18 topics badly explained by many Finance Professors

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vineviz
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18 topics badly explained by many Finance Professors

Post by vineviz » Sat Nov 10, 2018 10:58 am

Some of you might enjoy this short paper,
18 topics badly explained by many Finance Professors, by
Pablo Fernandez.

https://papers.ssrn.com/sol3/papers.cfm ... id=3270268

Not all the topics are investment related, but many are and some of the citations are interesting as well. The papers’s brevity means some topics are covered only cursorily, but I found it to be worth reading.

#18: Common errors in portfolio management and wrong advices
  • 1 Diversify the holding of risky assets according to the proportions of the market portfolio.
  • 2 The only risk that matters is volatility.
  • 3 The only risk that matters is beta.
  • 4 Markets are efficient all the time.
  • 5 The Sharpe ratio is useful.
  • 6 Higher return means necessarily to assume higher risk.
  • 7 Market indexes are difficult/impossible to beat.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Dottie57
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Re: 18 topics badly explained by many Finance Professors

Post by Dottie57 » Sat Nov 10, 2018 11:27 am

So does item #1 mean that cap weighted index funds are rubbish? If so I have done well with rubbish.

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vineviz
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Re: 18 topics badly explained by many Finance Professors

Post by vineviz » Sat Nov 10, 2018 11:43 am

Dottie57 wrote:
Sat Nov 10, 2018 11:27 am
So does item #1 mean that cap weighted index funds are rubbish? If so I have done well with rubbish.
Thankfully that’s not, I’m sure, what he means.

He doesn’t elaborate, but I suspect he’s referring to the fact that the market portfolio is not optimal for ALL investors and/or has no special properties with respect to diversification.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

TJSI
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Re: 18 topics badly explained by many Finance Professors

Post by TJSI » Sat Nov 10, 2018 12:09 pm

Thanks for the link--very informative paper.

TJSI

petulant
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Re: 18 topics badly explained by many Finance Professors

Post by petulant » Sat Nov 10, 2018 12:21 pm

Many interesting points, but he’a got some things wrong or poorly stated. For example, he says volatility is not a measure of risk—he likes volatility! That can be true for many investors for most of their lives, but volatility absolutely is a source of risk once somebody has to actually live on their portfolios. Volatility is directly linked to sequence of returns risk, which is an objective, rational risk. There’s also an argument that high volatility could lead to poor asset decisions due to stress/fear, which could be a legitimate risk via behavioral economics.

The citations on equity risk premium are very interesting though. I’ve aready shared with a consultant.

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vineviz
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Re: 18 topics badly explained by many Finance Professors

Post by vineviz » Sat Nov 10, 2018 12:27 pm

petulant wrote:
Sat Nov 10, 2018 12:21 pm
Many interesting points, but he’a got some things wrong or poorly stated. For example, he says volatility is not a measure of risk—he likes volatility! That can be true for many investors for most of their lives, but volatility absolutely is a source of risk once somebody has to actually live on their portfolios. Volatility is directly linked to sequence of returns risk, which is an objective, rational risk.
Don’t be quick to dismiss his point: what he says is generally accepted and well supported. English isn’t his first language, so maybe there’s a better way to phrase this point, but Pablo is a quite brilliant guy.

I think an argument could be made that volatility is a reasonable PROXY for risk in many cases. Possibly even “good enough” in some cases.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

b0B
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Re: 18 topics badly explained by many Finance Professors

Post by b0B » Sat Nov 10, 2018 12:34 pm

Perhaps when his professors said "Walk before you run", he heard it as "Walking is the only form of locomotion".

bgf
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Re: 18 topics badly explained by many Finance Professors

Post by bgf » Sat Nov 10, 2018 2:08 pm

15, 16, and 17 were both great.

by the way, sounds like an equal weight small cap fund would be more popular. i could only find EWSC...
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siamond
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Re: 18 topics badly explained by many Finance Professors

Post by siamond » Sat Nov 10, 2018 2:18 pm

Thank you for sharing. The article's points are poorly explained (the author must be a finance professor!), but there are a few basic truths in there that are worth repeating...

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vineviz
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Re: 18 topics badly explained by many Finance Professors

Post by vineviz » Sat Nov 10, 2018 3:37 pm

siamond wrote:
Sat Nov 10, 2018 2:18 pm
Thank you for sharing. The article's points are poorly explained (the author must be a finance professor!), but there are a few basic truths in there that are worth repeating...
I agree in large part: I’m not sure what the market is like for a paper like this. Feels more like a pet project than something likely to end up in the Journal of Finance.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

bgf
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Re: 18 topics badly explained by many Finance Professors

Post by bgf » Sat Nov 10, 2018 7:17 pm

vineviz wrote:
Sat Nov 10, 2018 3:37 pm
siamond wrote:
Sat Nov 10, 2018 2:18 pm
Thank you for sharing. The article's points are poorly explained (the author must be a finance professor!), but there are a few basic truths in there that are worth repeating...
I agree in large part: I’m not sure what the market is like for a paper like this. Feels more like a pet project than something likely to end up in the Journal of Finance.
from my lay perspective, it'll get exactly the reception from academia you'd expect it to get considering it sticks a magnifying glass over their conveniently overlooked flaws. i mean seriously, anyone who thinks the Sharpe ratio means anything can jump off a bridge, for example.

a good deal of finance seems more to me like wittgensteinan language games amongst themselves than anything with real, concrete, immutable applicability.

i dont think its their fault necessarily. i just think they are approaching the problem from an impossible angle.
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bogglehead125
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Re: 18 topics badly explained by many Finance Professors

Post by bogglehead125 » Sat Nov 10, 2018 8:53 pm

There are some insane things in this paper.

