Paul Krugman on Efficient Markets and Rip Offs

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Paul Krugman on Efficient Markets and Rip Offs

Post by tower » Wed Aug 12, 2009 8:05 am

Krugman in his August 9, 2009, New York Times book review of "The Sages" and "The Myth of the Rational Market" discusses the efficient market theory. His piece is a marvelously clear, innovative, brief history of financial thinking. I have one gripe. Here are his closing lines:

"And Wall Street's appetite for complex strategies that sound clever-- and can be sold to credulous investors--survived Long Term Capital Management's debacle; and why can't it survive this crisis, too?

My guess is that the myth of the rational market--a myth that is beautiful, comforting and, above all, lucrative--isn't going away anytiime soon."

What he gets backwards is that a belief in market efficiency leads to the belief that simple low-cost, broad-based, capitalization-weighted indexing is the best policy. It is a belief in market inefficiency that leads investors to pay higher fees to mutual fund managers who assert their ability to pick the winners and market time.

Ed Tower

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Post by Wagnerjb » Wed Aug 12, 2009 8:37 am

Ed: it is the incredible amount of evidence that active managers cannot predictably and consistently beat low-cost passive benchmarks that lead rational investors to prefer low-cost passive index funds.

It is the incredible amount of evidence that active managers cannot predictably and consistently beat low-cost passive benchmarks that lead rational investors to accept that our financial markets are highly efficient.

Best wishes.
Andy

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Re: Paul Krugman on Efficient Markets and Rip Offs

Post by walkinwood » Wed Aug 12, 2009 8:49 am

tower wrote: What he gets backwards is that a belief in market efficiency leads to the belief that simple low-cost, broad-based, capitalization-weighted indexing is the best policy. It is a belief in market inefficiency that leads investors to pay higher fees to mutual fund managers who assert their ability to pick the winners and market time.

Ed Tower
It is the other financial products, which are modeled on the EMH and CAPM that are really dangerous - eg. the ones that LTCM was based on.

The superiority of a low cost indexing strategy over active management does not depend on these theories. There is empirical proof of that in the market data available.

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Post by yobria » Wed Aug 12, 2009 9:03 am

The reviews can be found here:

http://www.nytimes.com/2009/08/09/books ... sq=krugman sages&st=cse&scp=1

As soon as somebody points out to me a consistently exploitable market inefficiency (allowing me to retire to my own private island), I'd agree that markets are no longer efficient.

Until then...

Nick

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Market efficiency and broad based indexing

Post by tower » Wed Aug 12, 2009 9:05 am

But wasn't the LTCM strategy based on the belief that certain assets were mispriced? And that this market inefficiency held the opportunity for profits? If LTCM had believed markets were efficient all the time it would not have advocated the strategies it did. Could we say that it was a belief in short term market inefficiency and long term efficiency that did the damage?

And aren't value weighting and small cap weighting, i.e. anything other than market-cap weighted indexing, based on the belief that markets are inefficient in that certain styles get mispriced?

Ed

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Re: Market efficiency and broad based indexing

Post by bob90245 » Wed Aug 12, 2009 9:14 am

tower wrote:But wasn't the LTCM strategy based on the belief that certain assets were mispriced? And that this market inefficiency held the opportunity for profits? If LTCM had believed markets were efficient all the time it would not have advocated the strategies it did. Could we say that it was a belief in short term market inefficiency and long term efficiency that did the damage?
Correct.
tower wrote:And aren't value weighting and small cap weighting, i.e. anything other than market-cap weighted indexing, based on the belief that markets are inefficient in that certain styles get mispriced?

Ed
No. The market is pricing for risk. Unless you believe that that large companies have equal amount of risk than small companies. And that healthy growing companies (growth stocks) have equal amount of risk than distressed companies (value stocks).
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Re: Market efficiency and broad based indexing

Post by yobria » Wed Aug 12, 2009 9:23 am

tower wrote:But wasn't the LTCM strategy based on the belief that certain assets were mispriced? And that this market inefficiency held the opportunity for profits? If LTCM had believed markets were efficient all the time it would not have advocated the strategies it did. Could we say that it was a belief in short term market inefficiency and long term efficiency that did the damage?
It's been a while since I read "When Genius Failed", but as I recall they made highly leveraged liquidity bets, the risk showed up, they couldn't unload their bonds to meet margin calls, and they went out of business. All this proves IMO is that risk happens.

Remember LTCM was playing with OPM. I'd be happy to risk your money on a strategy that has a 50% chance of a payoff for me.
tower wrote:And aren't value weighting and small cap weighting, i.e. anything other than market-cap weighted indexing, based on the belief that markets are inefficient in that certain styles get mispriced?
Some folks think that SV weighting is due to these stocks being more risky (eg look at RZV over the past year), some think they've found some psychological flaw with other investors, and some think it it's a silly pattern that will not exist going forward. (Overweighting SV does provide some level of diversification, since you have another "asset class"). Does this qualify as a consistent "market inefficiency"? That's what they called the January Effect, when that pattern was found. Until it went away.

