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How to Win the Loser's Game

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How to Win the Loser's Game, Part 5

September 24, 2014
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Diversification has been described as the one free lunch in investing. True, the interconnected nature of the global economy means there is greater correlation between market movements now than in the past. But spreading your risk across different regions and asset classes remains a crucial part of successful investing.

Part 5 examines Modern Portfolio Theory and the research carried out by the likes of William Sharpe, Eugene Fama and Ken French into the common factors that drive market returns.


This documentary aims to equip ordinary investors with the information they need to make more sensible decisions and to keep more of their investment returns for themselves. In the process, we hope to change the investment industry for the better. You can help us by sharing these videos with colleagues, family and friends.

Part 5, Transcript and References

Last time on How to Win the Loser’s Game…

Jean-Michel Courtault from Université 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.”

Vanguard founder John Bogle says: “The great hero of my life was Paul Samuelson, and he basically said, show me the brute evidence that managers can outperform.”

Professor John Cochrane from Booth School of Business says: “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.”

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: “Really 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. Even though prices don’t move in nice, let’s say, sine-wave fashion, prices do go up and down over time. So a stock will go up and down, sometimes many times over the course of a day, but certainly over longer periods of time. And basically what he discovered was, that’s true and every stock does that, but they don’t do it at the same time, and it’s almost like if you think of two sine waves that are in opposite phase with each other, they will ultimately cancel each other out. And even though it was not the case that these stocks were in opposite phase, as long as though they weren’t in exactly the same phase with each other, you still get some dampening effect.”

Then, in the 1960s came another important breakthrough, when Professor William Sharpe developed what he called the Capital Asset Pricing Model.

The CAPM, 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: “What we mean by factors are things that drive common variation across stocks. So if I’m trying to say, well, airline stocks tend to move together, you could imagine an airline stock factor because it’s going to pick up common variation. Or if you say, well, some stocks tend to move a lot when the market goes up, some stocks don't move so much when the market goes up. We can have a market factor in there, that just picks up the difference in the way that stocks move relative to the market. We happen to know small stocks tend to move together and big stocks tend to move together. Put together a size factor, something the way we defined it, we had lots of small stocks and we’re short lots of big stocks, that would pick up that variation between how small stocks behave and how big stocks behave. 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, companies whose ratio of book to market, earnings to price, or cash floated price - something where it was a fundamental of the company divided by the price. Those 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. And that’s just arithmetic.”

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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