Via The Aleph Blog:
I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:
- Beta is not a stable parameter; also, it does not measure risk well.
- Company-specific risk is significant, and varies a great deal. The effects on a company with a large amount of debt financing is significant.
What did they do in the old days? They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks. If less scientific, it was probably more accurate than MPT. Science is often ill-applied to what may be an art. Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.
I’ve also never been a fan of the Modigliani-Miller irrelevance theorems. They are true in fair weather, but not in foul weather. The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency. The cost of financing assets goes up dramatically when a company needs financing in bad times.
Read the full post here
Via The Curious Capitalist:
Eugene Fama said that in order to test whether markets were efficient in this sense you needed an economic theory of how prices were determined. He chose the Capital Asset Pricing Model, devised a few years before by Jack Treynor, Bill Sharpe and John Lintner. It said risky stocks would outperform less-risky ones, with the risk that mattered being something called beta—the correlation of a stock’s movements to those of the overall market.
Roll started pointing out issues with CAPM in the 1970s, and Fama and French concluded in 1992 that the conjunction of CAPM and the EMH simply didn’t match the data. They chose to jettison CAPM, not the EMH (Fischer Black made more or less the opposite choice). But without an economic theory of how stock prices should move, there’s no way of testing the claim that markets are efficient in the “price is right” sense. Pricing models like the arbitrage pricing theory or the Fama-French factor models simply assume that prices are right, then extrapolate from that what the relevant risk factors must be that determine prices. But this assumption that prices are right is now based on no empirical evidence at all. In fact, both Fama and Roll have said that there’s just no way to tell whether prices are right or not.
That leaves us with an efficient market hypothesis that merely claims, as John Cochrane puts it, that “nobody can tell where markets are going.” This is an okay theory, and one that has held up reasonably well—although there are well-documented exceptions such as the value and momentum effects. But if “we can’t tell where the markets are going” was all the finance professors had to offer, they wouldn’t have had much influence.
The price-is-right combo of EMH and CAPM allowed finance professors to say much more than “we dunno.” They may not have known exactly where a stock’s price was headed, but thanks to CAPM they could confidently predict the bounds within which it would move. Thus armed they went on to conquer the world, eventually transforming MBA curricula, legal thinking, corporate governance, financial regulation and many aspects of investment practice. It’s admirable that finance scholars—especially Fama, since it was his theory in the first place—kept sniffing around and eventually concluded that the EMH/CAPM combo didn’t match the evidence. It’s not so great that some of them now pretend that the price-is-right version of the efficient market hypothesis never existed, and fail to fully confront what its demise means for a lot of the other things taught in finance and investment classes.
Read the full post here
John Kay writing in the FT:
As anyone who has taken Finance 101 knows, there are three versions of the efficient market hypothesis. The strong version claims that everything you might know about the value of securities is “in the price”. It is closely bound up with the idea of rational expectations, whose implications have dominated macroeconomics for 30 years. Policy interventions are mostly futile, monetary policy should follow simple rigid rules, market prices are a considered reflection of fundamental values and there can be no such things as asset-price bubbles.
These claims are not just empirically false but contain inherent contradictions. If prices reflect all available information, why would anyone trouble to obtain the information they reflect? If markets are informationally efficient, why is there so much trade between people who take different views of the same future? If the theory were true, the activities it purports to explain would barely exist.
Yet although efficient market theory is not true, it may nevertheless be illuminating. The absurdities of rational expectations come from the physics envy of many economists, who mistake occasional insights for universal truths. Economic models are illustrations and metaphors, and cannot be comprehensive descriptions even of the part of the world they describe. There is plenty to be learnt from the theory if you do not take it too seriously – and, like Mr Buffett, focus on the infrequent inefficiency rather than the frequent efficiency.
