Dreman Criticizes Fama/French

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William Million
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Dreman Criticizes Fama/French

Post by William Million » Sun Oct 24, 2010 8:16 am

Forbes columnist David Dreman wrote an interesting critique of Fama/Franch:

http://www.forbes.com/forbes/2010/0927/ ... -beta.html

I bring this up in the spirit of debate since I realize many here believe in the Fama/French notion that small value stocks will outperform the market, at least in the long-run. Personally, I'm skeptical that a SV tilt is a good idea for most investors, especially coming off the past decade. I'm also more favorably disposed toward dividends than some posters on this forum.

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Post by Wagnerjb » Sun Oct 24, 2010 8:42 am

Pretty feeble stuff IMO. The guy is simply an active investor whose fortunes depend on beating the market.
I make my living investing in market inefficiencies.
If he wants to prove Fama and French wrong, he can do an indepth analysis and have it peer reviewed by critical academics. That's what Fama and French did, and their work reflects the best models we have today to explain how our capital markets work. Of course, many active investors try to convince naive investors that Fama and French are wrong....but that is the only way they will make money from them.

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Re: Dreman Criticizes Fama/French

Post by richard » Sun Oct 24, 2010 8:52 am

William Million wrote:I bring this up in the spirit of debate since I realize many here believe in the Fama/French notion that small value stocks will outperform the market, at least in the long-run.
Many here believe that SV will outperform, but that's not what Fama/French believe.

FF say that SV has more risk and therefore is expected to have higher returns. However, inherent in the notion of more risk is the possibility that returns will be lower, perhaps catastrophically so. If SV were sure to outperform over some time frame, then it wouldn't be riskier and therefore not expected to perform better.

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Post by Roy » Sun Oct 24, 2010 9:02 am

Wagnerjb wrote:Pretty feeble stuff IMO. The guy is simply an active investor whose fortunes depend on beating the market.
I make my living investing in market inefficiencies.
If he wants to prove Fama and French wrong, he can do an indepth analysis and have it peer reviewed by critical academics. That's what Fama and French did, and their work reflects the best models we have today to explain how our capital markets work. Of course, many active investors try to convince naive investors that Fama and French are wrong....but that is the only way they will make money from them.

Best wishes.
Wagner is right on all these points. The notion that the EMH is dead or discredited is absurd. This guy is just another speculator.

Despite Fama & French research, Fama himself never says to tilt to Small or Value, and indeed can understand tilts in the opposite dimension, or simply buying the market.

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Post by William Million » Sun Oct 24, 2010 9:53 am

Roy wrote:
Wagnerjb wrote:Pretty feeble stuff IMO. The guy is simply an active investor whose fortunes depend on beating the market.
I make my living investing in market inefficiencies.
If he wants to prove Fama and French wrong, he can do an indepth analysis and have it peer reviewed by critical academics. That's what Fama and French did, and their work reflects the best models we have today to explain how our capital markets work. Of course, many active investors try to convince naive investors that Fama and French are wrong....but that is the only way they will make money from them.

Best wishes.
Wagner is right on all these points. The notion that the EMH is dead or discredited is absurd. This guy is just another speculator.

Despite Fama & French research, Fama himself never says to tilt to Small or Value, and indeed can understand tilts in the opposite dimension, or simply buying the market.
Thanks for the thoughtful responses.

I disagree with Wagner's idea that peer review for academic publication provides a clear path to a better investment approach. I'm often surprised at the poor quality of research in many fields that passes through peer review. Academics often lack experience in an applied setting.

It is true that Dreman is an active rather than passive investor. However, in fairness to him, Forbes Magazine requires him to subject his investment recommendations during the the year to an objective measure. This is a higher standard than many academics have to meet.

I thought of introducing this article as a point of debate because I've been surprised at the number of Boglehead investors on this forum who tilt toward SV citing Fama/French. I believe this approach, as opposed to investing in the total market, is only right for a very limited pool of investors.

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Post by dbonnett » Sun Oct 24, 2010 10:10 am

and your credentials are......

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Post by Beagler » Sun Oct 24, 2010 10:33 am

Roy wrote: Despite Fama & French research, Fama himself never says to tilt to Small or Value, and indeed can understand tilts in the opposite dimension, or simply buying the market.
Just a little reminder of Mel's Unloved Midcaps as a viable alternative (the writings of mid-cap investing detractors not withstanding :) )

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Post by speedbump101 » Sun Oct 24, 2010 10:41 am

Look at Ken French's data and form your own opinion.

http://mba.tuck.dartmouth.edu/pages/fac ... brary.html

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Post by William Million » Sun Oct 24, 2010 10:49 am

dbonnett wrote:and your credentials are......
Obviously, I have zero credentials. I'm just a guy raising a subject for debate by spouting off my own opinion.

However, the fact that you are offended by my even questioning the SV tilt is somewhat telling - actually, it underscores my orignial point. Let me rephrase the question: Is there a collective dogma on this board that is causing many Bogleheads to depart from a sound Boglehead philosophy and adopt a risky SV-tilt strategy? Are some Bogleheads merely chasing the returns of a hot market segment during the past decade - not unlike the way some investors hop into the hot managed fund?
Last edited by William Million on Sun Oct 24, 2010 11:29 am, edited 1 time in total.

