God is a Capitalist

Friday, May 30, 2014

The Famous Fama - Investing is Gambling

Eugene Fama, the 2013 Nobel prize winner in economics, a professor at University of Chicago and a director and consultant for Dimensional Fund Advisors, recently said at a conference,
 I have one word for you and you're not going to like it - chance.
Of course, Fama is famous for his support of the Efficient Market Hypothesis (EMH) which states that the stock market is so efficient at pricing new information that investors can never beat broad market indexes such as the S&P 500. Fama's advice to investors is, 
You decide how much you want to tilt to these [types of risks and] returns and then you diversify the hell out of it," Fama said. Choose your asset allocation and then make sure you get fully diversified portfolios that get you there.
Investors who followed Fama’s advice lost enormous sums in the market crashes of 2000 and 2008. So many “anomalies” in the EMH have popped up that they gave birth to a new industry called behavioral investing that insists investors are not rational and make many mistakes.

In the short run, say under three months, movements in the stock market are essentially random. In the very long run the market tends to converge to the net present value of future earnings (NPV). So in both periods the EMH is correct. But in the medium run, the market deviates a great deal from NPV, and thus supports behavioral investing theories.

Austrian economics untangles the confusions of both the EMH and behavioral investing for serious investors. A chapter in my book, Financial Bull Riding, goes into more detail about what is wrong with both the EMH and behavioral investing schools of thought. Short run deviations in the market, such as what day traders attempt to profit from, are impossible to predict, while the long run trajectory offered by NPV is highly subjective because the analyst must forecast earnings (very difficult) and choose a discount rate (constantly changing). 

However, the medium term market is fairly predictable because it follows profits closely and responds to the risk tolerance of investors. The value may diverge from the long term NPV, but that doesn’t mean investors are irrational as behavioral investing insists. Investor risk tolerance and knowledge changes over time depending on circumstances, mostly profit reports. I use quarterly corporate profits and price/earnings ratios in the forecasts I publish on this blog and the model explains about 70% of the change in the quarterly averages. For economic and financial models that is a good fit. 

In addition, Fama and most analysts look to the percent returns of indexes as the standard measure for investment performance. For example, if the S&P 500 is up one year by 10% then your investments had better return more than 10% or you have failed. But as I show in my book, hedge funds consistently fail at matching the S&P 500’s percentage returns, yet make their clients far more money than those clients would have made passively investing in an index. They can do that by avoiding large declines in the market, such as happened in 2000 and 2008.

Professors like Fama forget that compounded interest works against the investor in bear markets just as it works for him in bull markets. To recover from disasters like 2000 and 2008, investors need extraordinarily good returns in bull markets. For a simplistic example, assume the stock market fell 30% at the beginning of the year and stayed down the entire year. Not only has the investor lost 30%, but he has forgone interest he might have earned in bonds. Then the market going up 30% the next year will not recover his losses because his base is lower. He will need about a 60% increase in order to recover his lost investment plus opportunity costs.

The Wall Street Journal printed a critique of hedge funds in the May 27, 2014 southwest edition page C6, with the headline “Hedge Funds Don’t Live Up to Their Billing.” The article said that HFR’s composite index of hedge funds returned 72% over the decade ending last month compared to a return of 100% for the Vanguard Balanced Index Fund, which has an allocation of 60% stocks and 40% bonds. Hedge funds got their names because the managers hedged against market downturns using short selling and derivatives. Hedging is the same as buying insurance against a market decline. Obviously, the costs of the insurance will weigh down returns in percentage terms, but will pay off handsomely after a disaster.

Studies have shown that hedge funds have significantly under performed the broad indexes in percentage terms while returning more to the investor in dollars than a broad index would. It sounds counter intuitive, but it’s worth checking out. As Fama said, “This is arithmetic, not a hypothesis.”

Of course, a better way is to learn how Austrian economics ties the stock market to the business cycle to fine tune your hedging as I show in Financial Bull Riding.
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