Active vs. Passive in Global Investing | Financial Planning

Active vs. Passive in Global Investing | Financial Planning:

"The S&P Report, called the SPIVA U.S. Scorecard, which also evaluated the performance of active vs. passive management for domestic funds and for bonds, found that in the international sphere over the past year 70% of global equity funds, 75% of international equity funds, 81% of international small-cap funds and 65% of emerging markets funds underperformed their benchmarks.
As a group, active managers fared even worse over a three- or five-year period, says Todd Rosenbluth, S&P’s director of ETF and mutual fund research."

and more from Bloomberg:

"...making a fund manager into a star is a big risk. If the headline act has a bad year, the media notices. And if the star leaves, they can take assets with them, as bond baron Jeffrey Gundlach did when he left TCW Group and co-founded DoubleLine Capital LP. Up to 30 percent of Pimco's assets could now leave the firm, Sanford Bernstein estimates. After this, "funds may think twice about building the brand around a single individual," adviser Harold Evensky says.The biggest firms, like Blackrock Inc. and Fidelity, now mostly do without big fund manager stars. That helps put the emphasis where it belongs -- on performance."

"http://www.bloomberg.com/news/2014-09-26/bill-gross-and-the-dying-breed-of-mutual-fund-superstars.html"



'via Blog this'

Related articles

• More evidence that the vast majority of actively managed funds fail to outperform their S&P benchmark indexes
• Another Nail in Active Management's Coffin - Barron's
• Earn 2 Percent More in 3 Easy Steps

Biggest pension shunning hedge funds a green light for liquid alts

Biggest pension shunning hedge funds a green light for liquid alts:

"The California Public Employees' Retirement System, commonly known as Calpers, announced Monday it is eliminating its $4 billion exposure to hedge funds for reasons largely related to high fees."

In a related article on Main St, Hal Bundrick writes:

"“We are always examining the portfolio to ensure that we are efficiently and cost-effectively achieving our risk-adjusted return goals," Ted Eliopoulos, interim chief investment officer for the nearly $300 billion pension fund, said in a statement. "Hedge funds are certainly a viable strategy for some, but at the end of the day, when judged against their complexity, cost, and the lack of ability to scale at Calpers’s size, the ARS program is no longer warranted."

"http://www.mainstreet.com/article/if-smart-money-is-exiting-hedge-funds-why-are-you-still-hanging-on/page/2"

Still on the hedge fund band wagon?  Let's go over to the Fool.com where Morgan Housel wrote back in January: 

"...it's become plainly clear in recent years that the biggest bull market was in inflated promises. As a group, hedge funds -- which now manage $2.5 trillion -- have consistently underperformed a basic S&P 500 index fund over the last five years. 

Anyone want to predict hedge fund fees will keep falling?

Related articles

• Nation's Biggest Pension Fund to End Hedge Fund Investments
• With Calpers Quitting Hedge Funds, Other Investors Reflect
• Why Everyone Needs to Know About CalPERS Changes: An Interview With Mitch Tuchman
• CalPERS Cutting Hedge Fund Investments To Reduce Costs

Fama on the history of Market Efficiency--MUST WATCH!

http://www.youtube.com/watch?v=NUkkRdEknjI

Asset Price Bubbles: A Survey by Anna Scherbina, Bernd Schlusche :: SSRN

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Asset Price Bubbles: A Survey by Anna Scherbina, Bernd Schlusche :: SSRN

In class next week we will be talking about bubbles. No not this one, nor even this one, but financial bubbles. Financial bubbles have a long history going back decades. A few examples: the famous Dutch Tulip Bubble, the South Sea Bubble (1720)--BTW WATCH THIS short video on it, VERY GOOD!),the late 1920s US stock market , the Japanese bubble of late 1980s, the Internet Bubble of 1998-2000 (here is a video from that time by CNN that is very telling), and of course the most recent real estate bubble.


One of the papers we will be examining is this by Scherbina and Schlusche:

"The persistent failure of present-value models to explain asset price levels led academic research to introduce the concept of bubbles as a tool to model price deviations from present-value relations. The early literature was dominated by models in which all agents were assumed to be rational and yet a bubble could exist. In many of the more recent papers, the perfect rationality assumption was relaxed, allowing the models to shift the focus to explaining how a bubble may be initiated, under which conditions it would burst, and why arbitrage forces may fail to ensure that prices reflect fundamentals at all times. In light of the recent U.S. real estate bubble, the question of why bubbles are so prevalent is once again a matter of concern of academics and policy makers. This paper surveys the recent literature on asset price bubbles, with significant attention given to behavioral models as well as rational models with incentive problems, market frictions, and non-traditional preferences"

I should add, that these are not all agreed upon as bubbles. Some explain the high volatility merely using high levels of volatility and a real option analysis. This definitely is a source of some price run-ups, but I have a hard time convincing myself that it explains a large portion of the price changes.

