4 Research Papers You Should Read In The Money By Zerodha

You know there’s a particular kind of snobbery that exists among market participants like us. I include myself there. It goes something like this. We think academics live in ivory towers or their own bubbles. They build elegant models and grand theories that assume investors are rational, markets are frictionless and perfect information exists. And then there is the messy real world which only we as practitioners understand. And look, I get where that line of thinking comes from. there’s enough evidence to support it. Theories and models that failed spectacularly. Ideas that ignored human behavior entirely. Equations that worked on paper and then blew up in practice. But here’s what I’ve come to believe after spending years in this business. That view, while not entirely wrong, misses something very important. If you ask the question, where do truly original pathbreaking ideas originate from? The ones that didn’t just describe markets but fundamentally changed how we understand them. Almost without exception, the answer usually is academia. But yes, it takes time, sometimes decades, the idea starts in a research paper, gets picked up by practitioners, get tested in the real world, gets refined, gets argued about, and then eventually becomes a framework inside which all of us operate. Over time, we become oblivious of this process. Now, I’m not saying the flow doesn’t happen the other way around. Sometimes ideas do originate from practice as well, and academia picks them up and reasons them out. The most part-breaking recent example is what is known as the transformer paper titled attention is all you need, which explains the algorithm underlying all the LLMs we use today. It was co-authored by eight Google engineers. In closer home, a lot of edges that play out in our markets, the often debated intraday straddle selling for instance. I’m still waiting for academia to explain that one. But more often than not, when the world of practice thinks they came up with an original idea, it’s usually a case of not knowing the fact that it was long discussed in some obscure paper. So, back to my quest of understanding capital markets better. years ago when I started asking fundamental questions. Why should equities give us a return above bonds over the long run? What are the genuinely prone ways of generating alpha over a benchmark? Is there a systematic edge in selling options? I kept finding myself going back to the same place, academic research. Explanations by fund managers and others just wouldn’t cut it. Again, not all academic research is useful. A lot of it is irrelevant, impenetrable, or just junk. But some of it, a relatively small number of papers, changed everything. They changed how markets are built, how portfolios are constructed, how risk is measured, and how traders actually think about an edge. In this episode, I want to share some of those papers with you. The ideas they talk about, and more importantly, what those ideas mean for you as an investor and as a trader. We’re going to cover four key papers today under the theme how markets work. I would later do papers on how prices move and how human behavior shapes both. I’m your host Sepra and these are the four papers about how markets work. Before we get into the paper, let me take a moment to answer a question that might already be bothering you. What exactly is a research paper? And how is that different from books that we usually talk about? You see, a book is written for an audience, usually a large audience. The author has an idea, a story or a point of view, and they spend 200, 300 pages making you understand it, believe it, and remember it. There’s a narrative to it. Usually, a research paper is a different beast. It’s written for other researchers. It’s typically 20 to 40 pages long. It starts with a question, describes exactly how the author tried to answer it, that is the methods used. It shows you the data, runs the numbers, and states what the numbers say. Then other researchers from the same space try to pull it apart. This last part is key. That’s what is called a peer review process. A book can say almost anything and get away with it. A research paper has to survive peer review, meaning other experts in the field read it, challenge the methodology, question the conclusions, and decide whether it’s worth publishing at all. It’s a brutal process. Most papers don’t make it. The ones that do, and especially the ones that get cited thousands of times by other researchers are the ones where the idea was strong enough to survive that scrutiny of experts and useful enough that the rest of the field kept building on top of it. Those are the kind of papers we are going to talk about today. Not papers that were published because some prof in some corner of the world had to do it to hold on to their jobs, but papers that became foundational ones that significantly added to the understanding of the space. Lastly, all published papers have a unique identifier what is called a DOI, digital object identifier. You will find that in the show notes for each of the papers that we talk about. The set of papers I’m going to talk about today focus on the questions how markets actually work, how risk and return are connected and how prices reflect information and what really drives the differences in returns across stocks. The first paper is portfolio selection by Harry Makowitz published in 1952 in the journal of finance. You see before this paper was published the conventional wisdom was to find the best stocks and put all your money there. Marowit said that is gambling not investing. His insight was that risk is measurable. It is the variance of your returns and that two individually risky stocks can reduce each other’s risk if they don’t move in lock step. As he writes in the paper, it is necessary to avoid investing in securities with high covariances among themselves. we should diversify across industries because firms in different industries have lower co-variances than firms within an industry. This gave us the concept of efficient frontier. The idea that for any level of risk, there is an optimal portfolio that maximizes return. It also gave us what many consider is the only free lunch in the world of investing. That is diversification. Marowitz won the Nobel Prize for his work in 1990. 