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The Missing Risk Premium: Why Low Volatility Investing Works Eric Falkenstein 2013 Copyright 2013 Eric G Falkenstein1.

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Presentation on theme: "The Missing Risk Premium: Why Low Volatility Investing Works Eric Falkenstein 2013 Copyright 2013 Eric G Falkenstein1."— Presentation transcript:

1 The Missing Risk Premium: Why Low Volatility Investing Works Eric Falkenstein 2013 Copyright 2013 Eric G Falkenstein1

2 Who am I I’m an economics PhD who has worked as a quant, risk manager, and portfolio manager. See more at the following websites – – Falkenblog – Old Book Finding Alpha (2009) New Book The Missing Risk Premium, out this spring 2Copyright 2013 Eric G Falkenstein

3 My 1994 dissertation, first 3 sentences: – “This paper documents two new facts. First, over the past 30 years variance has been negatively correlated with expected return for NYSE&AMEX stocks and this relationship is not accounted for by several well- known prespecified factors (e.g., the price-to-book ratio or size). More volatile stocks have lower returns, other things equal.” So, risk premiums and low-vol have been a bit of a hobby-horse My Interest 3Copyright 2013 Eric G Falkenstein

4 The Stakes “It is impossible to appreciate how the financial system works without understanding risk.” Stephen Cecchetti "Risk is not an add-on … it permeates the whole body of thought.“ Robert C. Merton Copyright 2013 Eric G Falkenstein4

5 5 “most returns and price variation come from variation in risk premia” John Campbell Risk free rate Risk premium Copyright 2013 Eric G Falkenstein

6 Big Idea: this is the Risk-Return Trade- off 6Copyright 2013 Eric G Falkenstein

7 In general, in practice: risk is not positively related to return Risk and Return 7Copyright 2013 Eric G Falkenstein

8 Risk aversion like aversion to smelliness The logic applied to this idea, via a utility function that has decreasing marginal returns, generates many mathematically consistent results that seem highly plausible Standard Theory is Intuitive 8Copyright 2013 Eric G Falkenstein

9 Leveraged Firms B vs. BBB rated Bonds Out-of-the-money options vs. at-the-money options S and C corps vs. equity indexes Highest volatility vs. modest vol stocks R rated movies vs. G rated movies Lotto vs. ‘quick pick’ lotteries 50-1 horses vs. 3-1 horses Mutual funds, currencies, futures, countries, yield curve …And Wrong 9Copyright 2013 Eric G Falkenstein

10 Finance Misleading Most practical finance is about generating expected values Finding covariances to generate different discount rates is a massive waste of time, pure rationalization in practice Copyright 2013 Eric G Falkenstein10

11 Conspiracy? Economists find standard utility functions much more productive (in theory) Asset managers can justify anything via ‘risk’, which is omnipresent and as yet unmeasurable Amenable to rigorous sequence of lectures Copyright 2013 Eric G Falkenstein11

12 Standard Theory Copyright 2013 Eric G Falkenstein12

13 St. Petersburg Paradox (1738): what is value of $1 paid if you get a head in a coin flip, where the payoff is (number of times coin flipped)^2? Should be infinity Why not? Diminishing marginal returns 13 Copyright 2013 Eric G Falkenstein Marginal Utility

14 Fundamental to economic reasoning Marginal Revolution transformed economics in 1860s – Walras, Jevons, Menger – Pre 1860s ‘classical’ economists: Marx, Smith, Ricardo, Mill Transformed Theory of Value Basic Idea of Utility Copyright 2013 Eric G Falkenstein14

15 Global concavity of utility is the necessary and sufficient condition for the existence of a risk premium Where does Risk Premium Come From? 15Copyright 2013 Eric G Falkenstein

16 Utility not applied between goods, but to everything Von-Neumann-Morgenstern (1944) Utility Theory and Risk Aversion Copyright 2013 Eric G Falkenstein16

17 Copyright 2013 Eric G Falkenstein17

18 Copyright 2013 Eric G Falkenstein18 Standard Deviation Expected Return 100% investment in security with highest E(R) 100% investment in minimum variance portfolio No points plot above the red line All portfolios on the red line are efficient Why we like efficient portfolios