"If risk is something bad for all investors, then volatility is not risk because many investors
(including the author) like volatility. What most equity investors do not like is bankruptcy, default... in their investments. A portfolio ‘mean-variance efficient’ is good for nothing because the variance (or volatility) is not an appropriate measure of investment risk."

Does... he think... volatility is unrelated to bankruptcy risk?

"For the following 10 years, do you prefer an investment with an annual return of 16% and a Sharpe ratio of 0,4 or another investment with an annual return of 13% and a Sharpe ratio of 1,3?” All of them (the 137 graduate students) preferred the first investment. And you?"

If you apply ~20% leverage to the second strategy you have the same annual return (16%) and lower volatility. But I must be forgetting that he likes volatility.

I am also surprised that he is recommending equal-weighted indices.

If you google "Pablo Fernandez", one of the first hits is a thread on econjobrumors in which people dismiss his research (https://www.econjobrumors.com/topic/pab ... -your-spam).

pascalwager
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Re: 18 topics badly explained by many Finance Professors

Post by pascalwager » Sat Nov 10, 2018 9:50 pm

In some cases, he seems to be adding to the bad explaining.
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Re: 18 topics badly explained by many Finance Professors

Post by jminv » Sun Nov 11, 2018 12:53 am

vineviz wrote:
Sat Nov 10, 2018 3:37 pm
siamond wrote:
Sat Nov 10, 2018 2:18 pm
Thank you for sharing. The article's points are poorly explained (the author must be a finance professor!), but there are a few basic truths in there that are worth repeating...
I agree in large part: I’m not sure what the market is like for a paper like this. Feels more like a pet project than something likely to end up in the Journal of Finance.
Pablo's goal is to maintain his ranking as the #1 SSRN downloaded 'researcher'. To do this, he continually releases papers of dubious quality and engages in spam/social tactics so that people will download them.

I've not met him in person but I have been subject to the spam. I clicked the link before reading who it was by so he suceeded again. It might be that he is running out of people to open his papers in the academic community.

I think he would really benefit from focusing on quality over quantity (but maybe not possible and then he would lose his SSRN ranking) and in making his papers a bit more readable. He's a professor at IESE so he could easily find students whose native language is english to help him revise his papers. I know a professor who recognized this limitation and used students to translate his entire book into english with good success.

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nisiprius
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Re: 18 topics badly explained by many Finance Professors

Post by nisiprius » Sun Nov 11, 2018 7:04 am

17.... I asked to 137 graduate students the following question: “For the following 10 years, do you prefer an investment with an annual return of 16% and a Sharpe ratio of 0,4 or another investment with an annual return of 13% and a Sharpe ratio of 1,3?” All of them (the 137 graduate students) preferred the first investment. And you?
I prefer the second, and his graduate students must not have thought about it much. But you do need to do a calculation. I have to work it out slowly, using a calculator and a scrap of paper, but I'd expect a grad student in economics to do it in their heads--or, at least, to take the time to do it.

Apparently unlike Fernandez, I personally dislike volatility and I have a right to my preferences. I'll get to "volatility versus risk" in a minute. I think I know my risk tolerance, and that tolerance creates a "risk budget" in my investing.

If we assume a riskless return of 3.5%, about the historic average for Treasury bills, then the first investment must have a standard deviation of 13%/0.4 = 32.5%, and the second must have a standard deviation of 10%/1.3 = 7.7%. The second has much lower volatility.

Well, a person who does no computations says, so what? It's all about the moolah, the bread, the spondulix, the Benjamins and rubs his thumb and index finger. Show me the money. I don't care about volatility so I won't even look at it or do any calculations with it.

Very well. Let's say I can tolerate 7% volatility, and let's say that I use a balanced portfolio consisting Investment 2 and the riskless asset. In order to get the volatility down to 7%, I need to dilute it just a bit, 91% Investment2 + 9% riskless. That will dilute my return to 91% * 13% + 9% * 3.5% = 12.1%.

To get the volatility down to 7% with investment 1, I need to keep the allocation way down: 22% Investment1 + 78% riskless. That will give me a return of 22% * 16% + 78% * 3.5% = 6.25%.

In short, if I want the same volatility, using investment 2 will give me double the return. If I in fact am willing to tolerate the volatility of 100% Investment1, I still will get a higher return by leveraging Investment2. The cost of leverage complicates things, but with this big a different I think investment2 will still be superior.

If I use bonds instead of the riskless asset, I think the balance shifts even in further of Investment2.

