Thursday, August 27, 2009
Finance Fallacy #1
OK, Here is fallacy #1 - saving is not investing. I don't think I would list this as number 1, as I think we are stepping into the realm of semantics a little here.
Finance Fallacy #2
In light of my recent post on "stocks for the long run" Zvi Bodie argues why the idea of "stocks for the long run" is flawed. Transcript and audio is here
His basic idea, which is not new, he's been harping on it for a long time, is that stocks will on average beat bonds, but only on average. This means that the average investor will do OK investing in stocks for their retirement. But some investors will do a lot better than average and some will be do terribly (and end up eating dog food in their old age, as Zvi elegantly states). As an individual investor has only one shot at getting it right, being right on average is not too helpful.
Definitely worth listening to.
Incidentally, this is finance fallacy number 2, I'll have to look up what #1 is.
His basic idea, which is not new, he's been harping on it for a long time, is that stocks will on average beat bonds, but only on average. This means that the average investor will do OK investing in stocks for their retirement. But some investors will do a lot better than average and some will be do terribly (and end up eating dog food in their old age, as Zvi elegantly states). As an individual investor has only one shot at getting it right, being right on average is not too helpful.
Definitely worth listening to.
Incidentally, this is finance fallacy number 2, I'll have to look up what #1 is.
Hedge Fund Letters
Ever wanted to know what a hedge fund manager thinks?...Felix Salmon posts links to two hedge fund letters. Interesting stuff.
Socially useless banks?
From the Guardian newspaper... Lord Turner (top financial regulator in the UK) wants to tax "excessive profiteering" by "socially useless banks" in the UK.
All this sounds like a slippery slope to me. What is "excessive" and does he really think that banks are "socially useless"? He also talks about "simplistic regulation". I don't think it was lack of regulation that lead to the particularly bad financial mess in the UK, just bad regulation. In particular, the government took the implicit role of lender of last resort to banks that are too big to fail. Instead, the government should regulate capital standards that are a function of the bank size.
Elsewhere in the article Turner questions whether the financial sector has grown too large. In a free market, capital will move to the the most productive use. In the UK, this turns out to be the financial sector, in part because there isn't much in the way of a significant manufacturing sector anymore. The only way that I could conceive that the financial sector was "too large" is if it is receiving some sort of government subsidy, such as an implicit guarantee. In which case, we know who to blame.
All this sounds like a slippery slope to me. What is "excessive" and does he really think that banks are "socially useless"? He also talks about "simplistic regulation". I don't think it was lack of regulation that lead to the particularly bad financial mess in the UK, just bad regulation. In particular, the government took the implicit role of lender of last resort to banks that are too big to fail. Instead, the government should regulate capital standards that are a function of the bank size.
Elsewhere in the article Turner questions whether the financial sector has grown too large. In a free market, capital will move to the the most productive use. In the UK, this turns out to be the financial sector, in part because there isn't much in the way of a significant manufacturing sector anymore. The only way that I could conceive that the financial sector was "too large" is if it is receiving some sort of government subsidy, such as an implicit guarantee. In which case, we know who to blame.
Tuesday, August 25, 2009
Liar's Poker
I just finished reading Liar's Poker. Its one of those books that I should have read years ago, but I just never got around to it. For the handful of folks who haven't read it, it is a true story of someone spending two years at Salomon Brothers in the 1980s. Its a great book, but reveals the rather ugly side of the investment banking world. I'd like to think things are all different now, 20 years later, but I seriously doubt it.
Bonds for the long run?
A few years back, Jeremy Siegel of the Wharton wrote a book called "stocks for the long run". The basic premise of the book was that over long periods - stocks beat bonds. He showed that for pretty much any 30 year period in history this was true.
Unfortunately, many people misunderstood the basic idea. They assumed that stocks HAD to beat bonds over 30 year periods. This is absolutely not the case, all Siegel is saying is that they have, historically done so.
Incidentally, I highly recommend his book.
Which brings me to an excellent post on the Fama French Forum in which someone asks whether bonds will continue to beat stocks....read here.
FF's answer is really insightful. The key point here is to understand the difference between an expected risk premium and a realized risk premium.
As an analogy, confusing a realized risk premium and an expected risk premium is like thinking that it is a good time to buy beach property after a 100 year hurricane (as long as you sell within 100 years)!
Unfortunately, many people misunderstood the basic idea. They assumed that stocks HAD to beat bonds over 30 year periods. This is absolutely not the case, all Siegel is saying is that they have, historically done so.
Incidentally, I highly recommend his book.
Which brings me to an excellent post on the Fama French Forum in which someone asks whether bonds will continue to beat stocks....read here.
FF's answer is really insightful. The key point here is to understand the difference between an expected risk premium and a realized risk premium.
As an analogy, confusing a realized risk premium and an expected risk premium is like thinking that it is a good time to buy beach property after a 100 year hurricane (as long as you sell within 100 years)!
Meir Statman on Behavioral Finance
Meir Statman (finance Prof at UC Santa Clara) has a nice article in the Wall Street Journal talking about many of the common behavioral mistakes that investors make. Hopefully some of my past MBA students recall me talking about this in my Portfolio and Security Analysis class.
Saturday, August 22, 2009
Thursday, August 20, 2009
Perfect markets
I've not been blogging for the past few weeks as I've been taking a break - vacation etc. Anyhow, the fall semester is up and running and its time to get back at it!
A recent article in the New Scientist (a UK publication) really illustrates how people - even very smart scientists just don't get economics.
In the article "Falling out of love with market myths", Terence Kealey (vice chancellor at the University of Buckingham, UK) attacks the economics concept of a perfect market.