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Re: Dreman Criticizes Fama/French

Post by lazyday » Sun Oct 24, 2010 11:19 am

my bold
richard wrote:FF say that SV has more risk and therefore is expected to have higher returns. However, inherent in the notion of more risk is the possibility that returns will be lower, perhaps catastrophically so. ...
Many seem to ignore this, considering how risk averse their posts make them seem to be.

Many tilt and hold significant FI, some maybe lots of FI. That strategy has usually worked well in the past, but a deep tilt might perform truly horribly someday, probably at the worst time, in an unexpectedly bad economy.

If in retirement and one has enough FI to live on to life end, and the heavily tilted equity portfolio is just for luxury, fine. Otherwise, retirement may be at risk.

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Post by lazyday » Sun Oct 24, 2010 11:27 am

William Million wrote:Are some Bogleheads merely chasing the returns of a hot market segment during the past decade - not unlike the way some investors hop into the hot managed fund?
I think so. When the 5 and 10 yr numbers look the worst for SV, there are fewer posts on it. When years align to show very good returns for SV, more excitement.

At least tilting to S and/or V is backed by academic research, so long as one understands the risks and they are appropriate, such as for a young aggressive accumulator. Still, whenever any asset class has outperformed, people will rationalize any "good" reasons to add or increase it, often sounding brilliant. Opposite when underperformed. These posts are sometimes hard to argue if they come from a good writer, some people can come up with fantastic stories.

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Post by bob90245 » Sun Oct 24, 2010 11:29 am

William Million wrote:Is there a collective dogma on this board that is causing many Bogleheads to depart from a sound Boglehead philosophy and adopt a risky SV-tilt strategy?
No, there is not a a collective dogma on this board that is causing many Bogleheads to depart from a sound Boglehead philosophy and adopt a SV-tilt strategy. Rather than "collective dogma", there is academic evidence that informs the opinions of Boglehead experts like Bill Bernstein, Rick Ferri and Larry Swedroe. This translates into building a more widely diversified portfolio that includes equity asset classes in addition to US Large Blend.
William Million wrote:Are some Bogleheads merely chasing the returns of a hot market segment during the past decade - not unlike the way some investors hop into the hot managed fund?
No doubt, it may appear that this is the case. However, if these same Bogleheads view the so-called "hot market segment during the past decade" as a long-term holding to be held for the rest of their lifespan, then it would not be the case of hopping "into the hot managed fund".
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Post by GammaPoint » Sun Oct 24, 2010 11:32 am

William Million wrote:
dbonnett wrote:and your credentials are......
Obviously, I have zero credentials. I'm just a guy raising a subject for debate by spouting off my own opinion.
He may have been asking this in response to you suggesting that peer-reviewed research is highly suspect in many fields. While no peer-review process is ever going to be perfect, I imagine that a topic as important to application as the Fama/French model would be a very sweet target for other researchers if the work hadn't been done correctly.

Paladin

Post by Paladin » Sun Oct 24, 2010 11:35 am

How do FF define big value, big neutral and big growth? Are they 3 distinct segments with no overlap?

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Post by speedbump101 » Sun Oct 24, 2010 11:54 am

Paladin wrote:How do FF define big value, big neutral and big growth? Are they 3 distinct segments with no overlap?
I think this is what you're asking.

http://mba.tuck.dartmouth.edu/pages/fac ... olios.html

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Post by GammaPoint » Sun Oct 24, 2010 11:56 am

William Million wrote: Is there a collective dogma on this board that is causing many Bogleheads to depart from a sound Boglehead philosophy and adopt a risky SV-tilt strategy?
Besides tax-efficiency and simplicity, what research backs a total market approach that allows it to deem itself as the "sound Boglehead philosophy"? Historically, does the total market approach not give you less return and/or higher volatility than a diversified portfolio which contains a tilt to SV stocks? Why can an approach with less theoretical backing be considered the "safer approach" than one with a theoretical backing?

Is it possible that some people are unnecessarily opposed to a small value tilt because they spent much of their investing lifetime not knowing about the Fama/French research and thus don't want to acknowledge that they may have missed out on some higher returns? Or maybe SV stocks aren't offered in ones 401k? There seems to be, at least with some people, an unnecessary opposition to SV tilting and the research that backs it.

If you think the SV research is legitimate, then add some SV to your portfolio. If your gut tells you it makes you uncomfortable, don't do it. It's more about sticking to an AA that you believe in then probably what you invest it anyway.

Do some people load up on SV too much on these boards? Maybe for how much I'm planning to wager on the SV premia I think so, but perhaps their financial situation allows them to take a larger risk on a larger SV allocation. When new investors come to ask questions about their portfolio, I do not think we tell them that they should do 60% FI and 40% SV.

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Post by BlueEars » Sun Oct 24, 2010 12:03 pm

Interesting to note that the 3 stocks recommended in Dremen's article are in the Vanguard Value Index Fund (LV) and make up 4% of that portfolio.

