Part 4, Transcript and References
Last time on How to Win the Loser’s Game:
Vanguard founder Jack Bogle says: “Probably about 1% of managers can beat the market over the very long term.”
Former fund manager Alan Miller says: “The bigger the institution, the bigger the brand, normally the more you pay and normally the worse the performance.”
Public policy adviser Michael Johnson says: “For virtually all investors, making a decision as to which active fund to invest in is a pure lottery.”
Investing is often referred to as a game that people play. And, the way most of us invest, that’s an apt description.
As with many games, there’s a very large element of luck as well as skill involved, and it’s almost impossible to distinguish between the two.
But investing shouldn’t be a game. After all, securing your financial future is a serious matter.
And, although the industry and the pundits like to play it down, there’s been a wealth of empirical research on this subject that investors can draw on.
We’re going to touch on some of the key principles of investing established by a long line of academics, including Nobel Prize-winners.
All investing comes with some degree of risk. But basing your investment strategy on those key principles will help you sleep soundly and enjoy life, safe in the knowledge that, if you stick with it for long enough, you will succeed.
Our story starts in Paris. It was here, in 1892, that a young man from Le Havre named Louis Bachelier came to study at university.
Louis Bachelier lost both his parents shortly after leaving school. To support his brother and sister, he took the reins of the family business. But what fascinated him most was mathematics, and at age of 22 he came here to Paris to study at the Sorbonne. Among the eminent mathematicians whose lectures he attended was the world-renowned Henri Poincaré. It was also in Paris that Bachelier developed an interest in the workings of the financial markets.
After graduating, Bachelier stayed at the Sorbonne to study for a PhD. His specific focus was how stock prices moved. Detailed study of the data led him to conclude that:
- all the available information is already included in the price of a stock
- prices react to new information which is, by nature, random
- therefore, price movements are also random (or, as he rather colourfully put it, no more predictable than the steps of a drunkard).
In conclusion, he said, “the expectation of the speculator is zero”.
Professor Jean-Michel Courtault from the University of Paris says: “The expectation of the speculator is zero because when you buy something you expect that the price is going to rise. But if you buy something someone else has to sell it and this other person thinks the price is going to go down. So if you want to have an exchange at the equilibrium, then the buyer cannot have an advantage over the seller, so the price must be such that future prices are completely unexpected.”
In 1900, after eight years in Paris, Bachelier completed his PhD thesis, La Théorie de la Speculation - The Theory of Speculation. It went largely unnoticed at the time, and it was only very late in his career that Bachelier was finally offered the professorial post he always wanted. But his thesis is now widely recognised as a brilliant work, and Bachelier as the father of financial mathematics.
It was the American economist Paul Samuelson who first recognised the significance of Bachelier’s thesis in the early 1950s, several years after the Frenchman’s death. The Theory of Speculation had a profound effect on Samuelson’s work.
For Samuelson, unpredictability was a necessary characteristic of a well-functioning market. In turn, his work greatly influenced the founder of Vanguard, the company that pioneered the use of index funds.
Jack Bogle says: “I am not much of an academic. Many of those articles, truth told, I cannot even understand. They’re very sophisticated. But the great hero of my life was Paul Samuelson. He had won the Nobel Prize in Economics - one of the first Americans to do so - back in the early 1970s. And providentially the first issue of the Journal of Portfolio Management came out in the spring of 1974. And there was an article by Paul Samuelson called Challenge to Judgement. And he basically said: show me the brute evidence that managers can outperform. If you can’t show me that brute evidence you should own a passive market index like the S&P 500, operated at very low costs with no sales loads. And that was the inspiration that basically inspired - got me going - on the idea."
There’s one institution more than any other that’s contributed to our understanding of asset pricing and how prices work. Over the years the University of Chicago has produced an almost embarrassing array of Nobel Prize-winners who’ve researched and written about this subject. I’ve come to interview the university’s latest Nobel laureate.