I'd like to take a moment to explain why he is completely wrong.
In financial economics, we frequently talk and think about things in terms of perfect markets. Usually a perfect market is one with full information to all participants and no frictions (such as trading costs or taxes).
Mr Kealey argues that perfect markets are "bizarre" and that the theory, and the efficient market theory are "false".
Unfortunately, Mr Kealey just doesn't understand what the purpose is of a perfect market. In finance, we don't think for a minute that markets are perfect. They are not, there are taxes, trading costs, regulation, information asymmetries etc. But by starting with an idea of what a perfect market would look like, we are able to more fully understand the distortions that market imperfections are likely to play. Perfect markets are used as the foundation of more complex theories that attempt to explain how the world really is, and more importantly, how it will change if we change the imperfections in the market.
Students might note that in introductory MBA finance, we start with perfect markets when considering capital structure and also asset pricing.
Notwithstanding this fairly poor article, the New Scientist is an excellent publication.
A recent article in the New Scientist (a UK publication) really illustrates how people - even very smart scientists just don't get economics.
In the article "Falling out of love with market myths", Terence Kealey (vice chancellor at the University of Buckingham, UK) attacks the economics concept of a perfect market.
I'd like to take a moment to explain why he is completely wrong.
In financial economics, we frequently talk and think about things in terms of perfect markets. Usually a perfect market is one with full information to all participants and no frictions (such as trading costs or taxes).
Mr Kealey argues that perfect markets are "bizarre" and that the theory, and the efficient market theory are "false".
Unfortunately, Mr Kealey just doesn't understand what the purpose is of a perfect market. In finance, we don't think for a minute that markets are perfect. They are not, there are taxes, trading costs, regulation, information asymmetries etc. But by starting with an idea of what a perfect market would look like, we are able to more fully understand the distortions that market imperfections are likely to play. Perfect markets are used as the foundation of more complex theories that attempt to explain how the world really is, and more importantly, how it will change if we change the imperfections in the market.
Students might note that in introductory MBA finance, we start with perfect markets when considering capital structure and also asset pricing.
Notwithstanding this fairly poor article, the New Scientist is an excellent publication.
Tuesday, August 4, 2009
A break down of the equity risk premium
Is the equity risk premium actually zero? This post makes this claim. The author argues for a range of reasons why a risk premium is less than the typical quoted number of 6%.
I am inclined to agree that it is less than 6%, but I think it is probably incorrect to say it is zero.
I have a few issues with some of his arguments:
1.He claims that various studies have shown that the risk premium is declining, particularly since the 2000 market crash. The problem here is that I think he is confusing survey evidence of peoples expectations of the market risk premium with the implied premium that actually generates current prices. Before the market crash, in the late 90s, most investors thought stocks were great, would give high returns, and therefore would expect a high return over bonds. But of course, stocks were very expensive then and the implied premium was very low. After the crash the opposite occurs. Investors think stocks are awful, and expect low returns, but as prices are low, the implied premium is high.
2. He argues that transaction costs are ignored. But the evidence for bid-ask spread induced costs that he quotes are largely from pre-decimilization, when spreads were much higher than they are now. I agree that frequent trading will eat returns, but I don't see how this is really relevant to the equity premium. Nor do I see how poor market timing will impact the equity premium. Both of these factors will impact realized returns, but the equity premium is a fairly refined concept of the return you will earn as a buy and hold investor holding the market portfolio. In essence, someone how has an index fund in his/her 401k.
3. He states that the geometric mean will be much lower than the arithmetic mean due to volatility. No argument here, but this is a straw man as no reasonable person uses the arithmetic mean to estimate historic returns.
4. Peso problem. I completely agree that the US is a special case in that it has posted one of the highest historic premiums of any country. There is no reason to believe that the US should not mean revert to the average of the developed world.
So what is the correct premium? I sort of skirted around this issue here. But I think it is somewhere between say 2-6%. But don't quote me on that.
Finally, what would a zero percent premium mean? Well I doubt it will be along the lines of the Dow trading to 36000..
I am inclined to agree that it is less than 6%, but I think it is probably incorrect to say it is zero.
I have a few issues with some of his arguments:
1.He claims that various studies have shown that the risk premium is declining, particularly since the 2000 market crash. The problem here is that I think he is confusing survey evidence of peoples expectations of the market risk premium with the implied premium that actually generates current prices. Before the market crash, in the late 90s, most investors thought stocks were great, would give high returns, and therefore would expect a high return over bonds. But of course, stocks were very expensive then and the implied premium was very low. After the crash the opposite occurs. Investors think stocks are awful, and expect low returns, but as prices are low, the implied premium is high.
2. He argues that transaction costs are ignored. But the evidence for bid-ask spread induced costs that he quotes are largely from pre-decimilization, when spreads were much higher than they are now. I agree that frequent trading will eat returns, but I don't see how this is really relevant to the equity premium. Nor do I see how poor market timing will impact the equity premium. Both of these factors will impact realized returns, but the equity premium is a fairly refined concept of the return you will earn as a buy and hold investor holding the market portfolio. In essence, someone how has an index fund in his/her 401k.
3. He states that the geometric mean will be much lower than the arithmetic mean due to volatility. No argument here, but this is a straw man as no reasonable person uses the arithmetic mean to estimate historic returns.
4. Peso problem. I completely agree that the US is a special case in that it has posted one of the highest historic premiums of any country. There is no reason to believe that the US should not mean revert to the average of the developed world.
So what is the correct premium? I sort of skirted around this issue here. But I think it is somewhere between say 2-6%. But don't quote me on that.
Finally, what would a zero percent premium mean? Well I doubt it will be along the lines of the Dow trading to 36000..
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