I don't have any credentials either :) but I think both TSM and tilt portfolio strategies are a decent way to go. If you do an extremely careful study you might even find techniques that reduce the risk of extreme drawdowns and remove the biggest concern about value stock investing i.e. that the risk shows up what you can least afford to take it. Such techniques are outside the scope of this forum.

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Post by Paladin » Sun Oct 24, 2010 12:07 pm

speedbump101 wrote:
Paladin wrote:How do FF define big value, big neutral and big growth? Are they 3 distinct segments with no overlap?
I think this is what you're asking.

http://mba.tuck.dartmouth.edu/pages/fac ... olios.html

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Post by LadyGeek » Sun Oct 24, 2010 12:08 pm

Background info:

Please see Fama and French Three-Factor Model on the Bogleheads Wiki.
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Post by iceport » Sun Oct 24, 2010 12:21 pm

GammaPoint wrote:
William Million wrote: Is there a collective dogma on this board that is causing many Bogleheads to depart from a sound Boglehead philosophy and adopt a risky SV-tilt strategy?
Besides tax-efficiency and simplicity, what research backs a total market approach that allows it to deem itself as the "sound Boglehead philosophy"?
GammaPoint,

I have no credentials on this topic. However, I do have a question: Has any academic expert that has actually performed research on three-factor model ever once claimed that the total market approach is not likely to be on the efficient frontier over the long term, or that it is not a perfectly valid -- even the best default -- portfolio construction?

Do Fama and French have any basis for their support of the total market approach?

--Pete

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Post by GammaPoint » Sun Oct 24, 2010 12:33 pm

petrico wrote:
I have no credentials on this topic. However, I do have a question: Has any academic expert that has actually performed research on three-factor model ever once claimed that the total market approach is not likely to be on the efficient frontier over the long term, or that it is not a perfectly valid -- even the best default -- portfolio construction?
Please, this is the internets. I have no credentials on this topic either ;)

I don't know how someone would argue that it's the "best default" portfolio construction without an argument suggesting why that is the case (unless the slight tax-efficiency advantage is considered enough). If someone has (and given a reason for it), then I'd be very interested in hearing what it was. Don't get me wrong, I do think a low-cost total market approach is a perfectly valid way to construct a portfolio. It's simple, tax-efficient, and very low cost. But I think the odds of it performing better than a S&D portfolio over the long-term are less than 50%, so I S&D.

Historically, the small value premia has been exceptionally reliable. So why not make a small bet in that direction? Sure, just because it happened in the past doesn't mean it will continue to happen in the future, but at the same time I'd rather tilt my portfolio to what worked best over the long-term in the past than what hasn't worked best in the long-term in the past.

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Post by GammaPoint » Sun Oct 24, 2010 12:36 pm

Responding to your edit (thanks for finding that link):
petrico wrote: Do Fama and French have any basis for their support of the total market approach?
From your link:
There is no single right answer to this question. If there were one answer, it would have to be the market portfolio of domestic, international, and emerging stocks, since that is the only portfolio that can be held by everyone.
That rationale doesn't seem to be a good enough reason to recommend a total market portfolio to an individual. As an investor, I don't care if my portfolio can be held by everyone, I just care if it can be held by me. Does anyone know if Fama/French provide a rationale with a little bit more teeth in it somewhere else (I haven't read the original papers)?

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Post by iceport » Sun Oct 24, 2010 12:46 pm

GammaPoint wrote:Responding to your edit (thanks for finding that link):

That rationale doesn't seem to be a good enough reason to recommend a total market portfolio to an individual. As an investor, I don't care if my portfolio can be held by everyone, I just care if it can be held by me. Does anyone know if Fama/French provide a rationale with a little bit more teeth in it somewhere else (I haven't read the original papers)?
Thanks for your thoughts. Reading the entire Q&A entry, the implication is that small-and value-tilting is but one more point along the theoretical efficient frontier. The total market approach lies along the same curve, but with lower expected returns and risks. If one believes in some form of the EMH, isn't the market portfolio the typical staring point for portfolio construction?

--Pete

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Post by bob90245 » Sun Oct 24, 2010 12:53 pm

petrico wrote:If one believes in some form of the EMH, isn't the market portfolio the typical staring point for portfolio construction?
Though both concepts include the term "efficient", it would be a mistake to confuse EMH with Efficient Frontier.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Post by iceport » Sun Oct 24, 2010 1:43 pm

bob90245 wrote:
petrico wrote:If one believes in some form of the EMH, isn't the market portfolio the typical staring point for portfolio construction?
Though both concepts include the term "efficient", it would be a mistake to confuse EMH with Efficient Frontier.
Yet one relies on the other. From Investing in Total Markets by John Norstad:
Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio. (The technical way to say this is that the total-market portfolio is always located on the "efficient frontier" in academic risk/return models. This is true in both the classical single-factor risk model of Markowitz and Sharpe and in the newer three-factor risk model of Fama and French.)
--Pete

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Post by richard » Sun Oct 24, 2010 1:57 pm

GammaPoint wrote:I don't know how someone would argue that it's the "best default" portfolio construction without an argument suggesting why that is the case (unless the slight tax-efficiency advantage is considered enough). If someone has (and given a reason for it), then I'd be very interested in hearing what it was.
In essence, if you believe the market is efficient, the total market is the best default portfolio because investors, as a whole, must hold the market. It is not possible for investors as a whole to tilt away from the market.

