Let us turn toward singleton stocks.
Many here are averse to holding a few singleton stocks. Why? History has shown that singleton stock returns are very often to be positively skewed (unlikely massive outperformance, but likely underperformance); also, history has shown that holding a large collection of stocks reduces both this skew and volatility. However, some still do hold singleton stocks. Why? If one supposes that expected returns do not differ and the volatility is higher; it would seem that holding singleton stocks is a bad choice. But why are some comfortable with the prospect of holding singletons? Two possibilities exist:
- They believe they can pick investments with a better expected return.
- They seek positive risk skew regardless of the returns.
I will leave research of this to the reader to find this skew.
Now, let us turn toward singleton high quality corporate bonds. It is more or less a repeat, so just note that the skew is negative in this case instead of positive.
Many here are averse to holding a few singleton high quality corporate bonds. Why? History has shown that holding a large collection of bonds reduces both skew and volatility. But here, singleton high quality corporate bond returns are very often to be negatively skewed (likely outperformance, but unlikely major underperformance). However, some still do hold singleton bonds. Why? If one supposes that expected returns do not differ and the volatility is higher; it would seem that holding singletons is a bad choice. But why are some comfortable with that prospect as well? Two possibilities exist:
- They believe they can pick investments with a better expected return.
- They seek negative risk skew regardless of the returns.
To illustrate this negative skew, suppose that one bond index fund has bonds that all have the same maturity, all have the same yield, and all have a default risk of 5% instantly (given independence, that is; but the argument is still reasonable). Suppose the fund closes after they all mature. Picking the index fund will likely give you about 95% of the yield and principal regardless by assumption. However, another investor buys only 5 such bonds and does the same. They have about a 77.38% chance of having no defaults, so they have about a 77.38% chance of outperformance. Massive underperformance is not the norm but it is possible.
So, let us talk about "play money". Aside from the fact that I detest the notion of risking money just for the fun of it, I understand it as money invested that deviates majorly from general indexes.
When we restrict ourselves to the primary indexes, we leave no room for adjustment for skew; we can really only modify expected return and volatility. To those not interested in or averse to skew, they can obtain a mostly efficient portfolio just by staying with these indexes.
So then there money invested to change the skew for the skew-seeking investors, and the optimal portfolio does not only stay in the indexes alone. It shows up as singleton stocks, singleton bonds, certain option strategies, bizarre investment alternatives, etc. When you consider investing with the acceptance of skew, you can definitely see why these deviations do occur.
Maybe this is a strange post, but I see that a lot of discussion can be explained by risk skew and the seeking for it.