid in the form of a higher return.  The additional 4% that equity investors earned over bond investors did not come free, but represented payment for the increased risk that equity investing entails.  Likewise, the 2% bonus that small cap investors earned over the broad market was compensation for the greater risk associated with small companies.

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Source: Diversification, Adaptation, and Stock Market Valuation

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