This paper, by a colleague of Fama's, is worth reading (at least read the conclusion)
http://papers.ssrn.com/sol3/papers.cfm? ... _id=218871

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Post by Paladin » Sun Oct 24, 2010 2:09 pm

petrico wrote:
bob90245 wrote:
petrico wrote:If one believes in some form of the EMH, isn't the market portfolio the typical staring point for portfolio construction?
Though both concepts include the term "efficient", it would be a mistake to confuse EMH with Efficient Frontier.
Yet one relies on the other. From Investing in Total Markets by John Norstad:
Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio. (The technical way to say this is that the total-market portfolio is always located on the "efficient frontier" in academic risk/return models. This is true in both the classical single-factor risk model of Markowitz and Sharpe and in the newer three-factor risk model of Fama and French.)
--Pete
That's a bold claim.

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Post by Beagler » Sun Oct 24, 2010 2:13 pm

GammaPoint wrote:Responding to your edit (thanks for finding that link):
petrico wrote: Do Fama and French have any basis for their support of the total market approach?
From your link:
There is no single right answer to this question. If there were one answer, it would have to be the market portfolio of domestic, international, and emerging stocks, since that is the only portfolio that can be held by everyone.
That rationale doesn't seem to be a good enough reason to recommend a total market portfolio to an individual. As an investor, I don't care if my portfolio can be held by everyone, I just care if it can be held by me. Does anyone know if Fama/French provide a rationale with a little bit more teeth in it somewhere else (I haven't read the original papers)?
When making broad statements about investing (for the Masses) it would make sense to recommend a total market portfolio for fear of:
Tracking Error -- "oops, my portfolio is not behaving like the S&P 500 this week." (Larry has referred to TE as "a fool's errand," but it can spook people.);
Fiduciary Responsibility -- when you are outperforming by holding a small-and value-tilted portfolio such as over the past dozen years or so, no one is going to find fault, but when the day comes when the FF premia don't show up for a while, there will be some explaining to do. If you are managing funds for a loved one, this could be problematic;
Financial Literacy -- how many of your friends and loved ones are schooled (and interested enough to follow along long-term) on the finer points of asset allocation? Will they stick with a size-and value-tilted portfolio through thick and thin?

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Post by Paladin » Sun Oct 24, 2010 2:15 pm

richard wrote:
GammaPoint wrote:I don't know how someone would argue that it's the "best default" portfolio construction without an argument suggesting why that is the case (unless the slight tax-efficiency advantage is considered enough). If someone has (and given a reason for it), then I'd be very interested in hearing what it was.
In essence, if you believe the market is efficient, the total market is the best default portfolio because investors, as a whole, must hold the market. It is not possible for investors as a whole to tilt away from the market.

This paper, by a colleague of Fama's, is worth reading (at least read the conclusion)
http://papers.ssrn.com/sol3/papers.cfm? ... _id=218871
In that case we should all move to 40% USA and 60% non USA. The other problem is the total market is not the "total" market. Real estate is one obvious asset class that is underweight.

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Post by Beagler » Sun Oct 24, 2010 2:31 pm

richard wrote:It is not possible for investors as a whole to tilt away from the market.
Isn't that the key distinction? On an individual level vs. The Entire Investing Universe? Who cares in what your neighbor's invested? Let's worry about our own returns.

Popularity (total net assets) in spite of SCV relative outperformance:
VG Total Stock Mkt. Fund: $138 billion http://tinyurl.com/3xlnc2s
VG SCV Fund: $6.1 billion http://tinyurl.com/324r4yg
Last edited by Beagler on Sun Oct 24, 2010 4:08 pm, edited 1 time in total.
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Post by dbr » Sun Oct 24, 2010 2:35 pm

Paladin wrote:
richard wrote:
GammaPoint wrote:I don't know how someone would argue that it's the "best default" portfolio construction without an argument suggesting why that is the case (unless the slight tax-efficiency advantage is considered enough). If someone has (and given a reason for it), then I'd be very interested in hearing what it was.
In essence, if you believe the market is efficient, the total market is the best default portfolio because investors, as a whole, must hold the market. It is not possible for investors as a whole to tilt away from the market.

This paper, by a colleague of Fama's, is worth reading (at least read the conclusion)
http://papers.ssrn.com/sol3/papers.cfm? ... _id=218871
In that case we should all move to 40% USA and 60% non USA. The other problem is the total market is not the "total" market. Real estate is one obvious asset class that is underweight.
Isn't the idea that the best default portfolio is relative to whatever universe of investments is under consideration. I guess FF analysis is theoretically applicable to any "market" but in fact is applied to the US stock market, or it is applied to the world stock market, or it is applied to a wider class of investable assets that have a market. I am not sure what the right concept of "having a market" actually means, but it is surely true that a very large fraction of world wealth is not on a market that looks like a stock exchange.