Related articles

• Mathematically detecting bubbles before they burst (eurekalert.org)
• An Asset-Pricing Model for the Contagion Age: Polson and Scott - Bloomberg (financeprofessorblog.blogspot.com)
• Housing Prices Article by Steve Keen (gillandrealestate.wordpress.com)

Just How Efficient Is The Market? - Seeking Alpha

Just How Efficient Is The Market? - Seeking Alpha:

The debate on whether Markets are efficient or not is seemingly never ending and in the end a debate no longer of absolutes ("it is" or "it is not") but one of degree ("not perfect but good" vs "not even close").

Seeking Alpha's Stockopedia lays out the case for the latter (Markets are not even close to efficient) but first attacking the assumptions (low hanging fruit?) and then showing some studies that show the view that market perfection is not the norm and that due to structural and behavioral factors the small investor may be better able to beat the market than the large institutional investor.

a couple of "look-ins"

"

Firstly, EMH is based on a set of absurd assumptions about the behaviour of market participants that goes something like this:

1. Investors can trade stocks freely in any size, with no transaction costs;
2. Everyone has access to the same information;
3. Investors always behave rationally;
4. All investors share the same goals and the same understanding of intrinsic value.

All of these assumptions are clearly nonsensical the more you think about them but, in particular, studies in behavioural finance initiated by Kahneman, Tversky and Thaler has shown that the premise of shared investor rationality is a seriously flawed and misleading one."

and :

"The reason that EMH theory has caught on despite its clearly absurd underlying assumptions is that it explains away something rather awkward - the persistent failure for the average fund manager to beat the market. But there is also another explanation for this woeful track record by fund managers, namely incompetence, coupled with the institutional imperative aka. herd behaviour. The vast size of many funds, the uncertainty of the timing of investment inflows and outflows, the fees/commission they charge and other factors discussed here also mean that institutional managers can be at a huge disadvantage to a motivated share-owner with less capital."

H/T Jordan a former student

FT Alphaville » Randomness and the lost lesson of Bill Miller

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FT Alphaville » Randomness and the lost lesson of Bill Miller:



FT Alphaville uses the retirement of Bill Miller to discuss randomness and probabilities:

" A newsletter published by Credit Suisse-First Boston in 2003, a few years before the streak ended, calculated the odds of a manager outperforming the market on chance alone for 12 straight years to be one in 2.2 billion.

But what if Miller’s streak wasn’t so remarkable to begin with?

The statisticians like those from CSFB were considering the odds that a specific fund would outperform for 12 straight years if the fund begins investing at a specific time. But as Mlodinow explained, maybe the better question to ask is actually this: given the number of mutual funds that have existed in the modern era, what are the odds that any of them would have beaten the market over any 15-year period of time on chance alone?

Answer: 3 out of 4."

Important to remember that! 

Related articles

• Bill Miller Heads for the Exit (fool.com)
• Legendary Mutual Fund Manager Bill Miller Is Stepping Down From Main Fund (businessinsider.com)
• Stock Picking Guru Bill Miller Leaves Mutual Fund (patspapers.com)
• Lucky or Good or Both? (growthology.org)
• Permabull Down: Bill Miller Is Out After "Falling Behind Peers" (zerohedge.com)

SSRN-Industry Information and the 52-Week High Effect by Xin Hong, Bradford Jordan, Mark Liu

SSRN-Industry Information and the 52-Week High Effect by Xin Hong, Bradford Jordan, and Mark Liu: "find

Interesting paper. Chances are you have heard of the George and Hwang 2004 article that reports that stocks near their 52 week high did better than firms not near their 52 week high (a strike against weak form efficiency). Now Hong, Jordan, and Liu further investigate this and find that there is a large industry effect and suggest the cause of the findings is an anchoring bias.