It was the advent of computers in the 1950s which enabled researchers like Eugene Fama to take financial mathematics to the next level.
It was for his work on the Efficient Market Hypothesis (EMH) that Professor Fama was recognised by the Nobel Prize Committee.
The EMH reinforces the view of Bachelier and Samuelson that all relevant information is already incorporated in the price of a particular stock.
If you take EMH to its logical conclusion, it’s impossible - or at least very difficult - either to purchase undervalued shares or sell stocks for inflated prices.
It’s also impossible - or all but impossible - to outperform the market, either through expert stock selection or through market timing.
Robin Powell asks: “To what extent do you think the Efficient Market Hypothesis has stood the test of time?”
Eugene Fama replies: “It’s a model. The word model implies that it’s not perfect. Clearly insiders have information that’s not in the market prices, and there’s pretty clear evidence that they gain from their trades. Once you get past that group it’s very difficult to find people who do have information that’s not in the price. So the proposition that markets are efficient has stood up very well.”
Robin Powell asks: “What do you say to those who argue that what happened between 2000 and 2003, and again between 2007-2009 when markets fell 50% or even more, those who say that that disproves the Efficient Market Hypothesis?”
Eugene Fama replies: “I put this in my Nobel lecture. I put in a little plot and I put in recessions on the plot. An what you see is that there are big price declines anticipating recessions, pretty consistently. The bigger the recession, the bigger the price decline. So in 2007-8 there was a recession and there was a 50% drop in the prices of stocks. That happens consistently. It’s expected to happen. In bad times prices are going to go down.”
As Eugene Fama says, the EMH is a hypothesis. It’s not meant to be perfect. And although assets are fairly valued today, they may still fall - or rise - sharply in price tomorrow, once new information is known. But it is generally accepted by academics who’ve researched this subject in detail that markets are fundamentally efficient. Yes, some experts do disagree with Professor Fama’s interpretation of the facts, but the evidence itself is indisputable.
Professor John Cochrane says: “The core of Gene’s research is really facts. When you think about Gene Fama and efficient markets, don’t think about Einstein and some big theory that nobody can understand. Gene’s theoretical framework is quite easy to understand. Competition means that prices reflect information. What Gene did is like what Darwin did. Darwin had a simple theory - evolution by natural selection. We can all understand that. But he went out and put all the finch beaks together and wrote the big book and saw how every different kind of animal fed into that. Well that’s what Gene did.”
It’s often said - by supposed experts - that the theories of Bachelier, Samuelson and Fama are outdated and don’t do justice to the complexity of today’s markets. True, their findings have been known for a long time. But they still haven't been disproved and, if anything, they’re more relevant now than they’ve ever been.
Again, it’s all to do with competition, with the principle of equilibrium on which Bachelier based his Theory of Speculation.
Simply put, there are two sides to every trade. For everyone buying a particular stock, thinking they’re getting a good deal, there’s a seller, equally convinced that they are.
Now think of the size of the global equity markets today, with millions of investors trading typically around $60 trillion every year.
Think of the increasingly high frequency of trading. A decade ago, there was an average of around 20,000 trades every second, but that figure has increased nearly 100-fold to 1.8 million.
Also, think of the growing number of professional stock pickers out there. In the US, for example, there are 14 times more mutual funds today than there were in 1979.
All these market participants are competing with one another, and each time they trade, they’re giving their estimate of how much a stock is worth.
So we should see the price of a stock as the very latest best estimate of the entire market.
That’s how efficient markets have become.
Next time on How to Win the Loser’s Game…
Art Barlow from Dimensional Fund Advisors says: “Really what we call the cornerstone of all Modern Portfolio Theory rests on this idea of diversification.”
Robin Powell says: “The price, Sharpe deduced, depends on two things. First the risk of holding that security when markets fall and, secondly, the expected return.”
Professor Ken French from Tuck School of Business says: “What we mean by factors are things that drive common variation across stocks.”