Nick

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Post by Kenkat » Wed Aug 12, 2009 9:26 am

LTCM's strategy was certainly based on the belief that certain assets were mispriced. And LTCM was correct by the way - the assets were mispriced - very slightly - but mispriced none the less.

LTCM's failing was that they didn't have a large enough bankroll. This is a term common to gambling (poker, blackjack, etc.) - i.e., you need to have a large enough bankroll to survive a run of negative (losing) results without getting busted.

LTCM was heavily leveraged and couldn't survive a temporary breakdown in their model without going bust. Using the analogy of picking up nickels in front of a steam-roller, they miscalculated the safe distance. Ultimately what killed them was not long-term efficiency but extreme short-term volitility (which they extremely underestimated).

I think the jury is still out as to whether you can pick up enough nickels with a margin of safety to make it all worthwhile. The weak theory of EMH says that the nickels are there, but not worth picking up while the strong theory says there ain't no nickels. Non-EMH believers are out there picking up nickels. Their long-term safety is in doubt however.

Ken

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Post by gchan » Wed Aug 12, 2009 9:49 am

LTCM's strategy was certainly based on the belief that certain assets were mispriced. And LTCM was correct by the way - the assets were mispriced - very slightly - but mispriced none the less.
I'm not entirely sure that the assets were always mispriced.

In the case of the bond convergence trades, they were being compensated for liquidity risk. And in hindsight, those who paid a premium for the more liquid bonds did well (?).

They also overleveraged the bankroll that they had. You can always overleverage a good trade into a bad one.
Remember LTCM was playing with OPM.
I recall from the book that they started kicking clients out and putting more and more of their own money in.
Bogle: Over a 50-year period, about 4% of all managers will beat the market. If you think I'm going to tell you it's impossible for my son to be in that 4%, you don't know me very well.

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Small and Value more risky?

Post by tower » Wed Aug 12, 2009 9:49 am

If advisers believed that small and value generated higher returns because they were more risky and not because of market inefficiency wouldn't they recommend weighting them according to market cap rather than overweighting them? If they do recommend overweighting them to all their clients, then they are implying that their clients have different risk preferences than the market at large (which seems implausible) or that markets are inefficient.

If we believe in efficient markets then cap-weighted indexation should provide the optimal diversification between asset classes.

Ed

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Re: Market efficiency and broad based indexing

Post by yobria » Wed Aug 12, 2009 9:49 am

bob90245 wrote:And that healthy growing companies (growth stocks) have equal amount of risk than distressed companies (value stocks).
Well looking at the top 10 holdings of Vanguard's Small Growth and Small Value funds, I couldn't find a difference in "level of distress". Their identical performance over the recent crisis seems to reinforce this.

One just has more tech stocks, one has more financials. Performance will simply depend on which of those industries does better going forward.

Nick

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Post by yobria » Wed Aug 12, 2009 9:52 am

gchan wrote: I'm not entirely sure that the assets were always mispriced.

In the case of the bond convergence trades, they were being compensated for liquidity risk. And in hindsight, those who paid a premium for the more liquid bonds did well (?).
Exactly - running in front of a steamroller to pick up a nickel does not imply mispricing - it implies taking a risk to make a return.

Nick

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Post by George-J » Wed Aug 12, 2009 9:55 am

kenschmidt wrote:...LTCM's failing was that they didn't have a large enough bankroll. This is a term common to gambling (poker, blackjack, etc.) - i.e., you need to have a large enough bankroll to survive a run of negative (losing) results without getting busted.
Ken
Yes, but after reading "When Genuis Failed" the underlying failing is I think pure "greed". Prior to their failure the LTCM principals calculated they could double their personal profits by kicking out half of their investment base - thus reducing their margin of safety in favour of more potential personal profit.

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Re: Small and Value more risky?

Post by bob90245 » Wed Aug 12, 2009 9:56 am

tower wrote:If advisers believed that small and value generated higher returns because they were more risky and not because of market inefficiency wouldn't they recommend weighting them according to market cap rather than overweighting them? If they do recommend overweighting them to all their clients, then they are implying that their clients have different risk preferences than the market at large (which seems implausible) or that markets are inefficient.

If we believe in efficient markets then cap-weighted indexation should provide the optimal diversification between asset classes.

Ed
1) "Optimal diversification" is an undefined subjective term.

2) Cap-weighted index like TSM will get you essentially a large-blend asset class. If an investor wishes to capture higher expected returns from small and value, they will need to overweight those classes in their portfolio.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Re: Small and Value more risky?