Abstract: (emphasis is mine)

"We find that the 52-week high effect (George and Hwang, 2004) cannot be explained by risk factors. Instead, it is more consistent with investor under-reaction caused by anchoring bias: the presumably more sophisticated institutional investors suffer less from this bias and buy (sell) stocks close to (far from) their 52-week highs. Further, the effect is mainly driven by investor under-reaction to industry instead of firm-specific information. The extent of under-reaction is more for positive than for negative industry information. A strategy that buys stocks in industries in which stock prices are close to 52-week highs and shorts stocks in industries in which stock prices are far from 52-week highs generates a monthly return of 0.60% from 1963 to 2009, roughly 50% higher than the profit from the individual 52-week high strategy in the same period. The 52-week high strategy works best among stocks with high R-squares and high industry betas (i.e., stocks whose values are more affected by industry factors and less affected by firm-specific information). Our results hold even after controlling for both individual and industry return momentum effects."

Video time: Simpsons on flashing, Bubbles, and Monkeys!

The weekend is a good time to catch up on some videos, so here are some. (And
I want my students to watch these, so I better make use a flashy article name!)

Three somewhat fun, but also pretty interesting videos:

The May Flash Crash was back in the news, so we will start off with this. You remember the flash crash. It was when stock markets fell with amazing speed back in May.
Flash Crash. Markets don't move that fast! (One of the theories was that someone with fat fingers just hit the wrong order. Now it may be just a metaphor, but the Simpson's make it interesting.  





For what it is worth, the Wikipedia article on the so-called flash crash is pretty good.


Christ Martensen does a good job with a 15 minute video on Bubbles.


and finally a Ted Talk by Laurie Santos that looks at predictable irrationality and Monkeys. (sorry if you don't like monkeys ;) )

Two videos on market efficiency

These are a bit dated (from last year), but perfectly timed for class...so I will include them.

YouTube - Lessons From the Father of Modern Portfolio Theory:





And Justin Fox:



Update: 6:45 AM Nov 20:

Two other videos that also deserve mention:
* a video asking whether Modern Portfolio Theory is dead from the president of Ibbotson?

* a shorter "trailer" for the Justin Fox book.

Warren Buffett Hires Todd Combs to Invest for Berkshire - NYTimes.com

Image via WikipediaWarren Buffett Hires Todd Combs to Invest for Berkshire - NYTimes.com:

"Mr. Buffett, 80, has said that upon his death or retirement, his roles of chairman, chief executive and chief investment officer will be split among multiple people. Mr. Combs now stands as the heir apparent to the chief investor position, though Mr. Buffett made clear such an appointment had not been decided.
“He’s got the best chance of being the successor, but if we find the right guy or gal, we’d take that person, too,” he said.

In class yesterday we just spoke if Buffett and his excellent long run performance.  Here is his year by year record from CNBC.
(Class assignment idea: calculate various performance measures--Sharpe, Treynor etc. based on his Berkshire Hathaway's Returns.)

Related articles

• Berkshire Hathaway names Combs investment manager (seattletimes.nwsource.com)
• Buffett's New Hire to Manage 'Significant' Chunk of Berkshire's Portfolio (dailyfinance.com)
• Potential Buffett Successor Out of the Running? (dealbook.blogs.nytimes.com)

Hedge Fund Exchange: Women Hedge Fund Managers Outperform Men

Hedge Fund Exchange: Women Hedge Fund Managers Outperform Men:

"Women also, apparently, make better money managers according to another study by two professors at UC Davis [3]. That study found that overconfidence caused men to trade stocks 45 percent more often than women, thus lowering their net portfolio returns by 2.65 percent per year (compared with 1.72 percent lower returns for women traders). Moreover, several studies show a link between profit and gender. Companies with several high-ranking women at either officer or director levels tend to have higher earnings per share, return on equity and stock prices than competitors with few or no senior women."

The article mentions other studies as well and I know the evidence suggests strongly that there are differences between genders when it comes to risk financial risk taking.

But I am still not totally convinced. Why? Well there is some conflicting evidence. For instance, Olivares, Diaz, and Besser report that gender differences in risk aversion appear to be driven by wealth differences.

Moreover, even if there is a difference in performance (which I by no means doubt), is it based on gender?

An alternative explanation might be based on the relative numbers of male and female money managers (or board members). For instance, supposed that 80% of board members (or portfolio managers) are male. Further suppose that an equal proportion of males and females are "good at being money managers (or board members). If we assume that on average the more qualified managers get jobs first, then it would be the case that females would outperform. Which MAY be entirely different than the risk aversion explanation.