…The strong version of the efficient market hypothesis is popular because the world it describes is free of extraneous social, political and cultural influences. Yet if reality were shaped by beliefs about the world, not only would we need to investigate how beliefs are formed and influenced – something economists do not want to do – but models and predictions would be contingent on these beliefs. Of course, models and predictions are so contingent, and an understanding of how beliefs form is indispensable. Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies. The future of investing – and economics – lies in that more eclectic vision.
Read the full article here
Further reading: Culture and Prosperity: Why Some Nations Are Rich but Most Remain Poor
Via Abnormal Returns:
One of the tenets of modern portfolio management most damaged due to the financial crisis has been asset allocation. We have discussed how during a bear market correlations tend to one, the myth of the all-weather portfolio and how investors may need a more dynamic approach to asset allocation. It seems we are not alone in our opinion(s).
Noted finance professor Andrew Lo of MIT has a piece in the Financial Times discussing how the practice of portfolio management has been upturned in part due to the financial crisis – asset allocation included. While we recommend you read the entire piece, the bottom line is that the investment world is now much more complicated post-crisis. Lo writes:
Diversification is still a good idea, but it has become much harder to achieve. Thanks to the increasing competition for additional yield, every type of investment vehicle and strategy has experienced substantial growth in assets under management.
The asset classes (and dynamic) strategies that have been touted as portfolio diversifiers have seen an influx of capital and managers. Lo cites the case of the “carry trade” that has become popular enough to have spawned an ETF that follows the strategy.
Read the full post here
Via Abnormal Returns:
For quite some time now financial advisers of all stripes have been in search of the elusive “all-weather portfolio.” That is, an asset allocation that serves to protect investors in bad times (bear markets) and performs well in good times (bull markets). Does an all-weather portfolio really exist?
Prior to the economic crisis many would have answered in the affirmative and would have pointed to the large university endowment funds as examples of investors who had achieved this goal. However the aftermath of the credit crisis and ensuing bear market indicate these funds have failed to achieve this goal.
Maybe it isn’t that case that asset allocation models are broken. It may simply be the case that we are asking too much of asset allocation as a discipline. In what other investing endeavor do we expect to have the best of all possible worlds?
Read the full article here
From the Financial Times:
Broker stock picks can help investors outperform most mutual funds, research by one of the largest hedge funds has suggested.
While most asset managers have long dismissed analysts’ recommendations as anything but reliable, traders and academics at GLG – the $21.5bn London hedge fund manager – have found otherwise.
Based on a database of the daily recommendations it received from European brokers for the past four years, the hedge fund found that a portfolio following analysts’ tips, and holding them for three months, would outperform 75 per cent of mutual funds.
Such a portfolio delivered annualised returns of between 2.8 per cent and 6.4 per cent above benchmarks and after fees in each of those four years.
GLG said the research was some of the first to be conducted into the value of equity analysts’ calls since the scandals and subsequent reforms that rocked brokerages after the telecoms and tech bubble.
“When you look at the returns the average active manager tries to beat benchmarks by, we think the outperformance of recommendations is reasonably good,” said Sandy Rattray, an asset manager at the fund.
GLG’s findings were based on all the recommendations from salespeople at a range of European brokerages it had received since 2005, based on a single daily “pick” given to the fund from each.
Read the full story here
This article ran in Fortune in 2002. If you never read it before, you should. If you have read it, it’s worth your time to read it again. It’s written by Justin Fox. He went to the University of Chicago to talk to Efficient Markets guru Eugene Fama and behavioral economist Richard Thaler. You can read the exchange below. Also, from this article, Justin wrote a recently published book that you should read. It’s called The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street
Is The Market Rational? No, say the experts. But neither are you–so don’t go thinking you can outsmart it.
By Justin Fox
December 9, 2002
Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control–costs–and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name “efficient markets.”
“In an efficient market,” wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, “prices ‘fully reflect’ available information.” That is, in an efficient market you can’t beat the market unless you have inside information. So why bother trying?
That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).
Meanwhile, back on campus, a new generation of finance professors has been ripping Fama’s teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.