Post by yobria » Wed Aug 12, 2009 9:56 am

tower wrote:If advisers believed that small and value generated higher returns because they were more risky and not because of market inefficiency wouldn't they recommend weighting them according to market cap rather than overweighting them? If they do recommend overweighting them to all their clients, then they are implying that their clients have different risk preferences than the market at large (which seems implausible) or that markets are inefficient.
Financial Advisers have all sorts of motives - the SV premia make great marketing material for example. But now we're getting out of the realm of hard data and economic theory.
tower wrote:If we believe in efficient markets then cap-weighted indexation should provide the optimal diversification between asset classes.
Edit: I didn't notice you said "between" asset classes. As mentioned below, this is not the case - we all have individual efficient portfolios.

Nick
Last edited by yobria on Wed Aug 12, 2009 8:12 pm, edited 1 time in total.

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statistical vs economic diversification

Post by tower » Wed Aug 12, 2009 10:05 am

Nick, Please clarify the difference between the two and what the implication for investors is.

Ed

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Post by Kenkat » Wed Aug 12, 2009 10:36 am

yobria wrote:
gchan wrote: I'm not entirely sure that the assets were always mispriced.

In the case of the bond convergence trades, they were being compensated for liquidity risk. And in hindsight, those who paid a premium for the more liquid bonds did well (?).
Exactly - running in front of a steamroller to pick up a nickel does not imply mispricing - it implies taking a risk to make a return.

Nick
Well, that's exactly the EMH argument. Does the risk offset the return or can you make a premium in exploiting mispricing? In other words, let's say that for some reason the market as a whole has an irrational fear of steamrollers such that there's more nickels than you'd expect. In that case, you have mispricing. Perceived risk does not equal actual risk.

EMH says that doesn't happen. The market sees nickels being picked up and people overcome the irrational fear very quickly.

Non-EMH says that this scenario can and does exist for some things. It takes awhile for people to notice there are nickels or to get over their fear of the steamroller. Profits are made until this occurs.

I honestly am on the fence so I am not advocating either side per se. I do think mispricings do occur but am not convinced that they can be reliably exploited. I also think assuming EMH is correct most of the time probably serves the average Joe best.

Ken

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Re: Small and Value more risky?

Post by Wagnerjb » Wed Aug 12, 2009 12:43 pm

tower wrote:If advisers believed that small and value generated higher returns because they were more risky and not because of market inefficiency wouldn't they recommend weighting them according to market cap rather than overweighting them? If they do recommend overweighting them to all their clients, then they are implying that their clients have different risk preferences than the market at large (which seems implausible) or that markets are inefficient.

Ed
The advisor with whom I am most familiar (he uses primarily DFA funds and works with my mother) overweights riskier assets in general and offsets that additional risk with lower risk fixed income investments. He believes that is a more optimal use of risk in the portfolio (ie, not taking risk in the fixed income side).

That is no different than the everyday choice we make between stocks and bonds. Nobody invests in "market weights" overall....the younger folks overweight stocks and retirees may overweight bonds. Most folks here will overweight US stocks. The rich will overweight tax-free bonds.

Choosing a risk profile that is appropriate to you has nothing to do with market efficiency.

Best wishes.
Andy

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Paul Krugman on Efficient Markets and Rip Offs

Post by YDNAL » Wed Aug 12, 2009 1:12 pm

As soon as somebody points out to me a consistently exploitable market inefficiency (allowing me to retire to my own private island), I'd agree that markets are no longer efficient.
Nick,

Was the S&P500 Index mis-priced at,
- 752.44 (11/20/08 )?
- or 676.53 (3/9/09)?

This is roughly a 3.5-month period of intense uncertainty - exploitable - with an irrational & inefficient market with lack of direction except to drive prices south. Hindsight 20/20, of course, unless you had (@&@%#$ (insert Spanish word).

"Consistently exploitable" is one thing, another is to say that markets can't be inefficient, irrational and exploitable. Identifying the levels that makes it wise to exploit the market - a totally different issue/debate.
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Re: Paul Krugman on Efficient Markets and Rip Offs

Post by drjdpowell » Wed Aug 12, 2009 1:22 pm

YDNAL wrote:Was the S&P500 Index mis-priced at,
- 752.44 (11/20/08 )?
- or 676.53 (3/9/09)?
Hopefully, 20:20 hindsight of the future will not reveal the market to have been irrationally overvalued on those dates.

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Post by CaveatEmptor » Wed Aug 12, 2009 1:29 pm

kenschmidt wrote:
...

I do think mispricings do occur but am not convinced that they can be reliably exploited. I also think assuming EMH is correct most of the time probably serves the average Joe best.

Ken
Ken: I concur with what you say, to which I would add that many (most?) people are reluctant to admit that, when it comes to investing, they are just an "average Joe". The overconfident belief in one's special skills is documented, ironically, in the same behavioral-finance literature that people are nowadays using to attack EMH.