It does however lead to at least more questions as to the view that markets are efficient and that any money manager is as good as any other.

SSRN-Short Seller Trading in Companies with a Severe Accounting Irregularity by Jap Efendi, Edward Swanson

So at least some people can identify accounting regularities! Will discuss in class.

SSRN-Short Seller Trading in Companies with a Severe Accounting Irregularity by Jap Efendi, Edward Swanson:

"We find that shorts establish significant positions more than a year before the average restatement announcement, those positions increase as the announcement month approaches, and the largest positions are held in companies that will announce an accounting irregularity that attracts class action litigation. Shorts are thereby well positioned to profit from the lengthy string of negative returns that precede the announcement of a severe accounting irregularity. Afterward, we find average short interest is sticky, and shorts retain positions in firms that experience a further price decline. In the six months after an announcement, positions in heavily shorted restating firms (i.e., short interest exceeding 2.5 percent before the announcement) earn an additional 24 percent (31 percent with class action litigation). We conclude that shorts have the skill to play an important private-sector role in identifying and disciplining companies with accounting irregularities."

Update 12/1
Miguel at Simoleonsense chips in the following article on the predictablity of restatements by Dechow Ge Larson and Sloan :

"The results reveal that during misstatement years, accruals and cash and credit sales are unusually high, while return on assets and the number of employees are declining. In addition, misstating firms finance more of their assets through operating leases and have relatively less PP&E. We find that market pressures appear to affect incentives to misstate. Misstating firms are raising new financing, have higher market-to-book ratios, and strong prior stock price performance. We develop a model to predict accounting misstatements."

Scaling the Heights of Corporate Greed: Chafkin and Lo on Risk - Freakonomics Blog - NYTimes.com

Great read! You will love the analogy to the Mount Hood tragedy (and if you teach will likely use it in class).

Scaling the Heights of Corporate Greed: Chafkin and Lo on Risk - Freakonomics Blog - NYTimes.com:

"Much of neoclassical economics is based on the assumption that individuals act rationally and that markets fully reflect all available information, i.e., markets are informationally efficient. So powerful and far-reaching are the implications of this hypothesis that we sometimes forget it is meant to be an approximation to a much more complex reality. Recent advances in the cognitive neurosciences have radically altered our understanding of human decision-making, underscoring the importance of emotion, “hardwired” responses, and neural “plasticity” (the adaptability of neural pathways) in producing observed behavior (see Lo 2004, 2005). These breakthroughs show that decisions are often the result of several distinct components of the brain — some under our direct control and others that work behind the scenes and below our consciousness — that collaborate to yield a course of action best suited to achieve our immediate goals. On occasion, those immediate goals may conflict with larger and more important goals, like survival."

SSRN-Dark Omens in the Sky: Do Superstitious Beliefs Affect Investment Decisions? by Gabriele Lepori

Rabbits feet, avoiding black cats and not walking under ladders, baseball players jumping foul line and refusing to talk to pitchers with no-hitters going, and not buying stocks? Who knew?


SSRN-Dark Omens in the Sky: Do Superstitious Beliefs Affect Investment Decisions? by Gabriele Lepori: "

...empirical analysis focuses on some beliefs associated with eclipses, phenomena that are typically interpreted as bad omens by the superstitious both in Asian and Western societies, and we employ a dataset containing 362 such events over the period 1928-2008. Using four broad indices of the U.S. stock market, we uncover strong evidence in support of our superstition hypothesis in four distinct ways. First, the occurrence of negative superstitious events (i.e. eclipses) is associated with below-average stock returns, which is consistent with a diminished buying pressure coming from the superstitious. Second, the size of the superstition effect is estimated to increase in times of high market uncertainty and when eclipses draw wide media coverage and public attention. Third, the negative performance of the market during the superstitious event is followed by a reversal effect of similar magnitude (10 basis points per day) on the subsequent trading days. Fourth, eclipses are accompanied by a trading volume decline. When we extend our analysis to a sample of Asian countries, we find analogous results. The patterns we document are inconsistent with the Efficient Market Theory, as eclipses are perfectly predictable events."

Really? wow. Hard to believe people still believe in that stuff.

Interesting article.

HT to WayneMarr for pointing it out.

Embracing the efficient market hypothesis can be a bit like stepping out on “the Ledge” « Nudge blog

GREAT article from the Nudge blog/Economist.