19 Copyright 2013 Eric G Falkenstein 19 Exp Return Volatility U1 U2 U3 Port-1 Port-2 Port-3 U4

20 Copyright 2013 Eric G Falkenstein20 Standard Deviation Expected Return RfRf A B C

21 Copyright 2013 Eric G Falkenstein21

22 22 Copyright 2013 Eric G Falkenstein How to Derive The Capital Asset Pricing Model

23 Copyright 2013 Eric G Falkenstein23 Beta Expected Return RfRf Market Portfolio 1.0 E(R)

24 Copyright 2013 Eric G Falkenstein24 General Equilibrium aka Stochastic Discount Factor  CAPM

25 Asset Pricing Theory Was Always Treated Well 1971 Institutional Investor :“The Beta Cult: The New Way to Measure Risk.” Contrast with almost constantly ridiculed Efficient Markets Hypothesis, which is much more successful (eg, it’s hard to outperform the indices) Copyright 2013 Eric G Falkenstein25

26 linear in risk factors, covariances with something include something very like the stock market as one of the prominent factors 26 Copyright 2013 Eric G Falkenstein Hope for Final Theory

27 Empirical Evidence Copyright 2013 Eric G Falkenstein27

28 ReturnVolatility Small Stocks17.30%33.4% Stocks13%20.2% Corporate Bonds6.0%8.7% Government Bonds5.70%9.4% T-bills3.90%3.2% Volatility Often Used as a Risk Shorthand Brealey and Myers Investments Book From Cam Harvey (editor of Journal of Finance) website 28Copyright 2013 Eric G Falkenstein

29 If only this worked in more places… Copyright 2013 Eric G Falkenstein29

30 The Risk Premium Problem After 45 years, there are no measure of risk that are generally positively correlated with returns Fama and French 1992 30 From Campbell 2000 Copyright 2013 Eric G Falkenstein

31 Fama-French (1992) Show beta is just a size effect Founding father (Fama) admits CAPM is ‘incomplete’, and beta itself useless Copyright 2013 Eric G Falkenstein31

32 Theory: Longer hair people are short Omitted variable: gender Theory: high beta firms have high returns Omitted variable: size Copyright 2013 Eric G Falkenstein32 Example of how small firm effect showed up in beta tests

33 CAPM Recognized as Empirical Failure “More empirical effort may have been put into testing the CAPM equation than any other result in finance. The results are quite mixed and in many ways discouraging.” – Mark Rubinstein “empirically vacuous,” – Fama and French “having a low, middle or high beta does not matter; the expected return is the same. – Stephen Ross Copyright 2013 Eric G Falkenstein33

34 A Survey of Empirical Anomalies to the Standard Model The standard theory involves a specific metric of covariance, and so it could be, we simply haven’t found the right one As a ‘framework’, not a theory, it is non- falsifiable However, it’s hard to conceive of one not correlated with total volatility Copyright 2013 Eric G Falkenstein34

35 My Dissertation (1994) page 53 Total Volatility and Returns Copyright 2013 Eric G Falkenstein35

36 Cross-Sectional Annual Returns Sorted by Idiosyncratic and Total Volatility Ang,, Hodrick, Xing and Zhang (JoF 2006) 36Copyright 2013 Eric G Falkenstein

37 Beta and Returns: 1962-2011 Beta-LowBeta0.5Beta1.0Beta1.5Beta-High AnnRet10.8%11.4% 8.2%4.5% AnnStdev13.1%11.6%17.4%26.2%33.9% Beta0.57 1.041.441.78 Copyright 2013 Eric G Falkenstein37

38 Low Rated Equities also have lower returns Equities and bond ratings (Distress) 38 StockReturns AAA12.4% AA13.9% A14.3% BBB14.2% BB15.0% B 8.6% C -12.7% Copyright 2013 Eric G Falkenstein

39 Leverage and Equity Returns Penman, Richardson, and Tuna. 2007 Equity Returns Practice Theory 39Copyright 2013 Eric G Falkenstein