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Post by matt » Sun Oct 24, 2010 2:42 pm

I agree with Dreman that the academic models are flawed. Unfortunately, that doesn't mean it's easy to beat the market or to recognize what the true risks are.

With Dreman, I am particularly interested with this comment from the article, my emphasis added:
Indeed, most of the big firms and their chief risk officers focus on beta but--at least until recently--have ignored most other types of risks. Little things like leverage and liquidity.
Rolling back in time to the market peak in October 2007, which stocks were Dreman recommending? CIT (filed for bankruptcy, equity lost 100%), Fannie Mae and Freddie Mac (taken under government conservatorship, equity lost over 99%) and Devon Energy (equity value down about 20%). See: http://www.forbes.com/forbes/2007/1015/106.html

So Dreman may be technically correct, but he failed just like everyone else. I credit him zero points in this debate.
Last edited by matt on Sun Oct 24, 2010 3:06 pm, edited 1 time in total.

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Post by bob90245 » Sun Oct 24, 2010 2:43 pm

petrico wrote:
bob90245 wrote:
petrico wrote:If one believes in some form of the EMH, isn't the market portfolio the typical staring point for portfolio construction?
Though both concepts include the term "efficient", it would be a mistake to confuse EMH with Efficient Frontier.
Yet one relies on the other. From Investing in Total Markets by John Norstad:
Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio. (The technical way to say this is that the total-market portfolio is always located on the "efficient frontier" in academic risk/return models. This is true in both the classical single-factor risk model of Markowitz and Sharpe and in the newer three-factor risk model of Fama and French.)
--Pete
There's a lot of confusion and misinformation out there. The above is one example.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Post by BlueEars » Sun Oct 24, 2010 2:58 pm

Hi Bob, among the more interesting products produced by this forum is a boatload of "confusion and misinformation". :D

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Post by bob90245 » Sun Oct 24, 2010 3:28 pm

Les wrote:Hi Bob, among the more interesting products produced by this forum is a boatload of "confusion and misinformation". :D
That's really sad. Efficient Market Hypothesis is a very common topic on this forum. In the investing world where the majority are stock pickers and market timers (i.e. non-Boglehead types), it's one of those concepts that is very hard to grasp.

Here is a recent comment I made on a recent thread:

http://www.bogleheads.org/forum/viewtop ... 004#852004
bob90245 wrote:
Rodc wrote:And for what it is worth, one does not need to invoke efficient markets. All you need to do is invoke that this is not Lake Wobgone.
In the end, this is what it all boils down to. It's what Eugene Fama found out thinking that it was easy for him to inhabit Lake Wobegone [i.e. pick a portfolio of stocks that would outperform a target benchmark]. It was not. And since it wasn't, he hypothesized the markets are efficient.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Post by iceport » Sun Oct 24, 2010 3:37 pm

bob90245 wrote:There's a lot of confusion and misinformation out there. The above is one example.
OK, I'll admit to being confused and misinformed. Could you be more specific in your criticism?

From Bill Bernstein:
And if you adhere to the EMH, then you ceteris paribus believe that you must hold the entire market in cap-weighted fashion. For academic types this means the CRSP-All Index, and for the rest of us it means the Russell 3000 or the Wilshire 5000, the latter of which can be purchased as the Vanguard Total Stock Market Fund. [Emphasis added.]
http://www.efficientfrontier.com/ef/900/barbell.htm

--Pete

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Post by cheapskate » Sun Oct 24, 2010 3:40 pm

matt wrote:I agree with Dreman that the academic models are flawed. Unfortunately, that doesn't mean it's easy to beat the market or to recognize what the true risks are.

With Dreman, I am particularly interested with this comment from the article, my emphasis added:
Indeed, most of the big firms and their chief risk officers focus on beta but--at least until recently--have ignored most other types of risks. Little things like leverage and liquidity.
Rolling back in time to the market peak in October 2007, which stocks were Dreman recommending? CIT (filed for bankruptcy, equity lost 100%), Fannie Mae and Freddie Mac (taken under government conservatorship, equity lost over 99%) and Devon Energy (equity value down about 20%). See: http://www.forbes.com/forbes/2007/1015/106.html

So Dreman may be technically correct, but he failed just like everyone else. I credit him zero points in this debate.
This highlights the problem with Active Value Investing (not just Dreman, but Dodge and Cox, Oakmark and many others). In an active (deep) value portfolio, there are some stocks/companies that will blow up. This simply cannot be avoided. How much these blowups affect the portfolio depends on how diversified one is. To insulate oneself adequately, one trends towards closet value-tilt indexing, at which point higher expenses serve as a measurable drag on return.

It is only a matter of time before investors like Fairholme blow up. Fairholme managers look like rockstars now, but it wasn't that long ago Oakmark Select (and Bill Nygren) were rockstars. And Oakmark Select blew up in a bad way on a few bad stock picks.

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Post by bob90245 » Sun Oct 24, 2010 4:01 pm

petrico wrote:
bob90245 wrote:There's a lot of confusion and misinformation out there. The above is one example.
OK, I'll admit to being confused and misinformed. Could you be more specific in your criticism?