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Re: Paul Krugman on Efficient Markets and Rip Offs

Post by YDNAL » Wed Aug 12, 2009 1:37 pm

drjdpowell wrote:
YDNAL wrote:Was the S&P500 Index mis-priced at,
- 752.44 (11/20/08 )?
- or 676.53 (3/9/09)?
Hopefully, 20:20 hindsight of the future will not reveal the market to have been irrationally overvalued on those dates.
Perhaps.

If valuations are important, and historical precedence is worth anything, then it's unlikely for these levels to be "irrationally overvalued"... ignoring the effects of semantics, like, what is irrationally or overvalued.
Landy | Be yourself, everyone else is already taken -- Oscar Wilde

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Post by Kenkat » Wed Aug 12, 2009 1:44 pm

CaveatEmptor wrote:
kenschmidt wrote:
...

I do think mispricings do occur but am not convinced that they can be reliably exploited. I also think assuming EMH is correct most of the time probably serves the average Joe best.

Ken
Ken: I concur with what you say, to which I would add that many (most?) people are reluctant to admit that, when it comes to investing, they are just an "average Joe". The overconfident belief in one's special skills is documented, ironically, in the same behavioral-finance literature that people are nowadays using to attack EMH.
Just to add - I include myself in the "average Joe" category!

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Re: Paul Krugman on Efficient Markets and Rip Offs

Post by Kenkat » Wed Aug 12, 2009 1:48 pm

YDNAL wrote:
As soon as somebody points out to me a consistently exploitable market inefficiency (allowing me to retire to my own private island), I'd agree that markets are no longer efficient.
Nick,

Was the S&P500 Index mis-priced at,
- 752.44 (11/20/08 )?
- or 676.53 (3/9/09)?

This is roughly a 3.5-month period of intense uncertainty - exploitable - with an irrational & inefficient market with lack of direction except to drive prices south. Hindsight 20/20, of course, unless you had (@&@%#$ (insert Spanish word).

"Consistently exploitable" is one thing, another is to say that markets can't be inefficient, irrational and exploitable. Identifying the levels that makes it wise to exploit the market - a totally different issue/debate.
I don't believe you will ever find consistent and exploitable mispricings at a macro level such as the S&P 500. There are just way too many variables involved.

If there are going to be mispricings that can be exploited, I believe they are much more likely to be small and at a micro level. It would be a LOT of work to exploit them. Even then, the jury is still out as to whether you can exploit them without getting whacked by risk.

Ken

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Re: Paul Krugman on Efficient Markets and Rip Offs

Post by kenner » Wed Aug 12, 2009 1:53 pm

tower wrote:Krugman in his August 9, 2009, New York Times book review of "The Sages" and "The Myth of the Rational Market" discusses the efficient market theory. His piece is a marvelously clear, innovative, brief history of financial thinking. I have one gripe. Here are his closing lines:

"And Wall Street's appetite for complex strategies that sound clever-- and can be sold to credulous investors--survived Long Term Capital Management's debacle; and why can't it survive this crisis, too?

My guess is that the myth of the rational market--a myth that is beautiful, comforting and, above all, lucrative--isn't going away anytiime soon."

What he gets backwards is that a belief in market efficiency leads to the belief that simple low-cost, broad-based, capitalization-weighted indexing is the best policy. It is a belief in market inefficiency that leads investors to pay higher fees to mutual fund managers who assert their ability to pick the winners and market time.

Ed Tower
Krugman's opinions started as a book review and morphed into an editorial comment on Wall Street's unwillingness to learn anything from the worst financial disaster in the last 70 years.

Krugman's ending comments are more about marketing than they are about markets.

As long as Wall Street greed can be satiated by selling questionable investments to investors who lack knowledge, Wall Street will do so. This is driven by Wall Street marketing prowess and investor behavior, not by market theory. The vast majority of laypeople do not know market theory. They turn to financial advisors because they have no real idea how to invest on their own.

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Post by jh » Wed Aug 12, 2009 1:56 pm

...
Last edited by jh on Tue Oct 06, 2009 11:40 am, edited 1 time in total.

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Re: Paul Krugman on Efficient Markets and Rip Offs

Post by YDNAL » Wed Aug 12, 2009 2:44 pm

kenschmidt wrote:I don't believe you will ever find consistent and exploitable mispricings at a macro level such as the S&P 500. There are just way too many variables involved.
There was mispricing at a macro level when everyone in the S&P500 got hammered with (without) cause in blanket (re)action. I've agreed, though, not consistently exploitable.
YDNAL wrote:"Consistently exploitable" is one thing, another is to say that markets can't be inefficient, irrational and exploitable.
I chose the S&P illustration since, as Bogleheads, we don't trade individual stocks. :wink:

This may be of interest.
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Post by Beagler » Wed Aug 12, 2009 3:21 pm

yobria wrote:The reviews can be found here:

http://www.nytimes.com/2009/08/09/books ... sq=krugman sages&st=cse&scp=1

As soon as somebody points out to me a consistently exploitable market inefficiency (allowing me to retire to my own private island), I'd agree that markets are no longer efficient.

