Rational or behavioral & 3 factor is quite shaky

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
richard
Posts: 7961
Joined: Tue Feb 20, 2007 3:38 pm
Contact:

Rational or behavioral & 3 factor is quite shaky

Post by richard »

"there is variation in expected returns, which leads to some predictability in returns. Where we disagree is whether it’s rational or irrational. And there’s nothing in the available evidence that allows one to really settle that in a convincing way. The stuff that both Shiller and I have done has been very illuminating in terms of the behavior of returns. The interpretation of that is open for reasonable disagreement."

"Fama-French three-factor model. It’s widely used both by academics and in industry. [He chuckles.] I’m laughing because the theoretical basis for the model is quite shaky."
http://www.nytimes.com/2013/10/27/busin ... wanted=all&
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: Rational or behavioral & 3 factor is quite shaky

Post by larryswedroe »

Richard,
Believe what Fama was saying is that we don't know exactly what explains the premiums and their size--behavioral or rational and if rational what are the causes--that's why we have so many papers on the subject. But that doesn't change the fact that the factor models do an exactly job of explaining the differences in returns and with the additions of MOM and profitability and another factor (investment) almost all the anomalies disappear. So the models work, we just don't know exactly why (:-))
Larry
User avatar
midareff
Posts: 7234
Joined: Mon Nov 29, 2010 10:43 am
Location: Biscayne Bay, South Florida

Re: Rational or behavioral & 3 factor is quite shaky

Post by midareff »

larryswedroe wrote:Richard,
Believe what Fama was saying is that we don't know exactly what explains the premiums and their size--behavioral or rational and if rational what are the causes--that's why we have so many papers on the subject. But that doesn't change the fact that the factor models do an exactly job of explaining the differences in returns and with the additions of MOM and profitability and another factor (investment) almost all the anomalies disappear. So the models work, we just don't know exactly why (:-))
Larry
Larry... after MOM and profitability have appeared in time measureable metrics hasn't the train already left the station?
Topic Author
richard
Posts: 7961
Joined: Tue Feb 20, 2007 3:38 pm
Contact:

Re: Rational or behavioral & 3 factor is quite shaky

Post by richard »

Larry, agreed. Fama is saying the model fits the data, but we don't know why. The first quote is similar - we don't know why models work the way they do.

How complete these models are, whether they will continue to work and whether better models will be developed is another matter.

BTW, the lack of any good quantification of risk makes the question of risk adjusted returns a bit odd.

BTW2, here's an article by Shiller http://www.nytimes.com/2013/10/27/busin ... f=business
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: Rational or behavioral & 3 factor is quite shaky

Post by larryswedroe »

Richard,
As we get more and more studies we have a better, more advanced, understanding of what drives returns, The factor model by Zhang etal using investment appears to do a much better job than the FF model as it eliminates most of the anomalies. So this should not be surprising that the "science" advances. It's no different than other fields.
And the fact that we don't have a perfect understanding is because we know that humans make behavioral mistakes and frictions prevent arbitrage from eliminating them. So personally I don't have a problem here

Midareff
No. For example MOM has been known for decades in many asset classes and it persists. And if you believe the risks stories it makes no difference if you discovery it---only the size of the premium should or could be impacted. Now if it is behavioral it MIGHT go away, but frictions matter there two, and limits to arbitrage and fear of margins, all allow anomalies to persist.
And finally I would add that if you believe a "newly discovered" factor is an anomaly you should JUMP on it quickly before it's arbed away--taking in the capital gains as investors slowly move to eliminate it.

Best wishes
Larry
fundtalk
Posts: 324
Joined: Tue Jun 05, 2007 3:52 pm

Re: Rational or behavioral & 3 factor is quite shaky

Post by fundtalk »

No real estate bubble? No Tech bubble? This doesn't make sense to me. Larry, you don't agree with this, do you? I assume you don't, since I recall you discussing selling out of Large growth in the late 90's.
YDNAL
Posts: 13774
Joined: Tue Apr 10, 2007 4:04 pm
Location: Biscayne Bay

Re: Rational or behavioral & 3 factor is quite shaky

Post by YDNAL »

richard wrote:Larry, agreed. Fama is saying the model fits the data, but we don't know why. The first quote is similar - we don't know why models work the way they do.