From Bill Bernstein:
And if you adhere to the EMH, then you ceteris paribus believe that you must hold the entire market in cap-weighted fashion. For academic types this means the CRSP-All Index, and for the rest of us it means the Russell 3000 or the Wilshire 5000, the latter of which can be purchased as the Vanguard Total Stock Market Fund. [Emphasis added.]
http://www.efficientfrontier.com/ef/900/barbell.htm

--Pete
Sure, I can be specific. Efficient Frontier is concept born of Harry Markowitz and Modern Portfolio Theory. By contrast, Efficient Market Hypothesis is a concept born of Paul Samuelson via Louis Bachelier. It was around that time that Fama coined the term "Efficient Market". You can read the history at this website:

http://www.e-m-h.org/history.html
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Post by Beagler » Sun Oct 24, 2010 4:01 pm

petrico wrote: From Bill Bernstein:
And if you adhere to the EMH, then you ceteris paribus believe that you must hold the entire market in cap-weighted fashion. For academic types this means the CRSP-All Index, and for the rest of us it means the Russell 3000 or the Wilshire 5000, the latter of which can be purchased as the Vanguard Total Stock Market Fund. [Emphasis added.]
Re: Bill Bernstein, who writes that if TE bothers you, alternative asset classes probably aren't for you.

Given the preponderance of size- and value-loaded asset classes in the model portfolios in his books, and in the many articles he's written, is he an adherent to EMH (strong? weak? Reminds me of the Goldie Locks story...)

He writes (in Intelligent Asset Allocator) the small investor has three big advantages over institutional investors:

Image page. 60
Last edited by Beagler on Sun Oct 24, 2010 4:16 pm, edited 1 time in total.
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Post by iceport » Sun Oct 24, 2010 4:14 pm

bob90245 wrote:
petrico wrote:
bob90245 wrote:There's a lot of confusion and misinformation out there. The above is one example.
OK, I'll admit to being confused and misinformed. Could you be more specific in your criticism?

From Bill Bernstein:
And if you adhere to the EMH, then you ceteris paribus believe that you must hold the entire market in cap-weighted fashion. For academic types this means the CRSP-All Index, and for the rest of us it means the Russell 3000 or the Wilshire 5000, the latter of which can be purchased as the Vanguard Total Stock Market Fund. [Emphasis added.]
http://www.efficientfrontier.com/ef/900/barbell.htm

--Pete
Sure, I can be specific. Efficient Frontier is concept born of Harry Markowitz and Modern Portfolio Theory. By contrast, Efficient Market Hypothesis is a concept born of Paul Samuelson via Louis Bachelier. It was around that time that Fama coined the term "Efficient Market". You can read the history at this website:

http://www.e-m-h.org/history.html
Bob,

That really doesn't address the question. So the two terms refer to two different things. Where did anyone say they were the same? The question is, what, specifically, in the Norstad quote is so wrong? I don't see anything in that quote that claims "EMH" and "efficient frontier" are one and the same. So what else is wrong?

--Pete

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Post by bob90245 » Sun Oct 24, 2010 4:31 pm

petrico wrote:
bob90245 wrote:
petrico wrote:
bob90245 wrote:There's a lot of confusion and misinformation out there. The above is one example.
OK, I'll admit to being confused and misinformed. Could you be more specific in your criticism?

From Bill Bernstein:
And if you adhere to the EMH, then you ceteris paribus believe that you must hold the entire market in cap-weighted fashion. For academic types this means the CRSP-All Index, and for the rest of us it means the Russell 3000 or the Wilshire 5000, the latter of which can be purchased as the Vanguard Total Stock Market Fund. [Emphasis added.]
http://www.efficientfrontier.com/ef/900/barbell.htm

--Pete
Sure, I can be specific. Efficient Frontier is concept born of Harry Markowitz and Modern Portfolio Theory. By contrast, Efficient Market Hypothesis is a concept born of Paul Samuelson via Louis Bachelier. It was around that time that Fama coined the term "Efficient Market". You can read the history at this website:

http://www.e-m-h.org/history.html
Bob,

That really doesn't address the question. So the two terms refer to two different things. Where did anyone say they were the same? The question is, what, specifically, in the Norstad quote is so wrong? I don't see anything in that quote that claims "EMH" and "efficient frontier" are one and the same. So what else is wrong?

--Pete
We disagree. In the excerpts you provided, the term EMH is being used to mean the same thing as "efficient frontier". You can even see that Nordstad refers to "efficient frontier":
Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio. (The technical way to say this is that the total-market portfolio is always located on the "efficient frontier" in academic risk/return models. This is true in both the classical single-factor risk model of Markowitz and Sharpe and in the newer three-factor risk model of Fama and French.)
EMH does not have anything to do with diversification, perfect or otherwise.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

Paladin

Post by Paladin » Sun Oct 24, 2010 4:59 pm

bob90245 wrote:
petrico wrote:
bob90245 wrote:
petrico wrote:If one believes in some form of the EMH, isn't the market portfolio the typical staring point for portfolio construction?
Though both concepts include the term "efficient", it would be a mistake to confuse EMH with Efficient Frontier.
Yet one relies on the other. From Investing in Total Markets by John Norstad:
Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio. (The technical way to say this is that the total-market portfolio is always located on the "efficient frontier" in academic risk/return models. This is true in both the classical single-factor risk model of Markowitz and Sharpe and in the newer three-factor risk model of Fama and French.)
--Pete
There's a lot of confusion and misinformation out there. The above is one example.
Bob. Could you say more about the misinformation in the above. I for one and interested.