Now, about risk and volatility. I agree that risk is complicated and multidimensional. But volatility is a form of risk, and e.g. Warren Buffett never said "volatility is not risk," he made a much more nuanced statement, "volatility is not the same thing as risk." We can also ask whether the standard deviation captures the idea of volatility (since many of us feel different about positive and negative skew). None of this matters unless you can define and exhibit an appropriate measure of risk and show that it is not closely correlated with standard deviation. I believe that in fact risk is risk and most forms of risk go more or less together and that the standard deviation is probably a good a measure of risk as sticking a thermometer in your mouth to measure core body temperature.

I did a casual explanation of this once, plotting a form of risk I care a lot about (maximum drawdown) against standard deviation in the real world, in a bunch of selected mutual funds representing different asset types and risk categories, and I'll show the result in a second. The point is it may well be true that small fluctuations during "normal" market conditions may not predict "crisis risk."

But when you look at any long-term data, standard deviation includes the numbers from crashes and in fact they carry a lot of influence on the long-term averages.

So, here's the "inappropriate" measure, standard deviation, on the X axis, and a more appropriate measure, maximum drawdown on the Y axis. Complaining that standard deviation isn't a perfect measure of risk is a red herring. It's no more relevant than saying "book-to-market is not value," or "the Dow Jones Industrial Average is not the market" or "your drugstore thermometer doesn't measure body temperature." No, but they're reasonably good, and good enough to be useful.

Image

Now, who knows, maybe Fernandez would go further and say "so what? Drawdowns are not risk, either." He does say "what most equity investors do not like is bankruptcy, default." But I am pretty sure you could show a strong relationship between large market drawdowns and bankruptcies and default.

Values from PortfolioVisualizer, using all data available in PV as of 1/2018. List of points plotted:
GLD (gold ETF)
PCRIX (commodities fund)
VTSMX (total stock)
DFSTX (small cap value fund)
ULPIX (2X daily-leveraged S&P 500 fund)
FNMIX (EM bond fund)
VEIEX (emerging markets)
VGTSX (global ex-US, international stocks)
FJPNX (Fidelity Japan fund)
VBMFX (Vanguard Total Bond)
VWEHX (junk bonds)
LMVTX (Legg Mason Value Trust, once-legendary active fund)
COIN (Bitcoin ETF) -- just kidding
"CASHX" (PortfolioVisualizer's "ticker symbol" for one-month Treasury bills)
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siamond
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Re: 18 topics badly explained by many Finance Professors

Post by siamond » Sun Nov 11, 2018 10:58 am

nisiprius wrote:
Sun Nov 11, 2018 7:04 am
Now, about risk and volatility. I agree that risk is complicated and multidimensional. But volatility is a form of risk, and e.g. Warren Buffett never said "volatility is not risk," he made a much more nuanced statement, "volatility is not the same thing as risk."
Agreed with what you just said, but... it seems to me that the paper's author largely concurred. His short summary (topic 18) is right on, and actually does not contradict your views (nor Warren's): 2 The only risk that matters is volatility. He didn't say that volatility doesn't matter, he said that this is NOT the ONLY form of risk (and some people are more or less sensitive to it, he said he's not, but he didn't generalize to humanity at large, nor should you when taking the opposite view).

And this directly reinforces his other point that the Sharpe ratio (as a very unidimensional perspective) is utterly useless. Can't agree more. I do look at volatility when analyzing market history, but on its own, separately from returns, and as part of a bigger picture.
nisiprius wrote:
Sun Nov 11, 2018 7:04 am
We can also ask whether the standard deviation captures the idea of volatility (since many of us feel different about positive and negative skew). None of this matters unless you can define and exhibit an appropriate measure of risk and show that it is not closely correlated with standard deviation. I believe that in fact risk is risk and most forms of risk go more or less together and that the standard deviation is probably a good a measure of risk as sticking a thermometer in your mouth to measure core body temperature.
It is true indeed that many short-term risk metrics, including those more clearly associated with what regular human beings would define as (a form of) risk, have been strongly correlated with standard-deviation, making stdev a decent proxy. Case in point, drawdowns (or better, Ulcer index), downside semi-deviation (leading to Sortino ratio), etc. This actually speaks to the approximate 'return to the mean' behavior of the market (so far). I don't know why one would use an inferior metric as opposed to a better one, but still, your point remains. Personally, I view those metrics as capturing 'emotional risk' and I like the Ulcer Index best.

I am afraid you're missing the point the author was making though (well, the point I would make, as the author barely provided any details about his own line of thinking). The only risk(s) that matters is NOT solely about the short-term. I would argue that long-term risk is MUCH more important (e.g. high/sustained inflation risk, low purchasing power risk, bankruptcy risk, longevity risk, etc), i.e. deep risk as the good Dr. Bernstein put it. And THAT is definitely NOT correlated with standard-deviation. On the contrary, actually. And this seems much more relevant to most long-term investors (e.g. Bogleheads).

But really, the key point is not to discard volatility. You said it well to begin with. Risk is complicated and multidimensional. One really needs to think beyond volatility, and this includes thinking long-term.

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