How complete these models are, whether they will continue to work and whether better models will be developed is another matter.

BTW, the lack of any good quantification of risk makes the question of risk adjusted returns a bit odd.

BTW2, here's an article by Shiller http://www.nytimes.com/2013/10/27/busin ... f=business
Models work the way they do because we create them when we already know what happened... followed by an a-ha! moment.

Now, lets build a model *today* to fit the data for 2014-2033 and NOT expect anything to go AWOL (missing), nor expect to have generous flexibility in expectations (AKA "variation in expected returns")... that would be incredibly valuable!

I know, I know... a risk story.
Landy | Be yourself, everyone else is already taken -- Oscar Wilde
User avatar
nedsaid
Posts: 13955
Joined: Fri Nov 23, 2012 12:33 pm

Re: Rational or behavioral & 3 factor is quite shaky

Post by nedsaid »

This is very interesting to me as I have always been interested in improving myself as an investor and in improving my returns.

I think the 3 factor model explains a lot. It reflects what I believed about the markets before I even heard of Gene Fama. I believed that the best investment returns were in stocks, that value was a great investment strategy, and that small stocks had more potential for price appreciation. Though early on I was more in the mid-cap area than small-caps. It took a financial review from my insurance company to realize I actually was light in small-caps. Oh well, to that point mid-caps worked well enough.

So when I read about factor based investing, my eyebrow shoots up.

At the same time, I realize that these models are not perfect. I believe in the 3 factor model because it confirms what I had believed as an investor and confirms my actual investing experiences.
A fool and his money are good for business.
User avatar
momar
Posts: 1359
Joined: Sun Nov 13, 2011 12:51 pm

Re: Rational or behavioral & 3 factor is quite shaky

Post by momar »

Wait, now there's a 6th factor (investment)? When did that happen?

I think these guys are going to have trouble now (finding 7, 8, 9 etc). Doesn't excel only go up to 6th order polynomials?
"Index funds have a place in your portfolio, but you'll never beat the index with them." - Words of wisdom from a Fidelity rep
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: Rational or behavioral & 3 factor is quite shaky

Post by larryswedroe »

Momar

The study described below is a different factor model that seems to go a long way to explaining the anomalies the FF model fails on.
Larry

The authors of the September 2012 study, “Digesting Anomalies: An Investment Approach,” which covers the period 1972-2011, propose a new multifactor model that goes a long way to explaining many of the anomalies that neither the Fama-French three-factor model nor the Carhart four-factor model (adding momentum as the fourth factor) can explain. In the new model (which they call the q-factor model), the expected return of an asset in excess of the riskless rate is described by the sensitivity of its return to four factors:
• The market excess return (MK T).
• The difference between the return on a portfolio of small-cap stocks and the return on a portfolio of large-cap stocks (rME). The size factor earns an average return of 0.31 percent per month and is statistically significant at the 5 percent level.
• The difference between the return on a portfolio of low-investment stocks and the return on a portfolio of high-investment stocks (R*A/A). The investment factor earns an average return of 0.44 percent per month and is statistically significant. It’s worth noting that the investment factor is highly correlated with the value premium (0.69), suggesting that this factor plays a similar role to that of the value factor.
• The difference between the return on a portfolio of high return on equity (ROE) stocks and the return on a portfolio of low return on equity stocks (rROE). The ROE factor earns an average return of 0.60 percent per month, and is statistically significant. Also of importance is that the rROE factor has very low correlation with the Fama-French factors. Thus, we can conclude that this factor provides important new information missing from the Fama-French model. In addition, it has a high correlation (0.50) with the momentum factor, meaning that rROE would play a similar role as the momentum factor in analyzing performance. They also found that the investment and return on equity factors are almost totally uncorrelated, meaning that they are independent, or unique, factors.