40 Volume($) > 2,000 50,000 500,000 Price> Count737266856423575746033939 AnnReturn-29.1%-35.4%-9.1%-13.5%-34.2%-41.0% Penny Stocks: Eraker and Ready (2009) 40Copyright 2013 Eric G Falkenstein

41 Call Options Sophie Ni (2007) Should amplify the equity risk premium the greater the out-of-the-money 41Copyright 2013 Eric G Falkenstein

42 IPO has a lot of Uncertainty Jay Ritter (see his website). 1970-2011. 8k observations Initial Public Offerings (IPOs) 42Copyright 2013 Eric G Falkenstein

43 Deither, Malloy, and Scherbina (2002). Table 2. Data from 1983-2000. Analyst Disagreement 43Copyright 2013 Eric G Falkenstein

44 Steve Sharpe and Gene Amromin (2005). People have higher expected returns when they have lower expected volatilities Total Volatility over Time 44Copyright 2013 Eric G Falkenstein

45 Contemporaneous Correlation Clearly Negative Total Volatility over Time Copyright 2013 Eric G Falkenstein45

46 SPY Total Return to Overnight vs. Daily Return Periods 46Copyright 2013 Eric G Falkenstein

47 Moskowitz, and Vissing-Jorgensen (2002) Small Business Returns 47Copyright 2013 Eric G Falkenstein

48 Currencies: Uncovered Interest Rate Parity Sharpe 0.99 from 1976-2008 in Burnside et al (2009) Here’s Long AUD, Short JPY Copyright 2013 Eric G Falkenstein48

49 Merrill High Yield Master II (HOAO) Merrill BBB-AA Index (COCO) Indices here overstate realized returns Corporate Bonds 49Copyright 2013 Eric G Falkenstein

50 Dimson, Marsh, Staunton (2005) 17 Countries, 1900-2005, Annual Data World Country Returns 50Copyright 2013 Eric G Falkenstein

51 Emerging market Returns Copyright 2013 Eric G Falkenstein51

52 1% premium from 0.25 to 3 years No premium from 5 to 30 years Volatility, Covariance, increasing linearly Treasury Yield Curve Copyright 2013 Eric G Falkenstein52

53 1% premium from 0.25 to 3 years No premium from 5 to 30 years Volatility, Covariance, increasing linearly Treasury Yield Curve Copyright 2013 Eric G Falkenstein53

54 Futures return from roll Harvey and Erb (2007) copper, heating oil, and live cattle were on average in backwardization, corn, wheat, silver, gold, and coffee were in contango It isn’t clear what covariance, volatility has to do with this Futures Copyright 2013 Eric G Falkenstein54

55 Devany and Walls (1999), 2015 movies from 1984-96 Movie Returns by Rating 55Copyright 2013 Eric G Falkenstein

56 Snowberg and Wolfers (2009) Sports Books: Longshot Bias 56Copyright 2013 Eric G Falkenstein

57 IPO has a lot of Uncertainty Jay Ritter (see his website). 1980-2008. IPO Returns -3.7% annually below size- matched firms for first 5 years Initial Public Offerings (IPOs) Copyright 2013 Eric G Falkenstein57

58 Trading Volume Turnover of stock a proxy for disagreement Highly correlated with beta Copyright 2013 Eric G Falkenstein58

59 Equity Risk Premium Top line return is not the same as average or marginal return Copyright 2013 Eric G Falkenstein59

60 What is the Equity Risk Premium? The most important constant in finance 60Copyright 2013 Eric G Falkenstein

61 Lorie and Fisher (1964): 9.0% raw return (no bond return) Ibbotson and Sinquefield (1976): 10.9% Mehra and Prescott (1986): 6.2% 1999 Barclays and CSFB estimated 8.8% Ibbotson (1926-97): 8.9% Finance Texts (1998): 8.5% Ivo Welch Survey (1998): 8.5% Crash! AIMR estimate (2002): 3.0% WSJ survey (2005): 2.0% CFO Magazine (2005): 5% Ivo Welch (2009): 2%-4% at most 1%-8% Equity Premium Evolution Copyright 2013 Eric G Falkenstein61

