SEC probes Krispy Kreme accounting - Jul. 29, 2004: "Krispy Kreme Doughnuts Inc. announced Thursday that the Securities and Exchange Commission was conducting an informal, non-public probe into the company's accounting."
The stock, which is down over 67% since last August, fell about 15% on the news.
This just continues a very bad year for the firm. In May the company's executives were sued for "disregarding signs that the company had expanded too quickly, that its wholesale business undermined sales at its retail stores, and that it faced stiff competition."
The current problems stem from the accounting treatment of the company's repurchasing of franchises and its May earnings forecast. As the Motley Fool reports, at least one of the repurchases was from the CEO's ex-wife.
Gee, what is this world coming to? The next thing you know someone will come out with a study that donuts are high in calories. ;)
additional sources:
http://www.whnt19.com/Global/story.asp?S=2106273&nav=1VPtPKDL
http://www.fool.com/News/Take/2004/take040729.htm
http://ir.thomsonfn.com/InvestorRelations/PubNews.aspx?partner=6012
Friday, July 30, 2004
Leverage decision and manager compensation with choice of effort and volatility
Leverage decision and manager compensation with choice of effort and volatility
Cadenillasa, Cvitani and Zapatero (CCZ) in an upcoming Journal of Financial Economics (JFE) paper, model the incentive effects of paying executives with either levered, or unlevered, equity.
Their model, which is probably too complex to use in most undergraduate classes, separates managers based on ability level. The authors conclude that “levered stock seems to be the optimal compensation for high-type managers, while unlevered stock is optimal for low-type managers.
The intuition is that the risk-neutral shareholders would like the manager to take more aggressive actions than the manager would otherwise prefer. Levered stock provides the correct incentives to good managers, as they will be more willing to take greater risk because their higher ability will enable them to correct a possible bad state through more effort.
However, low-type managers will be reluctant to accept the risk that comes with the extra (increase in) leverage, as they are more averse to the possibility that the value of the firm drops rapidly in price. For low-type managers, it follows that unlevered stock will be the preferable type of compensation.” (paragraph breaks inserted).
Additionally the model shows that levered equity grants are less favorable for risky firms, firms with little positive momentum, and smaller firms.
Even though the authors are careful to point out that the paper is dealing with the optimal grant of levered or unlevered shares, and hence a compensation paper, it may well have ramifications on capital structure as well. For instance, if we allow other things to remain constant it could be argued that firms with better management should have higher levels of leverage. Interesting!
http://jfe.rochester.edu/03323.pdf
Lifting the Veil: An Analysis of Pre-Trade Transparency at the NYSE by BOEHMER, SAAR, AND YU
Lifting the Veil: An Analysis of Pre-Trade Transparency at the NYSE by BOEHMER, SAAR, AND YU
Boehmer, Saar, and Yu give us an interesting look at how transparency affects trading. Specifically they examine how trades happen at the NYSE after the 2002 adoption of OpenBook. OpenBook is "allows traders off the NYSE floor to observe depth in the book in real time at each price level for all securities. Before the introduction of OpenBook, only the best bid and offer (representing orders in the book, floor broker interest, and the specialist's own trading desires) had been disseminated."
The current paper empirically examines the theoretical predictions of previous authors who have hypothesized that allowing traders to know more, may affect how they trade. For instance "Harris (1996) discusses two risks that are associated with the exposure of limit orders: (i) A trader may reveal to the market private information about the value of the security, and (ii) exposed limit orders can be used to construct trading strategies aimed explicitly at taking advantage of these limit orders."
This of course is not surprising. If you know what the other traders are doing (or are willing to do), that information will almost certainly influence your own trading.
Boehmer, Saar, and Yu find some confirmation of this: "After OpenBook is introduced [we] find a higher cancellation rate and shorter time-to-cancellation of limit orders in the book. We also find smaller limit orders after the change in transparency. This evidence is consistent with the idea that traders attempt to manage the exposure of their orders." (pp. 2-3)
OpenBook also impacts those who work at the NYSE. For instance the authors report "We find that the specialist participation rate in trading declines following the introduction of OpenBook. We also find that specialists reduce the depth they add to the quote (together with floor brokers) beyond what is in the limit order book. These changes in trading strategies are consistent with an increase in the risk of proprietary trading on the part of specialists
due to loss of their information advantage."
To see whether these changes have a good or bad impact on market prices and efficiency, the authors examine price movements before and after adoption (Hasbrouck's 1993 variance decomposition). They find: "smaller deviations of transaction prices from the efficient (random walk) price. We also find some indication (though weak) of a small
reduction in the absolute value of first-order return autocorrelations calculated from quote midpoints. These results are consistent with more efficient prices that are less subject to overshooting and reversal following the introduction of OpenBook." In non finance speak: prices bounce around less.
Additionally they find that the effective spreads drop, but they are quick to point out that this does not necessarily mean that total transaction costs drop. Why? It is likely because by breaking up their trades and cutting in front, the effective spread is narrowed. However, because there are more smaller trades, overall transactions costs may remain the same.
The loser in all of this? The specialist. "The evidence of a decline in effective spreads of trades suggests that the costs incurred by liquidity demanders decrease with the introduction of OpenBook. This evidence may also suggest a decline in investors’ compensation for exposing limit orders and supplying liquidity. The decrease in the participation rate of specialists is consistent with such erosion in the profitability of liquidity provision."
In wrapping up the authors summarize some of the consequences of their findings:
1. "We find that investors do change their strategies in response to the change in market
design: They submit smaller limit orders and cancel limit orders in the book more quickly and
more often. These findings are consistent with a more active management of trading strategies in
the face of greater risk of order exposure. Additionally, we find that traders shift activity away
from floor brokers toward electronically submitted limit orders."
2. "The results we document point to two welfare redistributions that are possibly associated with the introduction of OpenBook. The first is from liquidity suppliers to demanders. The decrease in the price impact of trades and marketable orders reduces the compensation for liquidity provision, hurting limit order suppliers and specialists. The second is from NYSE members to the exchange itself. We document a decrease in the specialist participation rate, and the evidence of a shift from floor to limit orders is consistent with a decline in the business of floor brokers. At the same time, the NYSE generates revenues from the OpenBook service."
This paper is forthcoming in the Journal of Finance.
http://www.afajof.org/Pdf/forthcoming/boehmer.pdf
The abstract is available at http://www.nyse.com/about/1047054054488.html
The paper is also available through FEN.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=368102
As an aside, market microstructure papers, while fascinating at some levels, often have the ability to bore those who are not already excited about finance. Hence I sometimes shy away from reviewing papers that are totally microsturcture oriented. This one however, is the exception. It is definitely interesting enough that it willhold the attention of even those who are only mildly interested in the topic and thus should be able to be used in class with no problems!