Model Based On Investment Based Asset Pricing Theory
The authors explain that their model is based on investment-based asset pricing theory. They explain that the negative relation between expected returns and investment is intuitive. Firms invest more when their marginal q (the net present value of future cash flows generated from one additional unit of capital) is high. Given expected cash flows, high costs of capital imply low net present values of new projects and in turn low investment, and low costs of capital imply high net present values of new projects and in turn high investment. As such, value firms with high book-to-market should invest less, and earn higher average returns than growth firms with low book-to-market. In general, firms with high valuation ratios have more growth opportunities, invest more, and earn lower expected returns than firms with low valuation ratios.
They go on to explain that “high valuation ratios often result from a stream of positive shocks on fundamentals, and low valuation ratios from a stream of negative shocks on fundamentals. High valuation ratios of growth firms can manifest as high long-term prior returns, and low valuation ratios of value firms as low long-term prior returns. As such, firms with high long-term prior returns should invest more and earn lower average returns than firms with low long-term prior returns.”
Summarizing, the authors believe that the q-factor model’s performance, combined with its clear economic intuition, suggests that the model can be used in practical applications such as evaluating mutual fund performance, measuring abnormal returns in event studies, estimating costs of capital for capital budgeting and stock valuation, and obtaining expected return estimates for optimal portfolio choice. And finally, investment companies can also adjust the structure of the financial products offered to investors, going beyond traditional styles such as size and book-to-market. Stay tuned.
Kewei Hou, Chen Xue , Lu Zhang, “Digesting Anomalies: An Investment Approach,” September 2012
Calm Man
Posts: 2917
Joined: Wed Sep 19, 2012 9:35 am

Re: Rational or behavioral & 3 factor is quite shaky

Post by Calm Man »

I am a medical scientist. All of these models being discussed, factors, etc observe correlations, relationships. Fama himself says he has no idea why they exist for his 3 factors. In the medical field if we do not have a good theory as to why we are loathe to ascribe any type of cause and effect. The observation of correlations or relationships is "hypothesis generating". You then test the hypothesis. I wish somebody, maybe Fama or a critic of DFA and the 3 factor model, would PROSPECTIVELY declare a portfolio that follows the model, define a time frame to observe prospectively and then conduct the experiment. It certainly though wouldn't happen from DFA's initiative as their business model (it is a business) would be at stake. And all of the advisers who can tell clients that the only way to access DFA is through them would lose that claim as well. I expect that any person who makes some of the money from DFA fund offerings to clients will vigorously defend the 3 factor model as would anybody paid by or employed by DFA.
User avatar
Archie Sinclair
Posts: 412
Joined: Sun Mar 06, 2011 2:03 am

Re: Rational or behavioral & 3 factor is quite shaky

Post by Archie Sinclair »

Calm Man wrote:I am a medical scientist. All of these models being discussed, factors, etc observe correlations, relationships. Fama himself says he has no idea why they exist for his 3 factors. In the medical field if we do not have a good theory as to why we are loathe to ascribe any type of cause and effect. The observation of correlations or relationships is "hypothesis generating". You then test the hypothesis. I wish somebody, maybe Fama or a critic of DFA and the 3 factor model, would PROSPECTIVELY declare a portfolio that follows the model, define a time frame to observe prospectively and then conduct the experiment. It certainly though wouldn't happen from DFA's initiative as their business model (it is a business) would be at stake. And all of the advisers who can tell clients that the only way to access DFA is through them would lose that claim as well. I expect that any person who makes some of the money from DFA fund offerings to clients will vigorously defend the 3 factor model as would anybody paid by or employed by DFA.
The experiment would have to run for decades, and at the end you still wouldn't know what caused the results.

Medicine has always used certain treatments without really understanding them. For example, no one has been able to prove conclusively how general anesthesia works (http://en.wikipedia.org/wiki/Theories_o ... tic_action). The people inhale the gas and they lose consciousness, but exactly why is a mystery.
stlutz
Posts: 5574
Joined: Fri Jan 02, 2009 1:08 am

Re: Rational or behavioral & 3 factor is quite shaky

Post by stlutz »

I wish somebody, maybe Fama or a critic of DFA and the 3 factor model, would PROSPECTIVELY declare a portfolio that follows the model, define a time frame to observe prospectively and then conduct the experiment.
Actually, this has occurred. The efficient market school came up with a hypothesis, CAPM, which stated that higher risk (beta) stocks should outperform lower risk stocks. It didn't work.

