Oh. Justin Fox Has a Book Coming Out...

Justin Fox wrote, long ago:

Is The Market Rational? No, say the experts. But neither are you--so don't go thinking you can outsmart it. - December 9, 2002: Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control--costs--and keep them as low as possible. Today that is pretty standard, if often unheeded, investment advice. Forty years ago it was revolutionary. The revolution started on college campuses, in particular at the University of Chicago, and it went by the unrevolutionary-sounding name "efficient markets."

"In an efficient market," wrote Chicago professor Eugene Fama in a landmark paper he delivered at the 1969 annual meeting of the American Finance Association, "prices 'fully reflect' available information." That is, in an efficient market you can't beat the market unless you have inside information. So why bother trying?

That logic led, among other things, to the creation of index funds that aim to mimic, not beat, the likes of the S&P 500 and the Wilshire 5000. Today such funds account for about 10% of total U.S. stock market capitalization, as well as 60% of what little money has flowed into equity mutual funds so far this year. But millions of small investors have continued to ignore the advice derived from efficient-markets theory, preferring instead to trade stocks and pile in and out of mutual funds in search of elusive market-beating returns (blowing much of their money on fees and commissions in the process).

Meanwhile, back on campus, a new generation of finance professors has been ripping Fama's teachings to shreds. The organizing principle for this new breed of scholars is not efficient markets but something called behavioral finance. Behavioral finance teaches that stock market investors are irrational, that future stock price movements are at least partly predictable from past behavior, and that careful analysis of past trends and financial reports can pay off. Which happens to be the way most investors see the market already.

Over the next few pages we're going to take you on a journey through the academic battles that have brought us to this point.... The message that the behavioral finance guys have for investors is that yes, you can beat the market, but--for reasons that are essential to the whole behavioralist case--you almost certainly won't. As a result, they end up offering much of the same investment advice that the efficient markets folks do. Only this time we might actually listen....

[L]et us document the behavioralists' triumph. Half of this year's economics Nobel went to their patron saint, Princeton psychologist Daniel Kahneman (the other half went to Vernon Smith of George Mason, whose economic experiments have also shot holes in efficient-markets dogma). Then there's the John Bates Clark Medal, awarded by the American Economic Association every two years to the most important U.S. economist under 40: The 1999 and 2001 editions both went to behavioralists. On the pop-culture front, Yale efficient-markets skeptic Robert Shiller's 2000 bestseller Irrational Exuberance was the most talked-about book by an economist in years.

The most dramatic development of all, though, may be that the office directly below Fama's at Chicago's Graduate School of Business now belongs to behavioralist pioneer Richard Thaler, 57. A magazine profile last year characterized Thaler, to the undying amusement of his students, as "thick-set," but that's not quite fair. He is not the jock that his upstairs neighbor is--Fama beats him at tennis. But Thaler, who arrived in Chicago in 1995 after years in the relative academic wilderness of Cornell University, appears to have eclipsed Fama as the most influential faculty member at the business school that has had more influence on the study of finance than any other....

Thaler, who was working on a Ph.D. in economics at Rochester in the early 1970s. His dissertation was an attempt to put a value on human life.... Thaler decided to ask a few friends how much they'd be willing to pay to eliminate a one-in-1,000 chance of immediate death and how much they would have to be paid to willingly accept an extra one-in-1,000 chance of immediate death. What he found was that they wouldn't pay much for the extra margin of safety but demanded huge sums to accept added risk--which isn't, strictly speaking, rational. "I came to two conclusions about these answers," Thaler wrote years later. "(1) I had better get back to running regressions if I want to graduate, and (2) the disparity between buying and selling prices was very interesting."... to be a newly minted psychology Ph.D., who sent Thaler a copy of a 1974 article by Israeli psychology professors Amos Tversky and Daniel Kahneman... argued that in making decisions involving probability and risk, people rely on mental shortcuts that "are highly economical and usually effective but ... lead to systematic and predictable errors."

It was that last part that was so significant. That people make judgment errors wasn't news, but if those errors were "systematic and predictable," well, that was something an equation-wielding economist could get up and run with..... The efficient-markets guys, meanwhile, not only had come to occupy the academic mainstream but also had moved in on Wall Street. Not surprisingly, their initial relations with the Street had been hostile. What the professors were saying, after all, was that highly paid fund managers and analysts were not worth a dime. Some of the professors clearly reveled in that: In one famous mid-1960s exchange, a money manager asked MIT's Paul Cootner, "If you're so smart, why aren't you rich?" To which Cootner replied, "If you're so rich, why aren't you smart?"