Boehmer, Saar, and Yu give us an interesting look at how transparency affects trading. Specifically they examine how trades happen at the NYSE after the 2002 adoption of OpenBook. OpenBook is "allows traders off the NYSE floor to observe depth in the book in real time at each price level for all securities. Before the introduction of OpenBook, only the best bid and offer (representing orders in the book, floor broker interest, and the specialist's own trading desires) had been disseminated."
The current paper empirically examines the theoretical predictions of previous authors who have hypothesized that allowing traders to know more, may affect how they trade. For instance "Harris (1996) discusses two risks that are associated with the exposure of limit orders: (i) A trader may reveal to the market private information about the value of the security, and (ii) exposed limit orders can be used to construct trading strategies aimed explicitly at taking advantage of these limit orders."
This of course is not surprising. If you know what the other traders are doing (or are willing to do), that information will almost certainly influence your own trading.
Boehmer, Saar, and Yu find some confirmation of this: "After OpenBook is introduced [we] find a higher cancellation rate and shorter time-to-cancellation of limit orders in the book. We also find smaller limit orders after the change in transparency. This evidence is consistent with the idea that traders attempt to manage the exposure of their orders." (pp. 2-3)
OpenBook also impacts those who work at the NYSE. For instance the authors report "We find that the specialist participation rate in trading declines following the introduction of OpenBook. We also find that specialists reduce the depth they add to the quote (together with floor brokers) beyond what is in the limit order book. These changes in trading strategies are consistent with an increase in the risk of proprietary trading on the part of specialists
due to loss of their information advantage."
To see whether these changes have a good or bad impact on market prices and efficiency, the authors examine price movements before and after adoption (Hasbrouck's 1993 variance decomposition). They find: "smaller deviations of transaction prices from the efficient (random walk) price. We also find some indication (though weak) of a small
reduction in the absolute value of first-order return autocorrelations calculated from quote midpoints. These results are consistent with more efficient prices that are less subject to overshooting and reversal following the introduction of OpenBook." In non finance speak: prices bounce around less.
Additionally they find that the effective spreads drop, but they are quick to point out that this does not necessarily mean that total transaction costs drop. Why? It is likely because by breaking up their trades and cutting in front, the effective spread is narrowed. However, because there are more smaller trades, overall transactions costs may remain the same.
The loser in all of this? The specialist. "The evidence of a decline in effective spreads of trades suggests that the costs incurred by liquidity demanders decrease with the introduction of OpenBook. This evidence may also suggest a decline in investors’ compensation for exposing limit orders and supplying liquidity. The decrease in the participation rate of specialists is consistent with such erosion in the profitability of liquidity provision."
In wrapping up the authors summarize some of the consequences of their findings:
1. "We find that investors do change their strategies in response to the change in market
design: They submit smaller limit orders and cancel limit orders in the book more quickly and
more often. These findings are consistent with a more active management of trading strategies in
the face of greater risk of order exposure. Additionally, we find that traders shift activity away
from floor brokers toward electronically submitted limit orders."
2. "The results we document point to two welfare redistributions that are possibly associated with the introduction of OpenBook. The first is from liquidity suppliers to demanders. The decrease in the price impact of trades and marketable orders reduces the compensation for liquidity provision, hurting limit order suppliers and specialists. The second is from NYSE members to the exchange itself. We document a decrease in the specialist participation rate, and the evidence of a shift from floor to limit orders is consistent with a decline in the business of floor brokers. At the same time, the NYSE generates revenues from the OpenBook service."
This paper is forthcoming in the Journal of Finance.
http://www.afajof.org/Pdf/forthcoming/boehmer.pdf
The abstract is available at http://www.nyse.com/about/1047054054488.html
The paper is also available through FEN.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=368102
As an aside, market microstructure papers, while fascinating at some levels, often have the ability to bore those who are not already excited about finance. Hence I sometimes shy away from reviewing papers that are totally microsturcture oriented. This one however, is the exception. It is definitely interesting enough that it willhold the attention of even those who are only mildly interested in the topic and thus should be able to be used in class with no problems!
Wednesday, July 28, 2004
A look at what happens when sport stars do good and when they do bad
Have you ever wondered what happens to the stock of a sponsoring firm when the endorser does well? How about when the endorser does bad? For example, when Kobe Bryant was arrested, what happened to the firms whose products he endorsed (namely Nike, McDonalds and Coke (the owner of Sprite))? I did and this past year I got talking about it with some students and we could not find much evidence so we began to investigate it ourselves. While the students changed over the course of the project (hence the large number of acknowledgements) we finally did finish it this past week. The paper is now coauthored by Betsy Drewniak and Dr. Mike Russell.
The result? After removing firms that had other news items on the same day (i.e. confounding events), when a endorsee did well (set a world records, named MVP etc), the sponsoring firm experienced an market adjusted abnormal return of just over 1% for the -1 to + 3 day event window. For bad events (that is when the endorsee is arrested etc), the stock price fell by about 2% over the 0-1 day window. (BTW good events tend to be more predictable, hence the -1 day instead of day zero.)
SO the results fit theory almost perfectly. The paper was just submitted, but if you have any suggestions, please let us know. THANKS!
http://www.financeprofessor.com/Jimspapers/endorsement/Endorsement%20Paper%20July%2020,%202004.pdf
PS Yeah I know this is sort of cheating putting my own work up, but I was in a real hurry today and would love comments, so....
The result? After removing firms that had other news items on the same day (i.e. confounding events), when a endorsee did well (set a world records, named MVP etc), the sponsoring firm experienced an market adjusted abnormal return of just over 1% for the -1 to + 3 day event window. For bad events (that is when the endorsee is arrested etc), the stock price fell by about 2% over the 0-1 day window. (BTW good events tend to be more predictable, hence the -1 day instead of day zero.)
SO the results fit theory almost perfectly. The paper was just submitted, but if you have any suggestions, please let us know. THANKS!
http://www.financeprofessor.com/Jimspapers/endorsement/Endorsement%20Paper%20July%2020,%202004.pdf
PS Yeah I know this is sort of cheating putting my own work up, but I was in a real hurry today and would love comments, so....
Tuesday, July 27, 2004
And you think Enron was bad? A look at Yukos
Sure US investors have seen their share of fraud cases (Adelphia, Enron, Worldcom etc.) However, with the seemingly imminent collapse of Russian Oil giant Yukos, it is worthwhile to remember that the US and Europe do not have a monopoly on fraud and corruption--in fact, it may be worse elsewhere!