Until then...

Nick
The Great Municipal Bond Sale that we experienced as hedge funds (and others) liquidated their positions in their rush to raise cash seems like an inefficiency. I know I'm not alone among purchasers.
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Re: Paul Krugman on Efficient Markets and Rip Offs

Post by Wagnerjb » Wed Aug 12, 2009 3:41 pm

YDNAL wrote:There was mispricing at a macro level when everyone in the S&P500 got hammered with (without) cause in blanket (re)action.
Well, didn't we just have a dramatic slowdown in our economy? Many big companies are suddenly going bankrupt, and you feel that the sharp decline in the S&P500 is "without cause"? Expectations of the future were being revised downward sharply.

There were precious few people at that time that were proclaiming "overreaction!". I am sure a few were, but an awful lot of people felt like the economic problems warranted a severe drop.

Hindsight sure makes it look like the market was "mispriced" in March, but it sure wasn't so obvious in March. :D
Andy

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Re: Paul Krugman on Efficient Markets and Rip Offs

Post by drjdpowell » Wed Aug 12, 2009 4:15 pm

YDNAL wrote:
drjdpowell wrote:
YDNAL wrote:Was the S&P500 Index mis-priced at,
- 752.44 (11/20/08 )?
- or 676.53 (3/9/09)?
Hopefully, 20:20 hindsight of the future will not reveal the market to have been irrationally overvalued on those dates.
Perhaps.

If valuations are important, and historical precedence is worth anything, then it's unlikely for these levels to be "irrationally overvalued"... ignoring the effects of semantics, like, what is irrationally or overvalued.
How useful has this chart been? If I had been following a rule using this chart that had me make money recently by buying near the PE low of about 13, then the last time I was buying stocks (reading off the chart) was back in 1988. If I sold out at a high number like 20, then I would have been out of stocks since 1993. Would I have really have gained much by following this strategy?

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Post by bschultheis » Wed Aug 12, 2009 4:41 pm

I think Fox (or his publisher) picked a very, very poor title for the book. I am not aware of anyone in academia that has ever argued that markets are rational all the time. In fact most, if not all would probably agree that markets can be highly irrational at times, due to speculative nature of investors.

In reading Lowensteins' book on LTCM, it seems that folks running it believed that markets can move out of synch from time to time, become slightly irrational. They would then step in to take advantage of reversion to rationality. As LTCM discovered, markets can remain irrational much longer than one can remain solvent.

Next question is, can investors (Shiller, Grantham included) consistently take advantage of any market irrationality, Easier said than done, as Shiller said so himself.

Who cares if markets are efficient or not. Pretty hard to consistently take advantage of inefficiencies.

In regards to Value and small mispricing, or inefficiencies, I personally believe it is as much/more a behavior issue as risk issue, but that is beside the point. If I tilt my portfolio away from TSM, I live with the decision, and in the long run isn't that big a deal in whether or not I reach my financial goals, unlike LTCM, that bet the farm, and lost.

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Post by bob90245 » Wed Aug 12, 2009 4:42 pm

Beagler wrote:The Great Municipal Bond Sale that we experienced as hedge funds (and others) liquidated their positions in their rush to raise cash seems like an inefficiency. I know I'm not alone among purchasers.
No. The market was pricing for risk. Many state's credit ratings were lowered. And some states (like California) were having budget woes due to dramatically lower tax revenues. Hence, the muni bond market became more risky.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Post by bschultheis » Wed Aug 12, 2009 4:59 pm

One more thing. I'd like to have Fox summarize his main theme of the book in one paragraph. Would be interesting to see what he has to say. I haven't read his book yet, but have certainly read enough reviews to be confused about his main message. Guess I will read it.

In regards to Krugman's rant on WS crowd, I agree they got carried away, and posted the same on my blog last week, 8/1. WS crowd took Markowitz stuff, which is surprsingly simple and elegant, in my opinion, and put it in the big black box, and out came complex formulas that said if you own all these fancy new asset classes in your account, you can get a portfolio that has market-beating returns with minimal risk.

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Post by AnimalCrackers » Wed Aug 12, 2009 5:38 pm

bschultheis wrote:One more thing. I'd like to have Fox summarize his main theme of the book in one paragraph.
I read the Fox book. My learned analysis: "It's a real good book." I don't know what he'd pick as its main theme to summarize in a paragraph though.

In hindsight, I bought the book and read it hoping Fox would have more to say about exactly how he reached the conclusion that he did below in a (superb) 12/09/2002 article titled "Is the Market Rational?" that I have kept the link to for years: http://www.pbs.org/wsw/news/fortunearti ... 09_06.html

Perhaps the book's summary would be what Fox had to say in two excerpts from the article:

"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."