Embracing the efficient market hypothesis can be a bit like stepping out on “the Ledge” « Nudge blog:

"...in the wake of last fall’s stock market collapse, fully embracing the efficient market hypothesis can be a scary proposition – a bit like stepping out on “the Ledge” at Willis Tower. (An absolute must if you’re in Chicago, by the way.) The events of the past year have sparked a rich debate between behavioral economists and EMH-ers over the the EMH’s validity that is nicely chronicled in this week’s Economist.

• “In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”. (Myron) Scholes, however, insists that the efficient-market paradigm is not dead: “To say something has failed you have to have something to replace it, and so far we don’t have a new paradigm to replace efficient markets.” The trouble with behavioural economics, he adds, is that “it really hasn’t shown in aggregate how it affects prices.”

An absolute "must-read" for my Behavioral Finance class! Going on the syllabus.

Buying High and Selling Low - NYTimes.com

More evidence that suggests we are not very good at market timing.

From The NY Times:

Strategies - Buying High and Selling Low - NYTimes.com:

"A study that appeared in the September 2007 issue of the Journal of Banking and Finance has found that poor market-timing decisions are the rule rather than the exception. Titled “Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability,” its authors are Geoffrey C. Friesen, a finance professor at the University of Nebraska, Lincoln, and Travis R. A. Sapp, a professor of accounting and finance at Iowa State University.

The professors analyzed investors’ behavior at all domestic equity funds from 1991 through 2004. They found that investors’ poor timing decisions reduced their average returns over this period by 1.6 percentage points a year."

The 2007 paper by Friensen and Sapp is available at SSRN. here.


BTW the Friensen and Sapp go one step further in another paper (teaming with Mercer Bullard) and find that those investors who deal with load fund (vs no load funds) have are even worse at market timing. This flies in the face of the view that financial professionals have added timing benefits.

No Such Thing as a Free Lunch, Revisited - Economix Blog - NYTimes.com

Whether you believe markets are efficient or not, this one has something for you. It will be a definte "MUST read" for my students this coming semester. It is by Ed Glassnor of Harvard.

No Such Thing as a Free Lunch, Revisited - Economix Blog - NYTimes.com:

"The absence of arbitrage possibilities does not imply that market prices always and everywhere reflect some sort of fundamental values. Plenty of housing price changes are predictable, and Las Vegas looked pretty overpriced 30 months ago. But how could I have profited from this knowledge, other than avoiding the folly of buying at the peak? There was no easy way to short Las Vegas real estate."

and

"...the existence of bubbles and market irrationality doesn’t mean that markets are inefficient, in the sense that they allow easy arbitrage. A classic paper written more than two decades ago by Brad DeLong, Andrei Shleifer, Larry Summers and Robert Waldmann showed that less-than-rational “ noise traders” (a term coined by Fischer Black) could move markets even when rational traders have arbitraged away all the free lunches. The vicious swings of our asset markets suggest that these markets may often be moved by strange, probably irrational forces, but that doesn’t imply that the Efficient Markets Hypothesis is dead."

The article concludes:

"...recognizing the occasional madness of markets can provide a bit of investment guidance. The difficulty inherent in finding free lunches doesn’t mean that buyers should just buy a house, or a mortgage-backed security or a stock, trusting that the market has priced things correctly. A house doesn’t become a good buy just because some other idiot paid a fortune for a similar home down the street. A similar fool may not be around when you are looking to sell."

I would also encourage you to read the comment by Tom Brakke:

"...it generally is good advice to buy asset exposures cheaply (as to fees), but only if you can really buy them cheaply (as to valuation)."

Study hints that alpha may be finite (at least in the short term)

Fascinating look (albeit not over a seriously long time frame) from AllAboutAlpha that is consistent with the long held economic view that if there are positive abnormal returns to be had (in financial or product markets), newcomers to market will drive down the returns (hence importance of barriers to entry etc).


AllAboutAlpha.com» Today's Post » Study hints that alpha may be finite (at least in the short term):

"As the hedge fund industry smashed through the one trillion dollar level a few years ago, it became vogue to ponder whether the new assets would dilute existing alpha opportunities. Was alpha a finite resource that needed to be shared among an ever growing number of industry players? And if so, was the hedge fund industry destined to become a victim of its own success...?