Background: As you proabbly know the Russian Oil giant Yukos owes an estimated $7 billion in back taxes but does not have the cash to pay this sum off. In order to claim those funds the Russian government is threatening to liquidate the firm. Today Yokos officials have admited they "may have to declare itself bankrupt if the Russian government carries out a forced sale of its production unit. "
The case, which has the makings of a cinema blockbuster, began in June 2003, but hit full stride in October when Mikhail Khodorkovsky (who is arguably Russia's wealthiest citizen" was arrested by "masked and armed members of the security police force FSB stormed his private jet at an airport in Siberia."
Prior to this Khodorkovsky was seen by many as "untouchable." Why? He was one of the often cited "Oligarchs" who rose in dominance after the collapse of communism through entrepreneurship, risk taking, and more than occasionally fraud. As the BBC points out in a great article, in this he was by no means alone. Operating in a quickly changing world where the business laws were unclear, transparency almost non existent, and in a society that had grown accustomed to the corruption and favoritism of former communist party officials, many of these first generation business people believed they were above the law and acted accordingly.
http://news.bbc.co.uk/1/hi/business/3927523.stm
This feeling of invincibility may have come to an end when in June 2003, the Russian government demanded that Yukos (the oil firm run by Khodorkovsky) pay its back taxes, distrust of the government and wealthy business leaders has not. Now some in Russia are claiming that the real reason behind the government pushing for payment of the back taxes is that Khodorkovsky is politically opposed to Putin and many at the Kremlin. Moreover, even the BBC is reporting it is interesting that the "most controversial episode of all, the 1995 auction of Yukos, has been left off the charge sheet. To include it would be seen as an attack on all the oligarchs who won the auctions for Russia's mineral wealth.
Nor has there been any mention of Menatep's offshore network which might have concealed many ill-gotten gains of its clients.
The events which have been left off the charge sheet speak volumes about the current situation Russia."
Sources
http://news.bbc.co.uk/1/hi/business/3867079.stm
http://news.bbc.co.uk/1/hi/business/3213505.stm
http://www.rusnet.nl/encyclo/k/khodorkovsky.shtml
http://news.bbc.co.uk/1/hi/business/3927523.stm--HIGHLY RECOMMENDED!!
Background: As you proabbly know the Russian Oil giant Yukos owes an estimated $7 billion in back taxes but does not have the cash to pay this sum off. In order to claim those funds the Russian government is threatening to liquidate the firm. Today Yokos officials have admited they "may have to declare itself bankrupt if the Russian government carries out a forced sale of its production unit. "
The case, which has the makings of a cinema blockbuster, began in June 2003, but hit full stride in October when Mikhail Khodorkovsky (who is arguably Russia's wealthiest citizen" was arrested by "masked and armed members of the security police force FSB stormed his private jet at an airport in Siberia."
Prior to this Khodorkovsky was seen by many as "untouchable." Why? He was one of the often cited "Oligarchs" who rose in dominance after the collapse of communism through entrepreneurship, risk taking, and more than occasionally fraud. As the BBC points out in a great article, in this he was by no means alone. Operating in a quickly changing world where the business laws were unclear, transparency almost non existent, and in a society that had grown accustomed to the corruption and favoritism of former communist party officials, many of these first generation business people believed they were above the law and acted accordingly.
http://news.bbc.co.uk/1/hi/business/3927523.stm
This feeling of invincibility may have come to an end when in June 2003, the Russian government demanded that Yukos (the oil firm run by Khodorkovsky) pay its back taxes, distrust of the government and wealthy business leaders has not. Now some in Russia are claiming that the real reason behind the government pushing for payment of the back taxes is that Khodorkovsky is politically opposed to Putin and many at the Kremlin. Moreover, even the BBC is reporting it is interesting that the "most controversial episode of all, the 1995 auction of Yukos, has been left off the charge sheet. To include it would be seen as an attack on all the oligarchs who won the auctions for Russia's mineral wealth.
Nor has there been any mention of Menatep's offshore network which might have concealed many ill-gotten gains of its clients.
The events which have been left off the charge sheet speak volumes about the current situation Russia."
Sources
http://news.bbc.co.uk/1/hi/business/3867079.stm
http://news.bbc.co.uk/1/hi/business/3213505.stm
http://www.rusnet.nl/encyclo/k/khodorkovsky.shtml
http://news.bbc.co.uk/1/hi/business/3927523.stm--HIGHLY RECOMMENDED!!
Tuesday, July 20, 2004
Dividend Policy, Agency Costs, and Earned Equity by DeAngelo, DeAngelo, and Stulz
In a well done and interesting work, DeAngelo, DeAngelo, and Stulz tie dividend policy and agency costs (particularly the free cash flow problem) together. Their main point is that if firms did not pay dividends, managers would have too much cash at their disposal.
The authors begin by asking the question "why do firms pay dividends." To answer the question they examine what would happen if firms didn't pay dividends. Specifically they "conservatively estimate that, had the 25 largest long-standing dividend-paying industrial firms in 2002 not paid dividends, they would have cash holdings of $1.8 trillion (51% of total assets), up from $160 billion (6% of assets), and $1.2 trillion in excess of their
collective $600 billion in long term debt. Absent dividends , these firms would have huge cash balances
and little or no leverage, vastly increasing managers' opportunities to adopt policies that benefit
themselves at stockholders' expense."
Moreover, the paper makes the important distinction (made before by Jensen & Meckling 1976 and Easterbrook 1984) that earned equity is in someways different than contributed equity (external financing). Notably, contributed equity comes with investor imposed monitoring and the so-called market discipline that is provided when firms must raise new money. Therefore, firms with higher levels of earned equity should pay out larger dividends since these firms have (ceteris paribus) a greater likelihood of a free cash flow problem.
Sure enough, the authors find that "For the 25 longstanding dividend payers discussed above, the median ratio of earned to total equity is 97%, suggesting that this measure does in fact identify historically profitable firms with potentially large agency problems. Our evidence is uniformly and strongly consistent with the prediction that the probability of paying dividends increases with the amount of earned equity in the capital structure."
Which really should not surprise anyone.
This importance of earned equity is important even after controlling for growth, cash on hands, and other factors thus "indicating that the impact of earned equity on the decision to pay dividends that we document here is an empirically distinct phenomenon from other factors that have previously been shown to affect the dividend decision."
VERY interesting!