***

"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."

The article's conclusion:

"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."

Why doesn't Justin Fox just promise me that I'll ultimately come out ahead if I just tilt and rebalance the equity side between TSM and SCV instead of just sticking with boring ol' TSM like I'm doing? Is that too much to ask? :D
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Post by bschultheis » Wed Aug 12, 2009 5:49 pm

Animal Crackers, thanks so much for sharing your thoughts, and summary, I appreciate it. I do intend to read it, working on Snowball/Buffett right now, a good read as well. I loved Capital Ideas by Bernstein, the history of it all, and hope that Fox' book will have similar historical insights.

Maybe someday, in 25 years, a historian/writer will comment on the important role bogleheads played in sorting out the good, bad and ugly of investing and bringing common sense investing to the masses.

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Henry Sadovsky
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The mother of all inefficiencies?

Post by Henry Sadovsky » Wed Aug 12, 2009 5:49 pm

.
bschultheis wrote:

Who cares if markets are efficient or not. Pretty hard to consistently take advantage of inefficiencies.

In regards to Value and small mispricing, or inefficiencies, I personally believe it is as much/more a behavior issue as risk issue, but that is beside the point.
You have contradicted yourself. If the S/V tilt story has been behavioral (I agree that such has likely played a large role), then tilters have benefited from the mother of all inefficiencies. Could such continue? A fascinating question, IMV.
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Re: Small and Value more risky?

Post by Lauren Vignec » Wed Aug 12, 2009 6:37 pm

tower wrote:
If we believe in efficient markets then cap-weighted indexation should provide the optimal diversification between asset classes.

Ed
Hello Ed,

This is only true if some really dramatic simplifying assumptions are made. Here is a paper by Harry Markowitz, with a great title:
"Market Efficiency: A Theoretical Distinction and So What?"

http://www.researchaffiliates.com/ideas ... ciency.pdf

I wish more academic papers had a "So What?" section, but anyway...

The Capital Asset Pricing Model comes to the conclusion that the market portfolio is an efficient portfolio, and that, in fact, it is the only efficient portfolio. One of the assumptions behind the model is that investors can borrow without limit. Even if all the CAPM's other assumptions are accepted, using more realistic assumptions about leverage changes the conclusions dramatically.

With more realistic assumptions it becomes clear that there is no average investor, and that a wide range of portfolios can be efficient portfolios. So a wide range of portfolios can provide optimal diversification. If the market portfolio is the optimal portfolio for a given investor, that is a coincidence.

Leaving the realm of theory, consider tax-exempt bonds versus taxable bonds. Maybe there is some investor who actually should hold the market weighting of taxable and tax-exempt bonds, but if so it is a coincidence. Or consider inflation-protected securities versus nominal bonds. Again, maybe some investor should hold the market weighting of inflation-linked and nominal bonds, but if so it is a coincidence.

Different stocks, and different stock asset classes, should have different risk and return profiles. Without empirical data, maybe it would be hard to guess whether it would be best to divide stocks by sector, or by market cap, or whatever. But there would still be no reason to assume a market portfolio of stocks will provide optimal diversification.

L

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bob90245
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Re: The mother of all inefficiencies?

Post by bob90245 » Wed Aug 12, 2009 7:30 pm

Henry Sadovsky wrote:
bschultheis wrote:
Who cares if markets are efficient or not. Pretty hard to consistently take advantage of inefficiencies.

In regards to Value and small mispricing, or inefficiencies, I personally believe it is as much/more a behavior issue as risk issue, but that is beside the point.
You have contradicted yourself. If the S/V tilt story has been behavioral (I agree that such has likely played a large role), then tilters have benefited from the mother of all inefficiencies. Could such continue? A fascinating question, IMV.
Why do people believe it is only Small and Value that are mispriced? Surely, you can put the shoe on the other foot and say that Large and Growth are the ones that are mispriced. In fact, I think it is a stronger argument to say that investors overpay for the safety of Growth stocks and Large stocks.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Post by alec » Wed Aug 12, 2009 7:52 pm

I read the Fox book, and I thought it came through pretty loud and clear that the "market will police itself" theory was advocated very hard by, who else, the people poised to profit from lax regulation.
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Post by yobria » Wed Aug 12, 2009 7:58 pm

kenschmidt wrote:Well, that's exactly the EMH argument. Does the risk offset the return or can you make a premium in exploiting mispricing? In other words, let's say that for some reason the market as a whole has an irrational fear of steamrollers such that there's more nickels than you'd expect. In that case, you have mispricing. Perceived risk does not equal actual risk.

EMH says that doesn't happen. The market sees nickels being picked up and people overcome the irrational fear very quickly.
Right, but there is no evidence LTCM got any free lunches. They simply took a lot of leveraged liquidity risk, the risk showed up, and they lost. No EMH violation there.