Research seemed to indicate that average alpha was indeed on the decline as the industry grew. But many also argued that the industry was being diluted by “unskilled” new entrants.

But if the new entrants were really “unskilled”, their effect on the returns of the incumbents should be minimal. If a group of 200 “skilled” managers were joined by 5,000 dart-throwing monkeys, then the original 200 should arguably be able to maintain their aggregate alpha. The simian stock-picking efforts of the monkeys should cancel themselves out...."

The finding? Sure enough the collective alpha of the industry fell thus supporting the long held view that competition will drive down abnormal returns.


BTW the finding that new entrants outperform (on average) existing participants really should not be surprising given that the new funds were presumably created to take advantage of an existing pocket of inefficiency and for at least a short period of time, would be more liekly to outperform.

The article is based off of this Weidenmueller and Verbeek paper.

Good stuff.

New Book: The Myth of the Rational Market

The Myth of the Rational Market: A history of Risk, Reward, and Delusion on Wall Street by Justin Fox (he of the recent Time Magazine piece on Stocks and bonds. .

The following excerpts are from TheBigMoney.

Spinning Math Into Gold: How academic debate transformed into Wall Street wealth. | The Big Money: "

"In the 1970s, the war between random walkers—theorists who believed that stock prices ultimately fit into the predictable pattern of a bell curve distribution—and professional investors began to settle into an uneasy but profitable truce. Hostilities still flared up from time to time, as on a mid-decade summer morning at Stanford Business School. On the first day of a weeklong seminar for money managers, a young accounting professor just arrived from Chicago kicked things off with a ferocious attack on the idea that anybody could beat the market."

Then an interesting insight on some of what led to corporate pension plans--regulations on pay:

"Stock holdings had begun to migrate in the 1950s from individual portfolios to institutionally managed ones....in the 1970s...another group of institutions came to the fore. These were pension funds, first used as a way to circumvent postwar wage and price controls by giving workers benefits that weren't counted as wages, and soon to become part of the social contract between large corporations and their workers. With General Motors leading the way, America's big companies began setting aside money and investing it to pay for future pension benefits. Together with foundations and university endowments, the pension funds had come to constitute a huge new pool of institutional money by the late 1960s."

And from a later Excerpt entitled "The Birth of Quants"

"Because of his bond job, Ibbotson was interested in possessing the sort of historical data on bond returns that his Chicago professors James Lorie and Lawrence Fisher had compiled for stocks. Sinquefield was in the midst of starting a stock index fund ... wanted updated stock market data....so Ibbotson and Sinquefield took on the job themselves. Then Fischer Black, who had recently joined the Chicago faculty as a finance professor...After getting a Ph.D. in applied mathematics (a.k.a. computer science) from Harvard in 1965, Black had gone to work at the Cambridge-based consulting firm Arthur D. Little. There Jack Treynor introduced him to the capital asset pricing model and its simple linkage of market risk and reward. Black soon sought out the other two creators of the theory, paying regular visits to John Lintner at Harvard and getting his employer to fly Bill Sharpe to Chicago for a meeting in a hotel near O'Hare Airport (Michael Jensen was there as well) to discuss CAPM's implications for performance measurement."

Interesting stuff. Both from a history perspective as well as a market efficiency point of view.

Lest we think I have totally given up on rationality, I still do believe markets are VERY tough (exceedingly tough) to beat. But that said, do they act rationally all the time? NO. So if nothing else to learn when these behavioral biases and irrationality problems are most present, the book definitely is next on my "Must Read" list.

And yes I JUST ordered one now.

Are Stocks Still Good for the Long Run? - TIME

Wow. The other day I reTweeted a tweet from Zvi Bodie. I did not have time to blog it then, but saved it. And just finished reading it and two follow-ups to it all I can say it that they are definite must reads! (and will be so for all of my fall classes!)

Are Stocks Still Good for the Long Run? - TIME by Justin Fox:

While now it is commony held that stocks have a higher expected return than bonds because of fact that stocks are more volatile (more risk, more return demanded), the article begins off by recounting that this was not always believed. After this interesting history, Fox brings the reader to the recent finding by Arnott that over the past 40 years stocks underperformed (albeit slightly and at a time when stocks had just fallen precipitously) bonds. (here is a post on that from last month.)