Paladin

Post by Paladin » Sun Oct 24, 2010 5:05 pm

bob90245 wrote:
petrico wrote:
bob90245 wrote:
petrico wrote:
bob90245 wrote:There's a lot of confusion and misinformation out there. The above is one example.
OK, I'll admit to being confused and misinformed. Could you be more specific in your criticism?

From Bill Bernstein:
And if you adhere to the EMH, then you ceteris paribus believe that you must hold the entire market in cap-weighted fashion. For academic types this means the CRSP-All Index, and for the rest of us it means the Russell 3000 or the Wilshire 5000, the latter of which can be purchased as the Vanguard Total Stock Market Fund. [Emphasis added.]
http://www.efficientfrontier.com/ef/900/barbell.htm

--Pete
Sure, I can be specific. Efficient Frontier is concept born of Harry Markowitz and Modern Portfolio Theory. By contrast, Efficient Market Hypothesis is a concept born of Paul Samuelson via Louis Bachelier. It was around that time that Fama coined the term "Efficient Market". You can read the history at this website:

http://www.e-m-h.org/history.html
Bob,

That really doesn't address the question. So the two terms refer to two different things. Where did anyone say they were the same? The question is, what, specifically, in the Norstad quote is so wrong? I don't see anything in that quote that claims "EMH" and "efficient frontier" are one and the same. So what else is wrong?

--Pete
We disagree. In the excerpts you provided, the term EMH is being used to mean the same thing as "efficient frontier". You can even see that Nordstad refers to "efficient frontier":
Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio. (The technical way to say this is that the total-market portfolio is always located on the "efficient frontier" in academic risk/return models. This is true in both the classical single-factor risk model of Markowitz and Sharpe and in the newer three-factor risk model of Fama and French.)
EMH does not have anything to do with diversification, perfect or otherwise.
Agreed.

Are you saying that this argument is flawed? I would not disagree with you. If so how is it flawed?
Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio. (The technical way to say this is that the total-market portfolio is always located on the "efficient frontier" in academic risk/return models. This is true in both the classical single-factor risk model of Markowitz and Sharpe and in the newer three-factor risk model of Fama and French.)

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Post by bob90245 » Sun Oct 24, 2010 5:24 pm

Paladin wrote:
bob90245 wrote:
petrico wrote:
bob90245 wrote:
petrico wrote:If one believes in some form of the EMH, isn't the market portfolio the typical staring point for portfolio construction?
Though both concepts include the term "efficient", it would be a mistake to confuse EMH with Efficient Frontier.
Yet one relies on the other. From Investing in Total Markets by John Norstad:
Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio. (The technical way to say this is that the total-market portfolio is always located on the "efficient frontier" in academic risk/return models. This is true in both the classical single-factor risk model of Markowitz and Sharpe and in the newer three-factor risk model of Fama and French.)
--Pete
There's a lot of confusion and misinformation out there. The above is one example.
Bob. Could you say more about the misinformation in the above. I for one and interested.
I don't know how much more I can say on this besides what I've already written in previous posts. I don't see how the market being efficient or not efficient has any bearing on building a diversified equity portfolio.

I take that back. If you think that markets are not efficient, then you would try to select active managers who you believe will outperform their benchmark index. On the other hand if you think markets are efficient, then you will use low-cost index funds, that simply match their benchmark index minus small costs, as your portfolio building blocks.
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 » Sun Oct 24, 2010 5:38 pm

If you want to see a more mathmatical argument for investing in total market portfolios, see also John's Three Proofs that TSM is Efficient.

Even in inefficient markets, I'd still want to use index funds. Also, Bogle's cost matter hypothesis works in efficient or inefficient markets.
"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 bob90245 » Sun Oct 24, 2010 6:04 pm

alec wrote:Even in inefficient markets, I'd still want to use index funds. Also, Bogle's cost matter hypothesis works in efficient or inefficient markets.
I remember we argued this point before. From the link:
In other words, market efficiency protects the less-skilled investor from consistently making bad investments because all stocks are fairly priced. There is, on the other hand, no such protection in a market where stocks are routinely mispriced. The active investing majority that underperforms the index will tend to be the same year after year. Thus, the argument for indexing is even stronger for individual investors if the stock market is not efficient.
The logic in the above excerpt does not follow. The stronger logic is that in a market where we can identify in advance those skillful managers that consistently outperform, you would be better off putting your money with those skillfull managers and not in the comparable index.
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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Post by dbr » Sun Oct 24, 2010 6:13 pm

alec wrote:If you want to see a more mathmatical argument for investing in total market portfolios, see also John's Three Proofs that TSM is Efficient.