The answer to that second question was that people on Wall Street didn't have to be smart to get rich, since they could make money off fees and brokerage commissions even when their market calls stank. But the devastating bear market of the 1970s caused some investors to question whether the people with whom they'd entrusted their money really were worth the expense. One logical result of such thinking was the index fund, which instead of trying to outsmart the market simply tried to imitate it while charging much lower fees than actively managed funds do. The first index fund for institutional investors was started in 1971 by Wells Fargo Investment Advisors (now Barclays Global Investors) in San Francisco. The first such fund for retail investors--the Vanguard Index Trust--was launched five years later....

[W]hile Sharpe believes in efficient markets, he has also spent much of his career helping investors make choices. That, it turns out, makes him a big fan of behavioral finance. "As a practical matter, I still think it's prudent to assume that the market is pretty close to efficient in terms of pricing and risk and return and all that," Sharpe says. "On the other hand, we've certainly learned from cognitive psychology that ordinary human beings need to have alternatives framed in ways that can help them make right decisions rather than wrong decisions."

Most of the wrong decisions investors make, behavioral research has shown, stem from overconfidence.... As a result, much of what the behavioralists have to offer in terms of advice has to do with protecting retail investors from themselves.... Daniel Kahneman, when asked by a CNBC anchorman the day after his Nobel was announced in October what investment tips he had for viewers, responded, "Buy and hold."...

[T]he real-world phenomenon that cemented the behavioralists' victory also illustrates why, when it comes to actual investing advice, they sound so much like Fama and Sharpe. That real-world phenomenon was the stock market bubble of the late 1990s. According to strict efficient-markets thinking, there must be a rational explanation for what happened. Fama describes those sky-high Internet stock valuations as a risky but not crazy bet that one or two of those money-losing Net companies would end up as big as Microsoft. But he's almost all alone on this one. "We have just lived through the biggest bubble of all time," says Malkiel, who now calls himself a "random walker with a crutch." Fama's favorite collaborator, Dartmouth's French, is on the verge of using the b-word as well when he stops himself. "I work very closely with Gene," he says. "He would be very upset if I used that word in print."...

The dirty little secret of the behavioralists is that, for all their work on investor irrationality and market anomalies, they still believe that markets work pretty well and that trying to outguess the collective wisdom of millions of investors is usually futile.... But efficient-markets theory has a dirty little secret, too, which is that for the market to remain efficient, there have to be lots of rational investors who believe enough in the market's inefficiency to spend their careers trying to beat it....

[T]he argument of modern behavioralists includes a crucial observation that wasn't in Keynes--that professional investors are now under so much pressure from their customers that they cannot make the kind of long-term bets that might beat the market. If they do, as was the case with a lot of value-oriented mutual funds in the late 1990s, they can soon find themselves without any customers' money to invest. That gets us to a world in which an investor with enough staying power and contrarian gumption can beat the market, but the vast majority of mutual funds and hedge funds don't. In other words, the behavioralists have reconciled the success of a Warren Buffett (which efficient-markets purists have absurdly termed dumb luck) with the overwhelmingly empirical evidence that most professional money managers fail to beat the market.

This is, we posit, a major intellectual accomplishment. What does it mean for you? That's easy: Buy and hold. Diversify. Put your money in index funds. Pay attention to the one thing you can control--costs--and keep them as low as possible.

Justin Fox (forthcoming), The Myth of the Rational Investor: Wall Street's Impossible Quest for Predictable Markets (New York: Collins: 0060598999) http://www.amazon.com/exec/obidos/asin/0060598999/braddelong00

Comments

[Kate G.]

Well, that was interesting.

Kate G.

[wood turtle]

But will that buy and hold strategy work as boomers start selling their stock for retirement?

Are there enough people in the population with the income and inclination to invest in the market to replace what will be coming out?

[bigTom]

I had kinda come to that conclusion myself, that if everyone bought into the efficient markets advice, and simply bought indices, there would no longer be any source of relative value judgements in the market. We need at least some percentage of stock pickers to set prices.

Then we have those very rare birds, investors like Buffet and Soros whose record is far better than can be explained by statistical variation.

[Barkley Rosser]

Just for the record, although Thaler may have discovered it independently, the gap between willingness to pay and willingness to accept had been discovered earlier in the late 1960s by environmental economists doing surveys.