BTW Jensen's 1986 free cash flow problem paper is one of my favorite papers of all time. So much so that I did my dissertation on firms with high cash--finding that investors believe that firms that build up cash reserves do in fact tend to waste them as measured by lower Q values. Thus, this paper by DeAngelo, DeAngelo, and Stulz fits perfectly into my semantic network of managers, excess cash, and dividends. Here is a bad version of a paper based on my dissertation in case anyone is interested. Yeah right!
The authors begin by asking the question "why do firms pay dividends." To answer the question they examine what would happen if firms didn't pay dividends. Specifically they "conservatively estimate that, had the 25 largest long-standing dividend-paying industrial firms in 2002 not paid dividends, they would have cash holdings of $1.8 trillion (51% of total assets), up from $160 billion (6% of assets), and $1.2 trillion in excess of their
collective $600 billion in long term debt. Absent dividends , these firms would have huge cash balances
and little or no leverage, vastly increasing managers' opportunities to adopt policies that benefit
themselves at stockholders' expense."
Moreover, the paper makes the important distinction (made before by Jensen & Meckling 1976 and Easterbrook 1984) that earned equity is in someways different than contributed equity (external financing). Notably, contributed equity comes with investor imposed monitoring and the so-called market discipline that is provided when firms must raise new money. Therefore, firms with higher levels of earned equity should pay out larger dividends since these firms have (ceteris paribus) a greater likelihood of a free cash flow problem.
Sure enough, the authors find that "For the 25 longstanding dividend payers discussed above, the median ratio of earned to total equity is 97%, suggesting that this measure does in fact identify historically profitable firms with potentially large agency problems. Our evidence is uniformly and strongly consistent with the prediction that the probability of paying dividends increases with the amount of earned equity in the capital structure."
Which really should not surprise anyone.
This importance of earned equity is important even after controlling for growth, cash on hands, and other factors thus "indicating that the impact of earned equity on the decision to pay dividends that we document here is an empirically distinct phenomenon from other factors that have previously been shown to affect the dividend decision."
VERY interesting!
BTW Jensen's 1986 free cash flow problem paper is one of my favorite papers of all time. So much so that I did my dissertation on firms with high cash--finding that investors believe that firms that build up cash reserves do in fact tend to waste them as measured by lower Q values. Thus, this paper by DeAngelo, DeAngelo, and Stulz fits perfectly into my semantic network of managers, excess cash, and dividends. Here is a bad version of a paper based on my dissertation in case anyone is interested. Yeah right!
Enron Sites for class use!
HoustonChronicle.com - Hot Topic: Enron: "ENRON COVERAGE FROM BEGINNING TO END"
Looking for Enron coverage? Given the recent arrest of Ken Lay, the problems facing Jeff Skilling, and Lea Fastow's jail time, it is worthy to look back to see how the story has developed.
So my top three list:
1. The Houston Chronicle continues to have the best coverage of the collapse of Enron and a scorecard of who is in jail, who is facing trial, etc.
http://www.chron.com/content/chronicle/special/01/enron/index.html
2. The BBC has great coverage of the scandal. While they offer a better perspective, they lack some of the details of the Houston Chronicle site.
http://news.bbc.co.uk/1/hi/in_depth/business/2002/enron/default.stm
3. FindLaw is very good. It is surprisingly detailed and very interesting! Maybe a bit much for an introductory class, but excellent!
http://news.findlaw.com/legalnews/lit/enron/
I will definitely be using these to help my students learn about what is arguably the most important finance story since the crash of 1987.
Looking for Enron coverage? Given the recent arrest of Ken Lay, the problems facing Jeff Skilling, and Lea Fastow's jail time, it is worthy to look back to see how the story has developed.
So my top three list:
1. The Houston Chronicle continues to have the best coverage of the collapse of Enron and a scorecard of who is in jail, who is facing trial, etc.
http://www.chron.com/content/chronicle/special/01/enron/index.html
2. The BBC has great coverage of the scandal. While they offer a better perspective, they lack some of the details of the Houston Chronicle site.
http://news.bbc.co.uk/1/hi/in_depth/business/2002/enron/default.stm
3. FindLaw is very good. It is surprisingly detailed and very interesting! Maybe a bit much for an introductory class, but excellent!
http://news.findlaw.com/legalnews/lit/enron/
I will definitely be using these to help my students learn about what is arguably the most important finance story since the crash of 1987.
Readings, Teaching ideas, and non finance stuff etc
Sorry I had not posted for a few days, but it is summer here, which is vacation time right? ;) lol.
Ok, so this will be my once a week, not strictly finance post. But I will start off with a finance type question. "What interesting ideas or strategies do you use to make classes more interesting?" or if you are a student "what would you like to see your FinanceProfessors do in class?" Email me at JimMahar@FinanceProfessor.com and I will include the best of the suggestions in future posts and in the newsletter.
What have I been reading? I finished three books this week. The first was The Teller of Tales, the biography of Sir Arthur Connan Doyle by Daniel Stashhower. It was good. I really enjoyed most of it, but the end when it focused so much on Spiritualism dragged on for a while. But overall, I am really glad I read it and I learned a ton.
http://www.amazon.com/exec/obidos/ASIN/0805066845/finpapers/104-9378365-5272442
I also finished Hallowed Grounds: a Walk at Gettysburg by James McPhearson. Sure it was too short, and informal, but I liked it. I wish I had ristened to it BEFORE this recent trip to Gettysburg.
http://www.amazon.com/exec/obidos/ASIN/0739306812/finpapers/104-9378365-5272442
The Glory of their Times provides a fascinating look at Baseball in the 1900-1920 era. It is a series of interviews with star players done in the early to mid 1960s when Lawrence S. Ritter was writing his classic book of the same name. This is just a collection of the actual interviews. It is really cool to see what has changed (salaries, willingness to play through injuries, homeruns, and relief pitching) and things that have not changed (past players thinking they were better, drugs and alcohol wrecking careers, and extremely competitive players who make the sport great. Highly recommended as a fun book!
http://www.amazon.com/exec/obidos/ASIN/1565112539/finpapers/104-9378365-5272442
Ok, that is enough about my reading etc. I am sure many of you are not interested, but I honestly do get emails asking me why I have not been updating my reading list on the blogs, so I hope it is not too annoying to the rest of you!
Have a great week!
Jim
* who is doing his Tyler Hamilton imitation in more ways than one. :( First our dog Quincy died of cancer. He went very very fast which is the only good thing I can say about it. Then this past Sunday I crashed my bike. Lots of scrapes and bruises, but fortunately nothing serious save having to buy a new helmet.