Even in inefficient markets, I'd still want to use index funds. Also, Bogle's cost matter hypothesis works in efficient or inefficient markets.
I think that in CAPM and FF it is an assumption embedded in the model that TSM is an efficient portfolio. That does not mean CAPM and FF prove that TSM is efficient but it does mean that if TSM is not efficient then CAPM and FF are not valid models. Valid is a word that with respect to models means "is not contradicted by reality." I have no idea what discrepancy arises or correction might be made to CAPM and FF to make them valid if TSM is not an efficient portfolio.

Paladin

Post by Paladin » Sun Oct 24, 2010 6:28 pm

bob90245 wrote:
Paladin wrote:
bob90245 wrote:
petrico wrote:
bob90245 wrote: Though both concepts include the term "efficient", it would be a mistake to confuse EMH with Efficient Frontier.
Yet one relies on the other. From Investing in Total Markets by John Norstad:
Another consequence of the EMH is that the total market is always perfectly diversified. Other portfolios that deviate from the total-market portfolio are never "more diversified" than the total-market portfolio. In other words, it is impossible for any other portfolio to have both a higher expected return and lower risk than the total-market portfolio. (The technical way to say this is that the total-market portfolio is always located on the "efficient frontier" in academic risk/return models. This is true in both the classical single-factor risk model of Markowitz and Sharpe and in the newer three-factor risk model of Fama and French.)
--Pete
There's a lot of confusion and misinformation out there. The above is one example.
Bob. Could you say more about the misinformation in the above. I for one and interested.
I don't know how much more I can say on this besides what I've already written in previous posts. I don't see how the market being efficient or not efficient has any bearing on building a diversified equity portfolio.

I take that back. If you think that markets are not efficient, then you would try to select active managers who you believe will outperform their benchmark index. On the other hand if you think markets are efficient, then you will use low-cost index funds, that simply match their benchmark index minus small costs, as your portfolio building blocks.
Do you believe that "total market is always perfectly diversified"?

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Post by William Million » Sun Oct 24, 2010 6:43 pm

cheapskate wrote:
matt wrote:I agree with Dreman that the academic models are flawed. Unfortunately, that doesn't mean it's easy to beat the market or to recognize what the true risks are.

With Dreman, I am particularly interested with this comment from the article, my emphasis added:
Indeed, most of the big firms and their chief risk officers focus on beta but--at least until recently--have ignored most other types of risks. Little things like leverage and liquidity.
Rolling back in time to the market peak in October 2007, which stocks were Dreman recommending? CIT (filed for bankruptcy, equity lost 100%), Fannie Mae and Freddie Mac (taken under government conservatorship, equity lost over 99%) and Devon Energy (equity value down about 20%). See: http://www.forbes.com/forbes/2007/1015/106.html

So Dreman may be technically correct, but he failed just like everyone else. I credit him zero points in this debate.
This highlights the problem with Active Value Investing (not just Dreman, but Dodge and Cox, Oakmark and many others). In an active (deep) value portfolio, there are some stocks/companies that will blow up. This simply cannot be avoided. How much these blowups affect the portfolio depends on how diversified one is. To insulate oneself adequately, one trends towards closet value-tilt indexing, at which point higher expenses serve as a measurable drag on return.

It is only a matter of time before investors like Fairholme blow up. Fairholme managers look like rockstars now, but it wasn't that long ago Oakmark Select (and Bill Nygren) were rockstars. And Oakmark Select blew up in a bad way on a few bad stock picks.
Interesting points on active value investing. My own view is that markets are efficient over the long-term term but highly inefficient over the short-term. The stock-picking value investor wants to exploit those short-term inefficiencies.

As you point out, they will often fail. However, you don't have to succeed on too many individual stocks in order to beat the market. That's because a successful value investor will find some stocks that go up 3- or 5- or 7- fold. Even if some stocks lose 100 percent, the investor might be ahead. You would have to look at Dreman's broader returns than a few bad calls in isolation.

I confess that I invest a small amount of my stock portfolio in individual stocks, trying to play this value game. The bulk, however, is in TSM.

That's part of the concern I have for the SV tilt. I believe it is worthwhile to occasionally try to exploit short-term inefficiencies. But the SV tilt is, if anything, a long-term inefficiency, especially after the past decade. Are SV tilters prepared to risk underperforming TSM to 2020 or 2025, given where we're at in 2010?

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Post by alec » Sun Oct 24, 2010 6:58 pm

dbr wrote:
I think that in CAPM and FF it is an assumption embedded in the model that TSM is an efficient portfolio. That does not mean CAPM and FF prove that TSM is efficient but it does mean that if TSM is not efficient then CAPM and FF are not valid models. Valid is a word that with respect to models means "is not contradicted by reality." I have no idea what discrepancy arises or correction might be made to CAPM and FF to make them valid if TSM is not an efficient portfolio.
To the bolded portion, it is not an assumption of CAPM that the market portfolio is an [or the] efficient portfolio. The conclusion in the CAPM is that "the tangency portfolio [from Markowitz] will be a value-weighted mix of all the assets in the world." See William Goetzman's nice summary of the CAPM [scroll down a bit to Section II].
"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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