[PaulC]

"I had kinda come to that conclusion myself, that if everyone bought into the efficient markets advice, and simply bought indices, there would no longer be any source of relative value judgements in the market."

It sounds like a self-correcting problem to me. As soon as the market becomes measurably inefficient, somebody is going to try to exploit the inefficiencies.

[prostratedragon]

Nice little synchronicity---less than an hour ago I finished a reread of Black (JoFin 1986) "Noise."

[Barkley Rosser]

PaulC,

Well, one of the more interesting models coming out of the complexity, heterogeneous interacting agents, Santa Fe, econophysics conglomeration of ideas is that of dynamics driven by agents switching from following simple rules of thumb, for example using index funds, versus seeking out information to make gains from information. The central part of this is as more people use the funds the returns to seeking independent information increase, and as more people seek independent information, the returns to using an index fund increase, hence setting thing up for oscillations between periods of quiescence and periods of volatility. The 1997 Econometrica paper by Brock and Hommes, "A Rational Route to Randomness" is a good example of this as was the Santa Fe stock market model of Arthur, LeBaron, et al.

[reason]

How does this all line up with the noise about "the market can stay irrational longer than you can stay solvent". Or "you can know what will happen to stock prices, but not when". Temporary and widespread insanity seems to missing from this model, even though it is easy to see in reality.

[John Emerson]

Don't these ideas mean that people who understand the industry they're buying or selling have an advantage, as well as those who have a reasonable guess about the future development of the economy? A lot of finance seems to be at a very high level of abstraction, like horse racing when you don't know anything about horses and just calculate from their W-L record.

Finance at the highly abstract end of the field seems like magical thinking -- voting on the seventh horse in the seventh race because you think a seven's due to come up. (I've known some very bright people who played the lottery.)

Offering high returns at low risk is squaring the circle, but if you're selling your services to investors that's what they demand. With a little luck in a growing economy, you can even give it to them for awhile. (Imagine roulette counselors. With a few good turns of the wheel, they look good, and the losers have to leave the casino.)

I don't know where Mandelbrot stands in the profession these days, but in his "Misbehavior of Markets" he seems to say that there's no way to use his ideas to beat the market either.

[John Emerson]

The basic rule will always be that in a stable society "Those who have, get", at least to the extent that they invest their money rather than spending it or giving it away.

Spending your money is good for the economy, but not good for you. There's a big problem here: if the American rate of saving were higher, as people keep telling us it should be, wouldn't the economy cool down? Maybe disastrously? People who live paycheck to paycheck and max out their credit are personally on thin ice and may be bad for the economy in the long run, but in the short run it keep things hopping.

[Nathan]

The index vs. active manager debate is pretty close to finished, but it seems to me that many people still think you can beat the total stock market by buying narrow index funds--typically value or small cap. If you have a 30-40 year time horizon (say in a retirement account), should you buy a total stock market index fund or a small cap value index fund. I believe this is still in debate.

[CJColucci]

If everyone buys index funds, then what sets the price of the stocks that make up the index? What are the index funds an index of?

[Alex R]

It has seemed to me for some time that what standard economics predicts is not a *perfectly* efficient market, but a market in which the inefficiencies are just large enough to allow the best investors to use them make more than they could get by doing something else. If the market were more efficient than these, those investors would be doing something else, and inefficiencies would grow. If the market were less efficient than this, investors would trade so as to reduce them.

It sounds as though Barkley is familiar with a more complex, dynamical model of how market inefficiencies could oscillate around this fixed point, but the basic idea that there must be enough inefficiency to reward those who would work to remove it remains.

[PaulC]

CJColucci: "If everyone buys index funds, then what sets the price of the stocks that make up the index? What are the index funds an index of?"

I will have to read Barkley Rosser's reply more carefully, because I didn't absorb it on the first try. But let me be more explicit about my comment, since I think it's a pretty straightforward classical take on this issue.

If you want to eat bread, you could make it yourself or buy it prepackaged. Assuming you just want ordinary bread at low cost, you would be better off buying it than baking it, because you don't have the expertise or economies of scale to do any better than buying it. (There are reasons to bake your own bread, but most people could find a more effective use of their time.)

If everyone followed this rule, then nobody would be baking any bread. But this is not a likely outcome, because there is demand for bread and some opportunities to make a living out of baking it.