Nick

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Re: Small and Value more risky?

Post by alec » Wed Aug 12, 2009 8:09 pm

Lauren Vignec wrote:
tower wrote:
If we believe in efficient markets then cap-weighted indexation should provide the optimal diversification between asset classes.

Ed
Hello Ed,

This is only true if some really dramatic simplifying assumptions are made. Here is a paper by Harry Markowitz, with a great title:
"Market Efficiency: A Theoretical Distinction and So What?"

http://www.researchaffiliates.com/ideas ... ciency.pdf

I wish more academic papers had a "So What?" section, but anyway...

The Capital Asset Pricing Model comes to the conclusion that the market portfolio is an efficient portfolio, and that, in fact, it is the only efficient portfolio. One of the assumptions behind the model is that investors can borrow without limit. Even if all the CAPM's other assumptions are accepted, using more realistic assumptions about leverage changes the conclusions dramatically.

With more realistic assumptions it becomes clear that there is no average investor, and that a wide range of portfolios can be efficient portfolios. So a wide range of portfolios can provide optimal diversification. If the market portfolio is the optimal portfolio for a given investor, that is a coincidence.

Leaving the realm of theory, consider tax-exempt bonds versus taxable bonds. Maybe there is some investor who actually should hold the market weighting of taxable and tax-exempt bonds, but if so it is a coincidence. Or consider inflation-protected securities versus nominal bonds. Again, maybe some investor should hold the market weighting of inflation-linked and nominal bonds, but if so it is a coincidence.

Different stocks, and different stock asset classes, should have different risk and return profiles. Without empirical data, maybe it would be hard to guess whether it would be best to divide stocks by sector, or by market cap, or whatever. But there would still be no reason to assume a market portfolio of stocks will provide optimal diversification.

L
Wow, that was an interesting article. Thanks L. However, no my questions is "What do I do know?" Do I start with the market portfolio and ask "How am I different?" For example, Larry Swedroe has most of his assets in taxable, so he's going to hold mostly muni bonds instead of taxable bonds.
"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair

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Post by Jack » Wed Aug 12, 2009 8:23 pm

bschultheis wrote:I think Fox (or his publisher) picked a very, very poor title for the book. I am not aware of anyone in academia that has ever argued that markets are rational all the time.
Apparently you haven't been paying attention to Gene Fama and his colleagues. Fama insists that there was no tech bubble in the 90s, that there was a rational justification for equity prices. He says the same about housing prices. Buyers were very careful and totally rational. In fact, Fama ridicules as arrogant any economist who believes the markets are irrational, ever.
Fama, 2007 wrote:Well, economists are arrogant people. And because they can’t explain something, it becomes irrational. The way I look at it, there were two crashes in the last century. One turned out to be too small. The ’29 crash was too small; the market went down subsequently. The ’87 crash turned out to be too big; the market went up afterwards. So you have two cases: One was an underreaction; the other was an overreaction. That’s exactly what you’d expect if the market’s efficient.

The word "bubble" drives me nuts. For example, people say "the Internet bubble." Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful.

I did a calculation. Microsoft was an example of a corporation that came from the previous revolution, the computer revolution. It was hugely profitable and successful. How many Microsofts would it have taken to justify the whole set of Internet valuations? I think I estimated it to be something like 1.4.
...
Housing markets are less liquid, but people are very careful when they buy houses. It’s typically the biggest investment they’re going to make, so they look around very carefully and they compare prices. The bidding process is very detailed.

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Post by bschultheis » Wed Aug 12, 2009 8:46 pm

bob, henry, this is getting interesting. On one hand we talk about not being able to "beat the market," and yet on the other hand we tilt portfolios with the expectation that we can exploit inefficiencies that willl beat the market. I agree with you that any inefficincies are just as likely a factor of "growth"stocks being bid up to levels that make them pretty expensive, vs "value" stocks being risky. I personally feel that the value premium will persist for as long as investors invest in the stock market, for the simple reason that people would rather buy well-run companies than run-down companies.

Ten years ago, when I started giving seminars, I shared the example of two grocery stores (real stores) in my neighborhood. One was super cool, everyone loved to shop there. The other one, down the street, was dusty, dirty, checkout guy was watching TV behind the checkout counter, three inches of ice on the ice cream bin. Which store would your rather own? Investors always end up paying a lot more for same dollar earned at the cool store. That will never change, and in my simple way of thinking, is why the value premium will always exist.

Ironically, turns out the cool store (Larry's Market), was poorly run, is now out of business. That same guy, ten years older, is still watching TV and still doesn't give a damn about the ice cream bin. But at least he's still in business and paying the bills.

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Post by bschultheis » Wed Aug 12, 2009 8:51 pm

Jack, thanks so much for pointing that out to me, wasn't aware of it. And it surprises me that Fama would say that.

