Even in these roller coaster financial times, Associate Professor Joseph Chen believes it is possible to make sense of Wall Street. Chen’s research reveals that stock market returns behave asymmetrically: for instance, they are more likely to make extreme moves on the downside than on the upside, and when markets go down, different stocks are more likely to move down together than when markets move up.This lopsidedness implies, says Chen, that portfolio diversification provides the least amount of protection precisely when it is most needed, because there are fewer places to hide when markets collapse.
However, Chen’s work also shows that investors are rewarded over time for taking these market risks. In fact, much of the stock market’s reward-to-risk tradeoff comes from exposures to downside risk rather than to upside potential. Chen also looks at how exposure to market risk varies over time, and investigates when extreme moves, such as stock market crashes, are more likely.
In another line of research, Chen is exploring the effects of company organizational structures in the portfolio management industry. He documents that mutual fund families exhibit increasing returns to scale, and that larger families outperform smaller ones because they can spread their fixed expenses over a wider asset base. However, Chen has also found that mutual funds themselves exhibit decreasing returns to scale, and smaller funds can better concentrate their portfolios into their best stock picks, and thus outperform larger funds. This effect is strongest for mutual funds investing in small illiquid stocks: mutual funds whose day-to-day management is outsourced to an external adviser tend to underperform internally managed funds.
Chen completed his Ph.D. at Stanford University and also holds a Chartered Financial Analyst designation. He earned a master’s in statistics at Stanford and a master’s in economics and mathematics at Yale University. In the mid-1990s he worked on Wall Street as a proprietary arbitrage trader of international equity derivatives at Bear Stearns. Before joining the Graduate School of Management, Chen was on the faculty at the University of Southern California and was a visiting assistant professor at the Massachusetts Institute of Technology.