I think it's a similar case when it comes to stock trading. Somebody will inevitably do the research to set rational valuations, but there is no reason for everybody to do it. There is also no reason to fear for a situation in which nobody steps in to do this. Inevitably, somebody will. In other words, the advice given to the typical investor is no more universal than the advice not to bake bread.

Some people will make money by setting rational valuations just as some people will make money by baking bread. There is just little reason for most individuals to take up either professionally.

[split_personality]

About ten years ago, when I was a poor student, I noticed a small mutual fund that seemed to be run by bright people with good ideas. They were also obscure and spent zero money on advertising. After tracking them for 5 years, I finally invested (it was a $25k minimum). Their annual return since inception is 29% (25% since I invested...both values are net of all fees...which are HUGE - 2.5% + 10% of any returns above the index...which makes them over 5% in total typically). Needless to say, my results have been spectacular...but they also scare the hell out of me, especially as I've become more aware of efficients markets theory. The better I do, the more scared I get that I'm exposing myself to dangerous downside risk. I think these guys are precisely the type of investors with "staying power and contrarion gumption that can beat the market" that the behavioralists describe. But the problem is, how can you be sure?

So I just pulled out half my cash and I'm going to put it into index funds across all world markets. So I'm going split personality...half efficient markets and half behavioral finance. Though it still feels pretty stupid to pull money out of a fund that's had over 200% cumulative return over the last 5 years.

[Matt]

I'll read the comments in a minute, then do some general research, but my first impression.

Irrationality will generally result from major institutions in the economy having update cycles that vary from hours to decades. When you have an long update coming from some major economic institution, then there is a period in which the predictions based on the last update are very noisy while predections on the current update are beginning to become clear.

Not only do major institutions have these long update cycles, but we even see price fixing agreements for which the individual has no knowledge, like Cheney's recent world trip and bribe taking adventure. We will have no idea what price fix trade-offs he performed until it is too late.

This is like taking the atomic view of the economy and firing it with a Cheney energy particle. It takes us a while to find out what this little crook has done.

[Emma Anne]

This all sounded so familiar to me, and then I realized that Malkiel is the guy who wrote "A Random Walk Down Wall Street." That book certainly convinced me, and I recommend it to anyone who wants to begin to understand investing. I do believe that Buffett can beat the market, but I also believe that *I* can't. Hence, index funds, diversification, etc.

[Emma Anne]

Paul C: I loved the baking bread analogy. Someone has to (bake bread/research the market) but that doesn't mean everyone ought to do it. Unless, as you say, they want to.

[PaulC]

split_personality: There's no reason why you couldn't be getting high returns over that timespan. The question is how much additional risk you've taken on to get those returns. Of course, it's possible that the answer is none and your fund manager is a genius, but there if it's purely a risk premium, then there is nothing about your experience that is inconsistent with an efficient market.

Suppose you play a game where 99/100 times you get a cookie, and the other time a 16 ton weight comes down on your head. It would take a long period of observation to determine that this was on average a really bad game to be playing, and you're likely to meet people along the way who have collected a lot of cookies and may even have post hoc rationalizations about how they avoided getting squashed.

I tend to view most anecdotal investment advice as analogous to the above. A lot of very risky strategies turn out well for enough people by chance alone that risk mitigation can seem irrelevant. But by the same token, you could save money by not purchasing fire insurance for your house (if the law allowed it). Catastrophic risk is just not something the brain is good at picking up by observation.

[bigTom]

paul/split.

Eccellent explanation, I think even the non-economists got it.
split, taking half the money off the (winning) table seems sensible to me. I had had a fund in 2000 that did too well -so I sold half, it is still well below the price I sold if at.
When I dabbled at trading a couple of years back, I seemed to have a strategy that worked great (made 3x while the market dropped substantially) -but I decided that the peculiar market dynamics I was able to exploit no longer applied, and stopped.

[dsquared]

[[T]he argument of modern behavioralists includes a crucial observation that wasn't in Keynes--that professional investors are now under so much pressure from their customers that they cannot make the kind of long-term bets that might beat the market.]

If he thinks this isn't in Keynes, it must be a while since he read the relevant chapter of the General Theory.

[split_personality]

Paul C - I agree completely. That's why I said that the better the fund does, the more scared I get. That being said, it isn't a case of Capital Decimation Partners (CDP) or your cookie/weight example. In those examples, you have a 100% chance of being squished at some point, the only question is when. I suspect that some hedge funds are that sort of game. In this case, The fund's holdings are certainly risky (gold, energy, metals) but it's still a conventional equity fund (no derivatives, short-selling, etc.) To ascertain whether they're good vs just lucky, I compare their returns to the indices for those same sectors, they beat them all by a lot.