38 years after the paper was published. The second paper is capital asset prices a theory of market equilibrium under conditions of risk by William Sharp published in 1964 in the journal of finance. So Marowitz taught us how to build an efficient portfolio. Sharp answered the question why do some assets give higher returns than others? His answer because they carry more of a specific kind of risk. The kind you cannot get rid of no matter how well you diversify. Think of it this way. Some risk is avoidable. If you own just one stock and it does badly, that’s your problem. You could have spread that money across other stocks and reduce the risk. The market doesn’t pay you extra for being careless. But some risk is unavoidable. When the market crashes and every stock falls, there is no portfolio construction that will protect you from that. So in a way the market has to compensate you for bearing that market risk. That compensation is what shows up as higher expected returns from equities. Sharp called market risk as unavoidable risk or systematic risk. And he gave us a number to measure how much of it any given stock carries that is beta. Stock with a beta of one moves in line with the market. A beta of two means it moves twice as much. A beta of 0.5 means it barely moves. The higher the beta, the more systematic risk you are carrying and therefore the higher the return the stock or the portfolio should give you in theory. So sharps capm in one line is this. Your expected return is the risk-free rate plus stocks or portfolio’s excess return multiplied by beta. Sharp shared the Nobel Prize with Marowitz in 1990. While this idea is simple and elegant, later papers would show it is incomplete. The third paper is efficient capital markets part two by Eugene Farmer published in 1991 in the journal of finance. Note the title. This is a sequel. Farmer had written the original efficient capital market paper in 1970 which laid out the three forms of market efficiency. 21 years later, he came back to review what the evidence had actually shown. He opens the paper with characteristic self-awareness. As he writes in the paper, sequels are rarely as good as the originals. So I approach this review with trepidition. The core idea remains intact. Security prices fully reflect all available information. But the conclusion of this paper is way more complicated. Farmer states that returns are in fact somewhat predictable from past returns, from dividend yields, from interest rate spreads, etc. This is really awkward coming from a strong efficiency believer like farmer. Farmer’s response to the holes in his own theory is interesting. He says just because you can predict returns doesn’t mean markets are inefficient. To prove inefficiency, you need a model to define what the correct or ideal returns should be. Then he says all such models are imperfect. So when we pick an instance and say that the market is inefficient, he says how do we know if the market is actually inefficient or is the model wrong. He called this the joint hypothesis problem. Critics called it a convenient escape hatch and I am with the critics. Schiller makes a sharp counterargument. He points out that stock prices are far more volatile than the dividends that are supposed to ride them. Think about it this way. If a company pays a steady predictable dividend year after year, its stock price should be relatively stable too. But we know that’s not what happens. Prices swing badly even when nothing fundamentally has changed. Still’s argument is that kind of volatility doesn’t look like rational risk assessment of an efficient market. It looks more like crowd behavior. The debate between farmer and Schilla became so central to the field that they were awarded the Nobel Prize together in 2013 which is arguably the most awkward joint Nobel in history given that they fundamentally disagree on whether markets are efficient and rational. What Farmer’s second paper gave traders and investors is an honest nuanced version of the efficiency idea. Not that markets are perfectly efficient but that beating them consistently after cost remains extraordinarily difficult which I think is the right way to look at it. The fourth paper is the cross-section of expected stock returns by Eugene Farmer and Kenneth French published in 1992 in the journal of finance. This paper challenges everything Sharp said about beta that is how much a stock moves relative to the market is what drives returns. Farmer and French ran the data from 1963 to 1990 and found something very different. Beta had almost no explanatory power as they put it in the paper. Market beta seems to have no role in explaining the average returns on NYC, MX and NASDAQ stocks for 1963 to 1990 period. What actually explained returns were two very different variables. The size of the company and the ratio of its book value to its market value. Similar to price to book value ratio. Small companies outperformed large ones. And cheap companies, those priced low relative to their book value, outperformed expensive ones. This paper is the foundation of what became factor investing, especially size and value factors. And it raised a question that still hasn’t been fully settled yet. Are these factors a reward for real risk? That is the risk that comes with buying into small-s size companies or buying stocks with low value. Or is it that markets mispric these stocks? Pause and think about it for a moment. This is a profound question. Pharma leans towards the former and the likes of Tala that is the behavioral economist lean towards the latter explanation. So to quickly summarize what we covered today, Marowitz showed us that risk is measurable and that diversification is the only free lunch in investing. William Sharp gave us beta, a way to price systematic risk that cannot be diversified away. Then Farmer told us markets are hard to beat, though he was honest enough to admit his own theory has cracks. And lastly, farmer in French showed us that the simple variables of size and value explain stock returns far better than beta did. Four papers and about 70 years of finance compressed into one episode. And that brings me to the end of this episode on key research papers, part one of it. That is I hope you found this episode useful. If you have any questions, feel free to drop them in the comments. I’ll be happy to respond. Till then, take care and trade safe and I’ll be back with the next one.