How to Win the Loser's Game, Part 5
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Last time on How to Win the Loser’s Game…
Jean-Michel Courtault: “The expectation of the speculator is zero."
John Bogle says: “Paul Samuelson basically said, Show me the brute evidence that managers can outperform.”
Professor John Cochrane says: "Gene Fama’s theoretical framework is quite easy to understand. Competition means that prices reflect information.”
Of course investors don’t just buy one stock, one mutual fund or one asset class. Or at least they’d be taking a considerable risk if they did.
It was another Nobel Prize winner - Professor Harry Markowitz - who first emphasised the importance of studying the risks and returns of an entire portfolio.
Art Barlow from Dimensional Fund Advisors says: “The cornerstone of all of what we call Modern Portfolio Theory rests on this idea of diversification. And until Harry Markwowitz gave what was almost an engineering analysis of how stock price movements interacted with each other, nobody had ever really considered it."
Then, in the 1960s came another important breakthrough, when Professor William Sharpe developed what he called the Capital Asset Pricing Model.
The Cap M, as it’s often referred to, is a model for determining the price of a capital asset such as a stock or a bond in an efficient market. The price, Sharpe deduced, depends on two things - the risk of holding that security when markets fall and the expected return. Ideally, Sharpe concluded, an investor should hold all the available securities with a particular market.
And, just in case there are any doubts as to his academic credibility, Sharpe too won the Nobel Prize in Economics.
In the CAPM, Sharpe also introduced the concept of market beta - the measure of the volatility of a security, or portfolio, in comparison to the market as a whole.
Sharpe referred simply to market risk. But, in the decades that followed, fellow academics identified specific types of risk, or beta, often referred to as factors. This gave rise in the 1990s to the Fama-French Three-Factor Model.
Professor Ken French from Tuck School of Business says: "So there was the overall sensitivity to the stock market. We also knew small stocks had a higher premium than big stocks and small stocks tended to move together relative to big stocks. And then we also knew value stocks tend to have a higher average return than growth stocks.”
To the original three factors - market risk, size and value - French and Fama have since added two more, profitability and investment.
So, companies with higher future earnings will have higher stock market returns.
And, perhaps surprisingly, firms that increase capital investment tend to produce poorer subsequent performance than those that don’t.
Eugene Fama from Booth School of Business says: “Profitability and investment explain the value factor, so you can actually drop the value factor if you want to, and use a four-factor model. Will there be more factors in the future? Possibly… A model stands until a better one comes along.”
Now some of that might sound a little complicated. But these are the basic building blocks of what is often referred to as the science of the capital markets. These are very important principles with implications for every investor. So, before we apply these principles, let’s recap.
Markets are competitive, and there are two sides to every trade.
The price of a security is the very latest, best-guess estimation of its value by the entire market.
Because it incorporates and reflects all the available information, markets are therefore very efficient.
Asset prices respond to new information, which is, by nature, random.
Price movements are therefore random as well.
And because the prices of different assets go up and down at different times, it pays to be diversified.
The optimum portfolio is one that holds every security available.
The return you can expect from a particular security is related to the risk of holding it when markets fall, and that risk is known as beta.
But there are different types of risk you can expose yourself to. Small company stocks and value stocks, for example, are generally more volatile than larger company and so-called growth stocks. But if you hold on to them for long enough, they should deliver a higher return.
Next time on How to Wing the Loser’s Game…
Nobel Prize-winning economist William Sharpe says: “Net of costs, the active euro in the passive sector must outperform the average euro in the passive sector.”
Vanguard CEO Bill McNabb says: “When you think about the average investor, who’s also a consumer, and they’re used to ‘The more I pay, the higher the quality, typically the better the results I get’, you come to investing and it’s just the opposite.”
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