I agree that everything I'm saying is anecdotal but it illustrates the problem between knowing something intellectually (efficient markets) and actually basing your investing on it. There's one other consideration about indexing. Take a look at the S&P500 or DJIA from about 1965-1980. It's a flat, noisy line - and that's the nominal value. Inflation hit double digits during that time. Index investing then would have yielded you negative real returns. That outcome is also a risk to be avoided. All that being said, I got lucky finding the fund I did (unless it was smarts:))

[Paul J. Reber]

It seems like this abstract reasoning misses a crucial element of rational investing: differential access to information.

I have a good friend who works in the bond industry who advises the "buy and hold index funds" strategy for me as well. Her point is that her people have access to company information that I'll never have. For example, when they consider a major stake, they can go meet the people in charge of the company and use this to guide their evaluation.

With their extra information, there's no way I can possibly out-rational the pros over any long-term.

To be clear, her assertion is that there is a small subset of professionals who work at this higher, above-market level. And those people do not need my additional investment money, so it's unlikely I can buy into their funds. These people/institutions are known and since they live on excess information, there is a limit to the amount of money they can invest and have time to maintain this information edge.

The majority of funds & stocks simply provide market-avg returns with different risk profiles and different recent short-term runs (volatility). The irrational small investor who churns across these by over-interpreting short-term runs of luck is both generating a lot of costly transaction fees and seems to be the one feeding the irrational bubbles that the real talent makes their living pounding back out of the market by virtue of their rationality and access to extra information.

So it doesn't appear to require an either/or answer. The behavioralists are describing the bulk of information-starved investors who create the inefficiency that information-enriched investors make their living off of correcting.

If you want to get seriously game-theoretic about it, I'm sure the above-market-pros are aware that their ability to make money gets reduced proportional to the rate regular investors switch over to the buy-and-hold-index-funds strategy. What would one do if one's livelihood depended on the existence of market inefficiency to exploit?

[split_personality]

"What would one do if one's livelihood depended on the existence of market inefficiency to exploit?"

hmm...pay for ads with celebrity pitchmen like Sam Waterston and Dennis Hopper? (how he's supposed to be a sane spokesman for investing, I'll never understand...baby boomers are a weird bunch). Alternately, maybe Jim Cramer's actually a CGI generated bot created solely for the purpose of fueling dumb investors so that the pros can keep their game going.

[jmickle]

Thanks for the plug, Brad! The book's going to be called "The Myth of the Rational Market," and it's due out from Collins next spring. I'm still not absolutely, entirely done with the thing, in part because of some of the very dilemmas outlined by commenters above.

Also, in response to dsquared: I'm a lot more familiar now with Chapter 12 of the General Theory than I was when I wrote that article, and yeah, I would phrase that differently now.

[Person]

According to the DFA site

http://www.ifa.com

Buffet *hasn't* actually beaten the market. That is, if you look at any equity index with similar volatility (micro-cap, emerging markets), the index outperforms Buffet.

Of course, I don't know if anyone has studied the claim documented there and tried to refute it.

[CJColucci]

PaulC.: Thanks.

[Barkley Rosser]

Before this scrolls off I should comment once more.

I fully agree that for the overwhelming majority of people they should probably just buy broad indexes, including ones that are broad in terms of currencies, at least 50% not in the US dollar.

However, the accumulated evidence is that some people can and do beat the market, at least for periods of time. These are either people who in the terms of these models have spent the effort, or have available, genuine inside information (not necessarily in an illegal sense) on one or more stocks. Pretty clearly such people are able to "beat the market" more than 50% of the time. But few are in such positions, and anybody getting their "information" from a public source is not in such a position.

The other fact is that at any given time there is usually some trading rule (or "anomaly") that one can beat the market with. However, again, such a rule will generally stop working once very many people come to figure out what it is. There is no permanent such rule or trick, they simply evolve, appearing and disappearing, and being able to jump onto one and make money off of it is essentially a matter of luck.

Of course, regarding the complex dynamics, they can involve long periods of being away from any fundamental, bubbles and all that, as well as mathematically complex dynamics of a variety of sorts, the literature on which is huge (and to which I have contributed some).