* who is listening to every Tour stage on Eurosport. Surely the Tour is the most exciting three weeks of the year in sports. Even in Olympic years!
* who is really ready for hot weather. It has been quite cool and wet in Western New York.
Ok, so this will be my once a week, not strictly finance post. But I will start off with a finance type question. "What interesting ideas or strategies do you use to make classes more interesting?" or if you are a student "what would you like to see your FinanceProfessors do in class?" Email me at JimMahar@FinanceProfessor.com and I will include the best of the suggestions in future posts and in the newsletter.
What have I been reading? I finished three books this week. The first was The Teller of Tales, the biography of Sir Arthur Connan Doyle by Daniel Stashhower. It was good. I really enjoyed most of it, but the end when it focused so much on Spiritualism dragged on for a while. But overall, I am really glad I read it and I learned a ton.
http://www.amazon.com/exec/obidos/ASIN/0805066845/finpapers/104-9378365-5272442
I also finished Hallowed Grounds: a Walk at Gettysburg by James McPhearson. Sure it was too short, and informal, but I liked it. I wish I had ristened to it BEFORE this recent trip to Gettysburg.
http://www.amazon.com/exec/obidos/ASIN/0739306812/finpapers/104-9378365-5272442
The Glory of their Times provides a fascinating look at Baseball in the 1900-1920 era. It is a series of interviews with star players done in the early to mid 1960s when Lawrence S. Ritter was writing his classic book of the same name. This is just a collection of the actual interviews. It is really cool to see what has changed (salaries, willingness to play through injuries, homeruns, and relief pitching) and things that have not changed (past players thinking they were better, drugs and alcohol wrecking careers, and extremely competitive players who make the sport great. Highly recommended as a fun book!
http://www.amazon.com/exec/obidos/ASIN/1565112539/finpapers/104-9378365-5272442
Ok, that is enough about my reading etc. I am sure many of you are not interested, but I honestly do get emails asking me why I have not been updating my reading list on the blogs, so I hope it is not too annoying to the rest of you!
Have a great week!
Jim
* who is doing his Tyler Hamilton imitation in more ways than one. :( First our dog Quincy died of cancer. He went very very fast which is the only good thing I can say about it. Then this past Sunday I crashed my bike. Lots of scrapes and bruises, but fortunately nothing serious save having to buy a new helmet.
* who is listening to every Tour stage on Eurosport. Surely the Tour is the most exciting three weeks of the year in sports. Even in Olympic years!
* who is really ready for hot weather. It has been quite cool and wet in Western New York.
Friday, July 16, 2004
Home Field Advantage: the Finance experience!
Home field advantage: Lambeau Field, Adelphia Coliseum, Reilly Center, Cameron Indoor Stadium, and the Korean Stock Market?
Do domestic investors have an edge?
The trading experience of foreign investors in Korea
Choe, Kho, and Stulz show that home field advantages do not just exist in sports, but also in finance!
They look at all trades on the Korean stock exchange for a two year period ending in November 1998 and “show that foreign money managers pay more than domestic money managers when they buy and receive less when they sell for medium and large trades.” However there does not appear to be a difference for small stocks trades (that is when the size of the trade is small).
As the authors point out, “There are at least three non-mutually exclusive explanations for this result. First, foreign investors could be more impatient or trade when liquidity is lower, so that they pay more to liquidity providers. Second, foreign investors are better informed, so that their trades have a larger permanent impact. Third, they make their trades after prices have already moved against them.”
Interestingly, they find evidence to rule out both the liquidity and the information hypotheses. Thus, they conclude that “the difference between foreign investors and domestic investors is that prices move unfavorably for foreign investors than for domestic investors immediately before they trade intensively. This difference is partly explained by the return-chasing behavior of foreign investors.”
How big of disadvantage is it for the foreign trader? “On a roundtrip trade foreign money managers face greater transaction costs of the order of 37 basis points compared to domestic money managers, which is substantial” “For instance, an investor who trades three times per year would contemplate a drag on his performance in excess of 100 basis points. To put this in perspective, Carhart (1997) reports that the difference in the monthly estimates of Jensen’s alpha between the top decile and the bottom decile of diversified mutual funds in the U.S. is 0.67% from 1963 through 1993.(See, for instance, Grinblatt and Keloharju (2000), Seasholes (2000), and Froot and Ramadorai (2001)”
While I found the article fascinating, it would be interesting to see if foreign investors were somehow tipping off their trades—maybe a different mechanism is followed, that would allow front running to exist.
http://www.cob.ohio-state.edu/fin/dice/papers/2004/2004-6.pdf
Do domestic investors have an edge?
The trading experience of foreign investors in Korea
Choe, Kho, and Stulz show that home field advantages do not just exist in sports, but also in finance!
They look at all trades on the Korean stock exchange for a two year period ending in November 1998 and “show that foreign money managers pay more than domestic money managers when they buy and receive less when they sell for medium and large trades.” However there does not appear to be a difference for small stocks trades (that is when the size of the trade is small).
As the authors point out, “There are at least three non-mutually exclusive explanations for this result. First, foreign investors could be more impatient or trade when liquidity is lower, so that they pay more to liquidity providers. Second, foreign investors are better informed, so that their trades have a larger permanent impact. Third, they make their trades after prices have already moved against them.”
Interestingly, they find evidence to rule out both the liquidity and the information hypotheses. Thus, they conclude that “the difference between foreign investors and domestic investors is that prices move unfavorably for foreign investors than for domestic investors immediately before they trade intensively. This difference is partly explained by the return-chasing behavior of foreign investors.”