62 1 to 2 to 1 has a total return of 0% 100%, -50% return has average of 25% Arithmetic returns useful if you rebalance, as opposed to invest all your money at inception Stock returns have volatility around 20%, for the indices, which implied a 2% adjustment Geometric vs. Arithmetic Averages Copyright 2013 Eric G Falkenstein62

63 Dichev (2005) 1, 2, 1 –  return 0% if cf is {-1,0,+1} –  return -17.7% if cf is {-1,-1,+1.5} Total return different than Internal Rate of Return based on timing of investments Distributions  Dividends-New Money Corr(Distributions t,Return t+1 )= +33% Corr(Distributions t+1,Return t )= -27%  bad timing Bad Market Timing Copyright 2013 Eric G Falkenstein63

64 Commissions, – 8.5% load through 1970’s to buy a mutual fund bid-ask cross – Stocks quoted at 8 ¾ - 9 in the 1990s – buy at 9, sell at 8 ¾, lose 2.78% – Phantom cost: most investors don’t know real time prices Stoll and Whaley (1983) 1.78% comm+bid-ask Bhardwaj and Brooks (1992): 4.4% total Currently very low if you are smart (0.2%) Transaction Costs Copyright 2013 Eric G Falkenstein64

65 USA primary data point in World Value Weighted Index Coincidentally, – 2-0 in World Wars – Never went communist Brown, Goetzmann, and Ross (1995) – Czechoslovakia, Hungary, Poland, Russia, and China all zeroed out Jorion and Goetzmann (1999) – US real return 350 basis points above median for 39 countries in 20 th century Survivorship Bias Copyright 2013 Eric G Falkenstein65

66 Peso-Dollar FX rate fixed from 1954-76 Higher interest rate in Peso Peso ‘floated’ in 1976: lost 45% Peso devalued by 82% in 1982 Small probability, big loss, explains interest rate premium Robert Barro (2006) argues a correct probability of a significant catastrophe explains much of the equity premium, about 300 basis points – 2% change of a 15% to 45% GDP decline Peso Problem Copyright 2013 Eric G Falkenstein66

67 10% stock return: 6% post tax with a 40% tax rate Gannon and Blume (2006) apply this to S&P500 assuming 20% turnover from 1961-2005, using actual capital gains, dividend top-tier tax rates Cap gain avg: 26% Top tax rate avg; 49% (includes 6% state tax) Lorie and Fisher (1964) found 2.2% adjustment Total after tax equity return 6.72%, vs. 10.62% pre tax Long Term Municipal Bond Buyer Index return: 6.14% Taxes Copyright 2013 Eric G Falkenstein67

68 Beardstown Ladies investment club 1983-94 return 23.4% Best selling authors Audited financials: 9.1%, below 14.9% for market Failed to include contributions People ignore costs all the time Copyright 2013 Eric G Falkenstein68

69 Investors Don’t Match Indices Dalbar study from the Investment Company Institute: 1990-2010 Annual Returns S&P500 return: 9.1% Average equity mutual fund investor: 3.3% Copyright 2013 Eric G Falkenstein69

70 Returns not Like in Representative Agent Model Equity Return Uncorrelated with GDP growth over a Century Copyright 2013 Eric G Falkenstein70

71 Hedge Fund Money Goes to Insiders From Simon Lack Copyright 2013 Eric G Falkenstein71

72 Geometric vs. Arithmetic Averaging 1.0% Survivorship Bias1.0% Peso Problems 1.0% Taxes 1.0% Adverse Market Timing 1.0% Transaction Costs 1.0% Sum 6.0% Most estimates around 3.5% for equity premium. With these additions, the Marginal Investor clearly could be seeing a 0% equity premium. Equity Premium Subtractions 72Copyright 2013 Eric G Falkenstein