As far as investing goes, the key questions isn't really behavioral vs. efficient/rational. If a model will tell me how the beat the market over the next 15 years, I couldn't really care less exactly why it works.

The behavioral/rational debate has much more significant implications in political and economic policy, which we don't really discuss here.

One of the implications of the papers Larry links to above is that one can explain most stock market returns by selecting any three factors that are not highly correlated with one another. The Fama/French model has dominated because of the dominance of the Chicago school in finance and economic thought at the time they were publishing, not because it's intrinsically "better" than other models.

In my view, a better questions for investors to ask is: "To what extent can I reasonably expect the future to be like the past?" With that kind of question, I think historians can give us a much better answer than scientistic financial analysis can.
afan
Posts: 5282
Joined: Sun Jul 25, 2010 4:01 pm

Re: Rational or behavioral & 3 factor is quite shaky

Post by afan »

Calm man,
That experiment has been done. The DFA funds have records that are easily checked. They were created along Fama lines and anyone can see the results. Bogleheads regularly report the fact loadings. They certainly seem to have succeeded in following their target factors. Some of their real world returns come from securities lending rather than stock returns, and from what they suggest is a smarter approach to passive investing. But I don't think you can accuse them of being all marketing with no data
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama
Calm Man
Posts: 2917
Joined: Wed Sep 19, 2012 9:35 am

Re: Rational or behavioral & 3 factor is quite shaky

Post by Calm Man »

afan wrote:Calm man,
That experiment has been done. The DFA funds have records that are easily checked. They were created along Fama lines and anyone can see the results. Bogleheads regularly report the fact loadings. They certainly seem to have succeeded in following their target factors. Some of their real world returns come from securities lending rather than stock returns, and from what they suggest is a smarter approach to passive investing. But I don't think you can accuse them of being all marketing with no data
Afan, that is great to hear (really). I have looked into SCV at Vanguard and it looks like for the last 5 years it exactly tracks TSM but beats it for 10 years. I do notice though that the qualified dividends are only 70% or so which reduces the tax adjusted gain. I wonder if anybody knows enough about tickers, etc of the DFA funds to post a chart as nisiprius always does comparing the DFA funds to the Vanguard TSM fund.
larryswedroe
Posts: 16022
Joined: Thu Feb 22, 2007 8:28 am
Location: St Louis MO

Re: Rational or behavioral & 3 factor is quite shaky

Post by larryswedroe »

First Fama and French 3 factor model was based on plenty of academic research showing the three factors. So they had their hypothesis already. All they said is that they did not know the source of the "risk" premiums, leaving that to further research, though they did call them risk premiums.
The CAPM was the finance world’s operating model for about 30 years. However, like all models, by definition they are flawed, or wrong. If they were perfectly correct they would be laws, like we have in physics. Over time, anomalies that violated the CAPM began to surface. Among the more prominent ones were:
• 1981: Rolf Banz’s “The Relationship Between Return and Market Value of Common Stocks” was published in The Journal of Financial Economics. Banz found that beta does not fully explain the higher average return of small (or lower market capitalization) stocks.
• 1981: Sanjoy Basu’s “The Relationship Between Earnings’ Yield, Market Value and Return for NYSE Common Stocks,” published in The Journal of Financial Economics, found that the positive relationship between the earnings yield (earnings/price) and average return is left unexplained by beta.
• 1985: Barr Rosenburg, Kenneth Reid, and Ronald Lanstein found a positive relationship between average stock return and the book-to-market ratio in their 1985 paper “Persuasive Evidence of Market Inefficiency” published in The Journal of Portfolio Management.
• 1988: Laxmi Chand Bhandari’s “Debt/Equity Ratio and Expected Common Stock Returns: Empiral Evidence” published in The Journal of Finance found that firms with high leverage have higher average returns than firms with low leverage.

Now there are probably 100 papers or more providing explanations, both risk based and behavioral for the factors.

Larry
Post Reply