How big of disadvantage is it for the foreign trader? “On a roundtrip trade foreign money managers face greater transaction costs of the order of 37 basis points compared to domestic money managers, which is substantial” “For instance, an investor who trades three times per year would contemplate a drag on his performance in excess of 100 basis points. To put this in perspective, Carhart (1997) reports that the difference in the monthly estimates of Jensen’s alpha between the top decile and the bottom decile of diversified mutual funds in the U.S. is 0.67% from 1963 through 1993.(See, for instance, Grinblatt and Keloharju (2000), Seasholes (2000), and Froot and Ramadorai (2001)”
While I found the article fascinating, it would be interesting to see if foreign investors were somehow tipping off their trades—maybe a different mechanism is followed, that would allow front running to exist.
http://www.cob.ohio-state.edu/fin/dice/papers/2004/2004-6.pdf
BBC NEWS | Business | Five months in jail for Stewart
BBC NEWS Business Five months in jail for Stewart: "Five months in jail for Stewart"
Yahoo's page
more later...sorry, no time
Yahoo's page
more later...sorry, no time
Thursday, July 15, 2004
SSRN-Which Institutional Investors Monitor? Evidence from Acquisition Activity by Lily Qiu
SSRN-Which Institutional Investors Monitor? Evidence from Acquisition Activity by Lily Qiu: "Which Institutional Investors Monitor? Evidence from Acquisition Activity by LILY QIU "
There has been quite a bit of evidence of late that all shareholders do not do equal jobs of monitoring management. For example Barclay, Holderness, and Sheehan find that private placements (which have been long seen as a means of improving monitoring) may actually reduce monitoring and help to entrench managers because many of those purchasing the blocks are not actively monitoring management.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=471720
Yale’s Lily Qiu dives into this question further and finds evidence that suggests that large public pension funds (PPF) may do a better job monitoring than insurance or mutual funds. Qiu's case is built on the finding that firms with large public pension fund holdings “engage in less merger and acquisitions activity.” Moreover, when M&A deals are done, Qiu reports that “The presence of PPF ownership is…significantly and positively associated with long-term M&A abnormal returns…[and]with post-M&A improvement in asset turnover rates.”
Not convinced yet? Qiu is not done: “the negative association between PPF ownership and M&A likelihood is concentrated among cash-rich and low Q firms; among M&A firms, those with higher PPF ownership are less likely to engage in "buying growth" acquisitions.”
A quick explanation of the last sentence? Ok, low Q values (technically Tobin's Q which is market value divided by replacement value) and high cash firms are often cited as being where the Free cash flow problem (see Jensen 1986) is the worst.
Thus, at these firms mergers and acquisitions are often seen as negative projects that only serve to make managers better off. That it is at this
type of firm where the PPF influence seems the strongest, suggests that PPF are stronger monitors of management than other blockholders.
http://papers.ssrn.com/paper.taf?abstract_id=521803
Cite: Qiu, Lily, "Which Institutional Investors Monitor? Evidence from Acquisition Activity" (December 2003).
Yale ICF Working Paper No. 04-15. http://ssrn.com/abstract=521803
There has been quite a bit of evidence of late that all shareholders do not do equal jobs of monitoring management. For example Barclay, Holderness, and Sheehan find that private placements (which have been long seen as a means of improving monitoring) may actually reduce monitoring and help to entrench managers because many of those purchasing the blocks are not actively monitoring management.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=471720
Yale’s Lily Qiu dives into this question further and finds evidence that suggests that large public pension funds (PPF) may do a better job monitoring than insurance or mutual funds. Qiu's case is built on the finding that firms with large public pension fund holdings “engage in less merger and acquisitions activity.” Moreover, when M&A deals are done, Qiu reports that “The presence of PPF ownership is…significantly and positively associated with long-term M&A abnormal returns…[and]with post-M&A improvement in asset turnover rates.”
Not convinced yet? Qiu is not done: “the negative association between PPF ownership and M&A likelihood is concentrated among cash-rich and low Q firms; among M&A firms, those with higher PPF ownership are less likely to engage in "buying growth" acquisitions.”
A quick explanation of the last sentence? Ok, low Q values (technically Tobin's Q which is market value divided by replacement value) and high cash firms are often cited as being where the Free cash flow problem (see Jensen 1986) is the worst.
Thus, at these firms mergers and acquisitions are often seen as negative projects that only serve to make managers better off. That it is at this
type of firm where the PPF influence seems the strongest, suggests that PPF are stronger monitors of management than other blockholders.
http://papers.ssrn.com/paper.taf?abstract_id=521803
Cite: Qiu, Lily, "Which Institutional Investors Monitor? Evidence from Acquisition Activity" (December 2003).
Yale ICF Working Paper No. 04-15. http://ssrn.com/abstract=521803
Proof of a clientele effect: evidence from Taiwan
Taxes and Dividend Clientele: Evidence from Trading and Ownership Structure By Lee, Liu, Roll, and Subrahmanyam
Lee, Liu, Roll, and Subrahmanyam (LLRS) provide convincing evidence that a dividend clientele effect does exist. While previous researchers (for example Scholz-1992, Dhaliwal, Erickson, and Trezevant-1999, and Graham and Kumar-2003) have also found the existence of a clientele effect, the current paper is different in that it is based on cleaner data and does not rely on complex modeling. Rather the authors examine trading, ownership, and tax rate data from Taiwan. As they state "Taiwan offers an excellent laboratory for studying clientele because the capital gains tax is zero and share repurchases were prohibited for most of our sample period."
Before getting to the findings, some background is necessary. Taiwan does not tax capital gains, but does tax dividend income. Data include all trades as well as approximations to the traders' marginal tax rate. Additionally the rules on stock buybacks changed in September 2000 which enabled the authors to "study the behavior of firms as they became able to evade dividend taxes."
And the findings? "Individuals appear to respond in the direction predicted by the clientele hypothesis." Wealthy individuals decrease their net buying after dividend increases and increase net buying after dividend decreases. Those in lower tax brackets "do just the opposite."
"Institutions as a group display an insignificant response to dividend changes."
LLSR further examine this using regression analysis. Consistent with the above findings, "there is a strong negative relation between dividend increases and the proportion of shares held by wealthy individuals."
Further examination of the institutional ownership suggests that "Among institutional types, both tax exempts and corporations significantly prefer higher dividends per share. They also prefer higher payout ratios and are joined in this preference by financial institutions."
Finally, the authors also look at changes in behavior after the legalization of share repurchases. They find that "firms with higher concentrations of highly taxed shareholders were significantly more likely to commence repurchase programs. More than forty percent of Taiwan firms actually engaged in share repurchasing after it became possible. A significant fraction (23%) of firms that had previously been paying dividends ceased paying them entirely and 21% reduced dividends and began repurchasing. The tendency to engage in these practices is significantly related to the proportion of a firm’s shareholders in higher tax brackets."
http://www.anderson.ucla.edu/acad_unit/finance/wp/2004/5-04.pdf
I am convinced. Are you? Definitely an interesting paper and it will make it to my class notes!
BTW How can there be so many interesting articles? I just do not understand. It seems like everywhere I look there are articles that are really really good! This is no exception.
Lee, Liu, Roll, and Subrahmanyam (LLRS) provide convincing evidence that a dividend clientele effect does exist. While previous researchers (for example Scholz-1992, Dhaliwal, Erickson, and Trezevant-1999, and Graham and Kumar-2003) have also found the existence of a clientele effect, the current paper is different in that it is based on cleaner data and does not rely on complex modeling. Rather the authors examine trading, ownership, and tax rate data from Taiwan. As they state "Taiwan offers an excellent laboratory for studying clientele because the capital gains tax is zero and share repurchases were prohibited for most of our sample period."