"...[after the 1929 crash the] idea that stocks could be good investments became a joke and remained that--in the popular view, at least--for decades. Yet whenever anyone in later years re-examined the data on stocks' long-run performance--major scholarly studies on the topic were published in 1938, '53, '64 and '76--they reached the same conclusion Smith did. Even with the dire experience of the early 1930s factored in, stocks had proved an excellent long-run investment, with returns that far outpaced those of bonds."

Much of the article is grounded on solid academic research including work done by Jeremy Siegel and others. This research suggests strongly that sometimes financial assets are mispriced and thus there may be significant relative performance differences for long periods of time where bonds outperform stocks (as in the 40 years that Arnott found).

So given what we know about mispricing and the historical performance of index funds vis-a-vis actively managed funds (unstated in article), one solution is to use a hybrid of indexing and picking. This suggests a strategy where rather than buying individual assets that have appreciated greatly (and are thus more likely to be overpriced) it is wiser to invest in assets that are out of favor (so called value stocks).

"He [Siegel] says the one significant change in his advice over the past decade has been an increased emphasis on "value" stocks with prices that are low relative to earnings, book value and other fundamental measures. Both Arnott and Siegel are boosters of a new investment approach called fundamental indexing, in which one assembles a portfolio weighted by earnings, dividends or the like in order to avoid the tendency inherent in conventional capitalization-weighted index funds to load up on the most expensive stocks.

An alternative solution, which Bodie has proposed many many times but has not yet caught on to a great degree, is to use TIPs and long term options. The logic behind this is that stocks are volatile (indeed more volatile in the long term than the short term) and largely because stocks do tend to be so risky, you can never be assured how they will perform over your investment horizon. Therefore, you should invest in TIPs to get the what you NEED for future and if you want to invest the rest in riskier scurities (long term options is Bodie's well reasoned choice) the extra for things you may WANT.

From the Time article and a follow-up piece from Time's Curious Capitalist blog.

"To Boston University finance professor Zvi Bodie, another frequent debating partner of Siegel's, this entire discussion is beside the point for most Americans. "He could be right," he says of Siegel's argument that stocks are a good deal right now. "I'm just more risk-averse than he is." Bodie, co-author of the perennially best-selling business-school textbook Investments, wrote a 2003 book titled Worry-Free Investing and has been trying ever since to steer personal-finance advice in a radically new direction. For most Americans, Bodie says, stocks are entirely inappropriate vehicles for saving for retirement. The reason they outperform bonds over time is the very reason they should be avoided: they're riskier. And if you're putting away money that you're going to need to live off in retirement, you shouldn't be taking any risk at all...."If your goal is to maintain your standard of living, then here's how much you should be saving and putting into TIPS," he says. "If you want to save more than that and speculate in the stock market, by all means, do it. But you need to recognize that you can't count on it when you do that."

In an email to Justin Fox as reported on Time's the Curious Capitalist blog, Bodie writes:

"If you doubt the rationality of the stock market, then isn't investing in stocks a crap shoot? How can you be sure that there is a positive risk premium? The historical evidence is far from conclusive. It depends on what time periods and what countries you look at. Even the experts disagree."

Bodie concludes:

Under such circumstances, shouldn't a rational investor follow the TIPS + calls approach that I advocate?"

The problem is, as Fox points out, that this will likely (albeit not necessarily) yield a lower return so

"To follow Bodie's advice, then, you're probably going to need to save a lot more money for retirement than you've been doing"

So what is the takeaway? With high long term volatility and the academic evidence pointing more and more to markets being less than perfectly efficient, it seems that Fox nails it when he end with

"Stocks are still the best investment for the long run. But maybe not for your long run."

Which again suggests that the investment world (at least individual investors worried about their retirement or other largely fixed future obligations) should give much consideration to Bodie's advice and use TIPs for the part that you "need" and then LEAPs and other risky securites for what you "want".

And lest you doubt that this is a new idea or that Bodie is just saying this after a bad period in stocks, here is from a 2004 FinanceProfessorBlog post.:

"So what is one to do? My favorite idea comes from Zvi Bodie who applies modern hedging theories to retirement planning. As he wrote in in 2001 Retirement Planning: a New Approach paper the first part of the plan is to assure some minimum standard of living (this is the minimum amount that you will need) by investing in "inflation-protected bonds and annuities as the way to guarantee a minimum standard of living in retirement.""

FTR His Worry-Free Retirement book is available here.

So if it is such a good idea why hasn't it caught on? I have thought about that a great deal. The best answer I have is transaction costs.