This past weekend my wife and I ventured out to a sushi place nearby for date night. Depending on the neighborhood you’re in and the time of day, parking in the city of Chicago can range from mild annoyance to excruciating pain. It’s not often I get compared to George Costanza (at least to my face), but when it comes to parking he is pretty much my spirit animal.
The fact that it was St. Patrick’s Day only compounded my already low expectations for finding a good spot. We were running a few minutes late as is, and as approached the restaurant my anxiety seemed all but confirmed…or was it?
After our second loop around the block, we once again went by what appeared on our first drive-by to be an “off limits” stretch of open spots lining the street less than a block from the restaurant. There were construction cones nearby and the adjacent streetlights had several NO PARKING signs tied to them. Upon further inspection, however, my wife noticed that the fine print on those signs said parking was only prohibited until 4 PM each day. Alas, we had our spot!
But still, I remained skeptical and channeled my inner Gene Fama. Surely this was no free lunch (or dinner in this case), right? There had to be SOME reason for the existence of this premium in the form of a parking spot. Back to this in a moment…
Practitioners of factor-based investing tend to attribute the existence of historical return premiums – and the confidence they will continue to exist in the future – to one or more of the following three explanations:
- Compensation for bearing rewarded risk: The most intuitive and obvious explanation is that investors require additional expected return for assuming additional risk.
- Persistent and exploitable behavioral biases: We’re all human, and it is those basic human instincts that leave us ill-equipped at times to behave (and invest) rationally.
- Structural impediments facing market participants: One investor’s limitations or restrictions can be another investor’s opportunities.
Going back to my parking experience from Saturday night, all three of the above are plausible explanations to consider whenever you come across a “too good to be true” parking spot:
- Compensation for bearing rewarded risk: Maybe the NO PARKING signs would have been for 24 hours a day. Maybe there was a fire hydrant in proximity. Maybe this was a residential parking zone that required a permit. Sure, we still could have parked there in those cases, but it would have been a risky move on our part to do so as our likelihood of receiving a ticket would have been rather high. In other words, it better be a damn good spot (expected return) to bear that sort of risk.
- Persistent and exploitable behavioral biases: It may seem odd, but perhaps the very fact that other cars weren’t parking there led people driving by to make the assumption that those open spots were indeed a mirage. The nearby construction cones and appearance of signs on the light posts may have signaled to their brains that these spots were off limits. We apply heuristics every day in our lives to solve problems quickly even when more complete and precise solutions exist. The driver aware of these behavioral foibles might have the awareness to explore the situation further.
- Structural impediments facing market participants: Imagine instead of several open spots, there was just one spot. We’ve all had the experience of coming across a spot that is just a tad too small to squeeze into. Either our car is too big for it or we lack the requisite confidence in our own parallel parking abilities. In this instance, the size of the spot itself is an impediment to us but could be an opportunity for another driver that either owns a Mini Cooper or works as a vehicular stuntman.
It’s fun – and admittedly nerdy – to come across real world parallels to different investing concepts. The takeaway here is that regardless of whether it’s your portfolio or real life, being rewarded feels good. But it’s also important to gain an appreciation for risk, human behavior and personal limitations Understanding these drivers of return may help distinguish between those rewards that may be repeated in the future and those that are simply attributable to another common – though not reliably persistent – source of excess return: pure dumb luck.