Before getting to the findings, some background is necessary. Taiwan does not tax capital gains, but does tax dividend income. Data include all trades as well as approximations to the traders' marginal tax rate. Additionally the rules on stock buybacks changed in September 2000 which enabled the authors to "study the behavior of firms as they became able to evade dividend taxes."
And the findings? "Individuals appear to respond in the direction predicted by the clientele hypothesis." Wealthy individuals decrease their net buying after dividend increases and increase net buying after dividend decreases. Those in lower tax brackets "do just the opposite."
"Institutions as a group display an insignificant response to dividend changes."
LLSR further examine this using regression analysis. Consistent with the above findings, "there is a strong negative relation between dividend increases and the proportion of shares held by wealthy individuals."
Further examination of the institutional ownership suggests that "Among institutional types, both tax exempts and corporations significantly prefer higher dividends per share. They also prefer higher payout ratios and are joined in this preference by financial institutions."
Finally, the authors also look at changes in behavior after the legalization of share repurchases. They find that "firms with higher concentrations of highly taxed shareholders were significantly more likely to commence repurchase programs. More than forty percent of Taiwan firms actually engaged in share repurchasing after it became possible. A significant fraction (23%) of firms that had previously been paying dividends ceased paying them entirely and 21% reduced dividends and began repurchasing. The tendency to engage in these practices is significantly related to the proportion of a firm’s shareholders in higher tax brackets."
http://www.anderson.ucla.edu/acad_unit/finance/wp/2004/5-04.pdf
I am convinced. Are you? Definitely an interesting paper and it will make it to my class notes!
BTW How can there be so many interesting articles? I just do not understand. It seems like everywhere I look there are articles that are really really good! This is no exception.
Reaction speed: good news is incorporated faster. A look at the Market Reaction to Annual Earnings Announcements by Louhichi Wael
SSRN-Market Reaction to Annual Earnings Announcements: The Case of Euronext Paris by Louhichi Wael: "Market Reaction to Annual Earnings Announcements: The Case of Euronext Paris "
As I am considering doing a paper on event studies, I have been looking at a few event study papers of late. In this research I stumbled upon this paper by Louhichi Wael. Wael looks at abnormal returns following overnight earnings announcements of French firms. The findings give several insights into market efficiency.
Probably the most convincing aspect of Wael’s paper is that the stock price moves on new information. While that is obvious, it is interesting to see exactly how this price change occurs. For instance the stock price change happens for both good and bad earnings announcements, but not for earnings that are "in line" with analyst forecasts. This is obviously consistent with semi-strong form efficiency.
There are several interesting things about this paper
1. The paper uses an event study methodology but uses minutes instead of days or months as the time period.
2. The author finds that for good earnings announcements (those above analysts’ expectations) there are on average no abnormal returns after the first 15 minutes of trading. However, even within this 15 minute window it would be difficult to make large returns as approximately 55% of the 1.74% positive excess return occurs on the first trade following the announcement, and a full 95% occurs within the first 15 minutes of trading.
The reaction for bad announcements is less pronounced. For bad earnings announcements, the firms experience a 1.04% drop for the day. However, this is a smaller drop than occurs on average after the first 30 minutes of trading where the stock price tends to bottom out at -1.28%. This is evidence of a slight overreaction that occurs within the first 30 minutes of trading following bad earnings announcements.
3. Bid-Ask spreads increase immediately after the announcement. The spreads and volume return to normal more quickly (within 15 minutes) for good news.
4. Volume is unusually high before and after the announcements.
5. Actual "price volatility remains abnormally high thirty minutes following the announcement of good news and fifty five minutes after bad news."
All in all some pretty convincing evidence that while the market is not perfectly efficient, it is pretty good (and fast) at incorporating new information.
Cite: Wael, Louhichi, "Market Reaction to Annual Earnings Announcements: The Case of Euronext Paris" (January 2004). EFMA 2004 Basel Meetings Paper. http://ssrn.com/abstract=498502
As I am considering doing a paper on event studies, I have been looking at a few event study papers of late. In this research I stumbled upon this paper by Louhichi Wael. Wael looks at abnormal returns following overnight earnings announcements of French firms. The findings give several insights into market efficiency.
Probably the most convincing aspect of Wael’s paper is that the stock price moves on new information. While that is obvious, it is interesting to see exactly how this price change occurs. For instance the stock price change happens for both good and bad earnings announcements, but not for earnings that are "in line" with analyst forecasts. This is obviously consistent with semi-strong form efficiency.
There are several interesting things about this paper
1. The paper uses an event study methodology but uses minutes instead of days or months as the time period.
2. The author finds that for good earnings announcements (those above analysts’ expectations) there are on average no abnormal returns after the first 15 minutes of trading. However, even within this 15 minute window it would be difficult to make large returns as approximately 55% of the 1.74% positive excess return occurs on the first trade following the announcement, and a full 95% occurs within the first 15 minutes of trading.
The reaction for bad announcements is less pronounced. For bad earnings announcements, the firms experience a 1.04% drop for the day. However, this is a smaller drop than occurs on average after the first 30 minutes of trading where the stock price tends to bottom out at -1.28%. This is evidence of a slight overreaction that occurs within the first 30 minutes of trading following bad earnings announcements.
3. Bid-Ask spreads increase immediately after the announcement. The spreads and volume return to normal more quickly (within 15 minutes) for good news.
4. Volume is unusually high before and after the announcements.
5. Actual "price volatility remains abnormally high thirty minutes following the announcement of good news and fifty five minutes after bad news."
All in all some pretty convincing evidence that while the market is not perfectly efficient, it is pretty good (and fast) at incorporating new information.
Cite: Wael, Louhichi, "Market Reaction to Annual Earnings Announcements: The Case of Euronext Paris" (January 2004). EFMA 2004 Basel Meetings Paper. http://ssrn.com/abstract=498502
Wednesday, July 14, 2004
Another look at retirement planning. Are equities the way to go?
As hoped and expected, the recent post on Ahmet Tezel's article in the Journal of Financial Planning on how much a retiree could safely take out of his/her retirement account has sparked further discussion.