I heard French speak one time, and he, toungue in cheek, said that Fama was certain of his convictions, until he wasn't. (or somthing like that).

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Post by stratton » Wed Aug 12, 2009 9:23 pm

bschultheis wrote:Jack, thanks so much for pointing that out to me, wasn't aware of it. And it surprises me that Fama would say that.

I heard French speak one time, and he, toungue in cheek, said that Fama was certain of his convictions, until he wasn't. (or somthing like that).
The difference was the companies that made it big from the computer business such as Microsoft or Cisco made a profit before going public. The ones in the Internet crash for the most part weren't profitable before going public. Google on the other hand was profitable when it went public. Admitedly Google came just after or at the tail of the Internet crash.

I shopped at the Larrys Bill mentioned, assuming its the one on 124th just off 405 in Kirkland, before moving to Bellevue and shopping at the one there before the small chain went out of business.

Paul

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Post by yobria » Wed Aug 12, 2009 9:41 pm

Jack wrote:Apparently you haven't been paying attention to Gene Fama and his colleagues. Fama insists that there was no tech bubble in the 90s, that there was a rational justification for equity prices. He says the same about housing prices. Buyers were very careful and totally rational. In fact, Fama ridicules as arrogant any economist who believes the markets are irrational, ever.
Since no human is totally rational, I don't believe Fama said this. Peering into the minds of millions of investors to determine "rationality", whatever that means, is impossible. There is no way to identify “irrational markets”, much less exploit them. That is why we didn’t all retire at 25.

Nick

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Henry Sadovsky
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Fama's nightmare

Post by Henry Sadovsky » Wed Aug 12, 2009 9:52 pm

.

Bill-
bschultheis wrote:On one hand we talk about not being able to "beat the market," and yet on the other hand we tilt portfolios with the expectation that we can exploit inefficiencies that willl beat the market.
Of course, not all are in agreement that such inefficiencies exist. Hence, the risk story. You would think the risk would have been defined by now. You would also think an inefficiency would have been eliminated by now. Its a puzzle.

I agree with you (Bob) that any inefficincies are just as likely a factor of "growth"stocks being bid up to levels that make them pretty expensive, vs "value" stocks being risky.
I'm guessing you meant to say "vs value stocks being shunned." In which case, it would seem to me to be a distinction without a difference. In one case one so inclined would tilts toward S/V. In the other one would tilt away from L/G. Same result.
I personally feel that the value premium will persist for as long as investors invest in the stock market, for the simple reason that people would rather buy well-run companies than run-down companies.
Depends on the price. If the price on the run-down company is low enough, rational people would buy it once it had been demonstrated that they could make a lot of money using such a strategy.

Fama's nightmare must be S/V tilting ceasing to provide an extra-volatility premium. That would show that he had been popularizing the mother of all inefficiencies.

.
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Re: Fama's nightmare

Post by bschultheis » Wed Aug 12, 2009 11:27 pm

Henry Sadovsky wrote:.


the mother of all inefficiencies.

.
Henry, thanks for clarifying a few of my points. And your comment above, I think hits the nail on the head, in that the value premium is the "mother" in the stock market because everyone wants, not only to shop, but to own the Larry's Markets of the world.

Paul, Now Joe's is out of business as well, so what's a guy to do. REI is asking too much for their freeze dried food.

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Post by tetractys » Wed Aug 12, 2009 11:57 pm

bschultheis wrote:On one hand we talk about not being able to "beat the market," and yet on the other hand we tilt portfolios with the expectation that we can exploit inefficiencies that willl beat the market.
Why does a premium have to be based on an inefficiency? A simple look at nature will reveal that increased entropy is accompanied by increased turbulence at the edges. You can see this in simple hydraulic systems, the weather, galactical movements, and even in group behavior. You might call that drag and feel greater discomfort there. There may even be small areas that never go anywhere. But a funny thing happens there: greater velocity. EMH, I think, could be better equated with fluidity, and maybe renamed FMH.

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Post by Beagler » Thu Aug 13, 2009 6:54 am

bob90245 wrote:
Beagler wrote:The Great Municipal Bond Sale that we experienced as hedge funds (and others) liquidated their positions in their rush to raise cash seems like an inefficiency. I know I'm not alone among purchasers.
No. The market was pricing for risk. Many state's credit ratings were lowered. And some states (like California) were having budget woes due to dramatically lower tax revenues. Hence, the muni bond market became more risky.
Got to part ways with you on your analysis, and this is from someone who more than doubled his muni holdings, taking advantage of this inefficiency. I've never purchased a single CA muni, and the ones I picked up were all AAA or AA. The deals out there were outstanding. Even Larry commented on them. They were dumped on the market to raise cash -- the hedge funds didn't just dump "risky" munis.
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