One of my heroes, Professor Eugene F. Fama, recently won the Nobel Prize in Economics (along with professors Robert J. Shiller and Lars Peter Hansen). Mind you, I don’t have too many heroes. When I do, they’re usually the David (vs. Goliath) in some kind of a legal- or sports-related skirmish.
Dr. Fama is a different kind of hero. I consider him a mentor in my business and my life. He has helped me make sense of all the noise and confusion in the world of investing and has brought rhyme and reason to my wealth management practice. His work makes it possible to actually have an investment philosophy to put into practice.
Dr. Fama received the Nobel Prize this October, for his “empirical analysis of asset prices,” dating back to the 1960s. Sounds innocent enough. But his lifetime of work contributing to the subject of Modern Portfolio Theory – most notably the “Efficient Market Hypothesis” – landed him in the Pantheon alongside the likes of professors Harry Markowitz and William Sharpe, who shared the 1990 Nobel Prize in Economics for similar contributions.
It’s hard to imagine that in the decades before the work of these great men, billions of dollars were managed by trusts, pension funds and insurance companies without the benefit of the concepts and understandings we have gained during the past half-century.
Of course things were very different back then in ways most of us have forgotten or never knew. For example, there were no such things as IRAs and 401(k)s or, for that matter, much direct investing going on among the general public. Before the 1990s, when the laws governing fiduciary investing were changed to reflect changing times, many states had “legal lists” of securities that were the only ones institutions were permitted to trade on behalf of their beneficiaries. Most important, back in the day, investment professionals did not focus on portfolios as a whole, but on individual holdings in isolation; such as the shares of General Motors or US Treasury Bonds.
Compare it to the early days of flight, before there were sophisticated instruments to guide the way. This would have obligated even experienced pilots to fly strictly according to what they could see with the naked eye versus adopting a total flight plan.
Fortunately, just as the aeronautics industry has evolved, so too has our understanding of how to navigate with increased confidence in markets where conditions are often inclement.
In 1964, Dr. Sharpe published his first paper on the Capital Asset Pricing Model (CAPM). This model describes a number of simple, yet astounding, principles:
1) Company-specific risk is one thing – Individual securities are subject to company-specific risk (e.g., Apple stock will fall if the sales of IPhones fail to meet expectations)
2) Market risk is another thing – Portfolios of stocks are subject to “market” risk (macro level economic phenomena, such as inflation and unemployment; terrorist attacks; or the bankruptcy of a systemically important firm, like Lehman Brothers);
3) Some risk is avoidable, some isn’t – Critically, while some stocks may perform better than others, by owning a diversified portfolio of most of the stocks in a market, company-specific risk can be eliminated, leaving only the unavoidable market risk (which Sharpe labeled beta) to be managed.
The index fund was born, as a way to cost-effectively invest in most of the stocks in a market.
An equally important contribution of CAPM was that one could control the risk/return profile of an overall portfolio by combining a riskier stock portfolio (and the additional returns it was expected to produce) with as much exposure to risk-free Treasury Bills as one desired or needed.
The idea of the “balanced” portfolio was popularized.
Enter the “Efficient Market Hypothesis” (EMH)
If Dr. Sharpe indicated why it was too risky to try to “beat the market,” then Dr. Fama showed how it is nearly impossible to do so consistently.
What Dr. Fama theorized – and then set out to prove – is that the stock market is “informationally efficient.” That is, current prices immediately incorporate everything that is known about the economy and individual companies that traders could assess in making their decisions to buy and sell stocks.
The purpose of EMH – and subsequent empirical research – was to determine whether well-informed traders could gain enough edge in the market to consistently forecast future prices so they could successfully buy low and sell high.
So, what did we learn and what does this mean for investors?
Trading rules don’t work. Many investors rely on systems, newsletters and so-called technical analyses that purport to predict future price movements based on past price movements. “Buy Google when it’s gone up for three months.” But if today’s forward-looking price contains all the available information, how could it have any predictive value? The only facts that actually impact future prices are those that we don’t yet know. A legion of economists have researched these forecast-based systems and demonstrated they are not expected to perform any better than pure luck, and likely even worse after factoring in the costs involved.
Fundamental analysis is superfluous. Securities analysts the world over, with vast databases and powerful computers pore over company reports and pound the pavement looking for clues. Every day they make decisions to buy or sell shares based on this information, combining stocks into concentrated portfolios of companies they think will achieve returns greater than the “market” portfolio. But there are no secrets out there (unless one is an illegal trader using inside information) and all of that information – both positive and negative – is summed up in today’s prices.
So what good is it to hire a manager to try to outsmart these armies of smart and diligent analysts? The data is now overwhelming. Decades of empirical research demonstrate that while some managers beat their benchmarks some of the time; on average, after costs, most fail to beat the market most of the time. (Actually, this is a mathematical certainty.) And, it is impossible to identify in advance which ones will be successful.
From the 1960s through the 1990s, perplexed researchers realized that CAPM and beta do not entirely explain the differences in the returns of diversified portfolios. But in 1992, working with Dartmouth Professor Kenneth French, Dr. Fama was finally able to account for the differences in returns. In their paper, “The Cross-Section of Expected Stock Returns,” they demonstrated that, beyond just an expected market premium, size (small-cap outperforms large-cap) and value (value outperforms growth) also have an effect on returns. Thus, the Fama/French “Three Factor Model” was born.
Importantly, this model comports with CAPM in a crucial respect: small companies are riskier than large companies and value stocks (because of unreliable earnings and distressed balance sheets) can be seen as riskier than growth stocks.
As with most of life’s bonuses, there’s a catch. Both small and value stocks march to different drummers than the market as a whole, so maintaining a portfolio designed to capture these premiums requires an investor to be out of step with overall market swings, sometimes for long periods of time. That means, like a pilot on a long flight to a desired destination, you must be prepared to patiently remain on course across long, occasionally dark horizons, trusting your instruments and settings along the way.
So, if we aren’t in the forecasting business, what do we do? We build broad, globally diversified, multi-asset class portfolios; using low-cost, passive (index or index-like) mutual funds. We customize the portfolios to reflect individual goals and appetite for risk. Portfolios are periodically rebalanced back to their original allocations to help you stay on course. (As yet another bonus, rebalancing also helps you buy low and sell high in a disciplined manner. That’s a good subject for another article sometime.)
This evidence-based strategy – eschewing clever maneuvering skills – is often extremely counterintuitive and discomfiting to smart, hardworking people who have successfully utilized excellent reflexes in other parts of their lives.
To round out our flight analogy, think of it as similar to pilots needing to trust their reliable instruments even when (especially when) their base instincts are sending alternate commands. Investors who wish to take their portfolios the distance are advised to depend on the half-century of capital market evidence – compliments of professors Fama, French, Sharpe, Markowitz and other academic heroes – to guide their long-term way.
PS: You can observe Dr. Fama’s own modest perspective on his life’s work in this short video, “Fama – On Modern Finance.”