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Tags: behavioral finance, EMH, emotions, investing, MPT, portfolio-management
EMH, behavioral finance, capital-markets, investing, portfolio-management | Graham | 
Tuesday, September 8, 2009 10:24 pm | 
Comments (1)
These are two great quotes from Arthur Zeikel. Read these and truly think about them.
“Thinking, good thinking that is, is a lonely sport. This may explain why so many of us do it so poorly. Good thinking is also an inefficient process. It takes a lot of thinking to come up with those few good, new ideas that are clearly worth thinking about – ideas that can be exploited in the marketplace. Particularly, as Seldon so accurately noted in 1912, ‘Most coming events cast their shadow before, and it is on that intelligent speculation must be based.’
At the heart of the thinking process is the need to anticipate change correctly, and on a timely basis. Investment thinkers must develop for themselves a model, or systematic perception, as to how markets really work. Those believing strongly in the efficient market hypothesis are, of course, relieved of such undertakings. However, as is becoming increasingly clear, portfolio theory does not fully explain security price movements, either here or abroad, or tell us too much about how to achieve better-than-average performance. Most practitioners of active money management need to improve their thinking procedures.”
“The consensus view is usually wrong because it’s based on a more-or-less simple extrapolation of past trends and events and does not effectively incorporate change into expectations. Theory tells us that value-changing events occur in a random fashion and cannot be predicted with any accuracy or consistency. This is not so. There is a flow to the news because there is a flow to the events that make the news. Stock prices begin reflecting new developments before it is generally recognized that these developments have taken place.”
This is a great article on investing by Dr. Scott Brown of Investment U.
For decades, economists and academics have tried to define exactly how the stock market works – and the best way to profit from its moves.
In the 1950s, one argument stated that short-term market activity results in the law of one price – i.e., that buying and selling mispriced shares of the same stock forces a single price to dominate.
Then came the “modern portfolio theory,” which claimed that investors simply couldn’t beat the market averages. This so-called “market efficiency theory” was the impetus behind the formation of the Vanguard 500 Index Fund (NYSE: VFINX) – the world’s largest mutual fund.
Score one for the stuffy “efficiency theorists.”
But while they congratulated each other over brandy and cigars, a little-known professor spoiled the party in the 1980s with a straightforward study that is still the driving force behind one of the most lucrative wealth-building approaches today…
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How Did We Get It So Wrong:
So how did we get it so wrong? How did we get here? Let’s go back to first principles: Ideas have consequences. And bad ideas tend to have bad consequences. We’ve taught two generations of financial managers theories that were patently absurd. Rob Arnott is going to be here later with us for the panel discussion. Rob recalls standing in front of 200 academics, professors in schools that teach economics. He asked them, “How many of you believe in the efficient market hypothesis?” Something like two or three raised their hands. “How many of you teach it?” All of them raised their hands.
We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. The classic line is from Ibbitson, is a brilliant professor and a brilliant mind, who said economics is a science. No it’s not. It’s barely an art form. It’s voodoo. That’s what we practice. We look at the entrails of the Wall Street Journal and try to predict the future. Sometimes it’s about as bloody as sheep entrails. CAPM… poor Harry Markowitz’s Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. I gave a speech at a big hedge fund conference about five years ago, talking about why Modern Portfolio Theory was not going to work. The next year it was the 50th anniversary of Modern Portfolio Theory, and they brought Harry out to speak. He of course talked about why it was. I remember meeting him in the hall of this big hotel. And I asked him a couple of questions; I forget what they were because he so staggered me with, “Oh, you missed the whole concept of correlation and assets. Correlations change.”
And he started drawing quadratic equations in the air. But because I was standing in front of him, he was drawing them backwards so I could see them. I mean, this guy is absolutely brilliant. But he’s right, you should have a diversified portfolio of noncorrelated assets; but as John was showing yesterday, correlations in a crisis all go to one.
What money managers did was to create models that said, “If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes — see what happens? You get long-term positive results.”
And they would project that into the future. But they didn’t project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?
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