SSRN-Irrational Optimism by Elroy Dimson, Paul Marsh, Mike Staunton: "Although the probable rewards from equity investment are attractive, stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational. "
On one hand it is true that given the track record of equities, the more money invested in equities, the more that can generally be taken out. But equities are also risky so the more invested, the higher probability of the portfolio suffering economically significant declines. (that word generally will always get you in trouble ;) )
This is particularly important because we do not know the future and any model we use is "assumption dependent." These assumptions are not as easy to make as some may believe. For instance, consider without searching the web or a book, what is the historical return on equity investments? No doubt many of you (myself included) figured somewhere around 12% for large stocks (see virtually any investment text for these numbers) which corresponds to a risk premium of around 8%. (keeping math simple ;) )
However, Dimson, Marsh, and Staunton report that this is probably an overly optimistic number. Not because the expected equity risk premium is expected to fall in the future because the market is currently overvalued as those in the Campbell-Schiller camp believe (although it may be), but because we are not looking at the right historical returns! (BTW for more on the Campbell-Schiller view see the January FinanceProfessor newsletter Investments section)
So what is wrong? Virtually every finance text book dutifully reports US equity returns from 1926 to the present. However, this is a period where the US stock market was a very strong performer. Dimson, Marsh, and Staunton do two things to adjust for this: 1. they go back further--to 1926 and 2. they look at global returns and not just US returns. Their findings? Stocks have had lower returns and higher risks.
For instance, it has been widely reported that in the US the stock market has never lagged inflation over a 20 year period. Many have concluded therefore that stocks are safer than they really are. However, looking more globally this is not true. As the authors write: "We find only three non-US equity markets (with a fourth on the borderline) that never experienced a shortfall in real returns over a 20-year period. The worst 20-year real returns of 11 countries were negative. Historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return."
Therefore, the authors conclude that investors who rely on the optimistic US-only data are irrational: "prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational."
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."
The second part is to determine when you will need the money. Obviously the longer you wait to start taking money out, the more you can take out and the more risks you would be willing to live with. Bit he is careful to warn that just because you have a longer holding period, it does not mean that equities are the right investment: their risk goes up as well. This is driven home in his interview with Financial Advisor Magazine: "If stocks are safer the longer you hold them, Bodie says, a put option should be cheaper with a longer time horizon. But the cost of put options generally rise proportionally to the number of years going out."
Finally, and maybe most importantly, Bodie suggests that rather than merely investing the remainder of your portfolio in equities, you "use call options to lever potential income gains." That is, you buy long term call options to allow you to participate in stock gains without putting as much of your money at risk. This solution is not costless as options are generally not available in maturities matching the investor needs so they will have to be periodically updated, but overall it is a great (and very low risk) strategy!
Still unclear? Bodie has written a great deal on this issue. Financial Advisor Magazine has a very good article on Bodie's strategy. I highly recommend it (both the article and the strategy!)
Bodie did an interesting interview with Business Week on his strategy and of course his book Worry Free Investing focuses on the issue. (FTR I have not read his book--Sorry!)
http://www.financialadvisormagazine.com/articles/jan_2004_stocks.html
SSRN Cite:
Dimson, Elroy, Marsh, Paul and Staunton, Mike, "Irrational Optimism" (December 2003). LBS Institute of Finance and Accounting Working Paper No. IFA397. http://ssrn.com/abstract=476981
SSRN-Irrational Optimism by Elroy Dimson, Paul Marsh, Mike Staunton: "Although the probable rewards from equity investment are attractive, stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational. "
On one hand it is true that given the track record of equities, the more money invested in equities, the more that can generally be taken out. But equities are also risky so the more invested, the higher probability of the portfolio suffering economically significant declines. (that word generally will always get you in trouble ;) )
This is particularly important because we do not know the future and any model we use is "assumption dependent." These assumptions are not as easy to make as some may believe. For instance, consider without searching the web or a book, what is the historical return on equity investments? No doubt many of you (myself included) figured somewhere around 12% for large stocks (see virtually any investment text for these numbers) which corresponds to a risk premium of around 8%. (keeping math simple ;) )
However, Dimson, Marsh, and Staunton report that this is probably an overly optimistic number. Not because the expected equity risk premium is expected to fall in the future because the market is currently overvalued as those in the Campbell-Schiller camp believe (although it may be), but because we are not looking at the right historical returns! (BTW for more on the Campbell-Schiller view see the January FinanceProfessor newsletter Investments section)
So what is wrong? Virtually every finance text book dutifully reports US equity returns from 1926 to the present. However, this is a period where the US stock market was a very strong performer. Dimson, Marsh, and Staunton do two things to adjust for this: 1. they go back further--to 1926 and 2. they look at global returns and not just US returns. Their findings? Stocks have had lower returns and higher risks.
For instance, it has been widely reported that in the US the stock market has never lagged inflation over a 20 year period. Many have concluded therefore that stocks are safer than they really are. However, looking more globally this is not true. As the authors write: "We find only three non-US equity markets (with a fourth on the borderline) that never experienced a shortfall in real returns over a 20-year period. The worst 20-year real returns of 11 countries were negative. Historically, in 6 of the 16 countries, investors would need to have waited more than 50 years to be assured of a positive return."
Therefore, the authors conclude that investors who rely on the optimistic US-only data are irrational: "prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational."
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."
The second part is to determine when you will need the money. Obviously the longer you wait to start taking money out, the more you can take out and the more risks you would be willing to live with. Bit he is careful to warn that just because you have a longer holding period, it does not mean that equities are the right investment: their risk goes up as well. This is driven home in his interview with Financial Advisor Magazine: "If stocks are safer the longer you hold them, Bodie says, a put option should be cheaper with a longer time horizon. But the cost of put options generally rise proportionally to the number of years going out."
Finally, and maybe most importantly, Bodie suggests that rather than merely investing the remainder of your portfolio in equities, you "use call options to lever potential income gains." That is, you buy long term call options to allow you to participate in stock gains without putting as much of your money at risk. This solution is not costless as options are generally not available in maturities matching the investor needs so they will have to be periodically updated, but overall it is a great (and very low risk) strategy!
Still unclear? Bodie has written a great deal on this issue. Financial Advisor Magazine has a very good article on Bodie's strategy. I highly recommend it (both the article and the strategy!)
Bodie did an interesting interview with Business Week on his strategy and of course his book Worry Free Investing focuses on the issue. (FTR I have not read his book--Sorry!)
http://www.financialadvisormagazine.com/articles/jan_2004_stocks.html
SSRN Cite:
Dimson, Elroy, Marsh, Paul and Staunton, Mike, "Irrational Optimism" (December 2003). LBS Institute of Finance and Accounting Working Paper No. IFA397. http://ssrn.com/abstract=476981
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