73 Scope of the Risk Premium Failure 73 Positive Risk Premium (3)Zero Risk Premium (14)Negative Risk Premium (12) 1.Short End of Yield Curve 2.BBB-AAA Corporate Spread 3.Efficient Equity Investor 1.Long-End of Yield Curve 2.B to BBB Bond 3.Futures 4.Private Investments 5.Movies 6.Mutual Funds 7.VIX and Equity 8.World Equity 9.Emerging Markets 10.Hedge Funds 11.Real Estate 12.CTAs 13.Private Equity 14.Intraday Stock Return 1.Average Equity Investor 2.Betas 3.Volatility 4.Financial Distress 5.Trading Volume 6.Analyst Disagreement 7.Equity Options 8.Lotteries 9.Sports Betting 10.Currencies 11.IPO equity Returns 12.MVPs Copyright 2013 Eric G Falkenstein

74 New Theory In general, risk and return are uncorrelated because risk is a deviation from the consensus This makes risk symmetric, too much or too little exposure generates similar risk Thus, volatile assets don’t need extra return to be held… Copyright 2013 Eric G Falkenstein74

75 Basic Idea of Relative Risk and no Premium 75 Total ReturnAvg.Relative Return XY XY State 10-10–55 State 2203025–55 Copyright 2013 Eric G Falkenstein

76 Taking the first order condition, we have Since each agent is identical, in equilibrium each agent holds the same amount So Which means, the expected return on risky assets is te risk free rate Utility Proof Copyright 2013 Eric G Falkenstein76

77 Taking the first order condition in the standard model we have This is the standard result, that higher volatility generates a higher return, linear in the variance, adjusted by the coefficient of risk aversion Because the exponential utility is CARA, not CRRA, higher amount in the risky asset generates a higher risk premium Utility Proof Benchmark Copyright 2013 Eric G Falkenstein77

78 See how relative utility model explains – Why when investors take risks, they expect above average returns – Returns are relative to the risk free rate – Don’t short assets with expected return { "@context": "", "@type": "ImageObject", "contentUrl": "", "name": "See how relative utility model explains – Why when investors take risks, they expect above average returns – Returns are relative to the risk free rate – Don’t short assets with expected return

79 Abel (1990): Gali (1995): DeMarzo,, Kandiel, Kremer (2003): Roussanov (2010): Relative Risk in academia 79Copyright 2013 Eric G Falkenstein

80 Outside the Box Evidence Like any truth, it has lots of footprints Copyright 2013 Eric G Falkenstein80

81 Within a society, rich people tend to be much happier than poor people. But, rich societies tend not to be happier than poor societies (or not by much). As countries get richer, they do not get happier. Easterlin’s Paradox (1974) Copyright 2013 Eric G Falkenstein81

82 Progress and Happiness a Puzzle – Gregg Easterbrook’s The Progress Paradox, – David Myers’s The American Paradox, and – Barry Schwartz’s The Paradox of Choice Japan: between 1958-1987 per capita income rose 500% – No change in subjective well-being Knight and Song (2006): Chinese villagers more affected by relative than absolute wealth, compared to their villages Choose between – World A: $100,000 a year in perpetuity while others earned $90,000 – World B: earn $110,000 while others earned $200,000 – Most prefer World A Easterlin’s Paradox Copyright 2013 Eric G Falkenstein82

83 Half of all stocks have expected returns below the market Zero recommendations for firms with expected returns below the market return Buy Recommendations exclude low risk firms Risk Expected Return Buy! Who cares? Copyright 2013 Eric G Falkenstein83

84 Should invest in world portfolio Chan, Covrig, and Ng (2005): Everyone is investing mainly in domestic portfolio Avoiding easy way to diversify risk Low covariance with risks from home economy Home Bias Copyright 2013 Eric G Falkenstein84

85 “I want a product to be defined relative to a benchmark” Bill Sharpe ‘Risk, see Benchmarking’ Kenneth Fisher’s Only Three Questions that Count “small stocks were in a depression” in the 1980’s Eugene Fama, Merton Miller Everyone Benchmarks 85Copyright 2013 Eric G Falkenstein

86 “…rank among our equals, is, perhaps, the strongest of all our desires.” – Adam Smith “Men do not desire merely to be rich, but to be richer than other men.” – John Stuart Mill “any individual or group of individuals, who consent to a reduction of money-wages relatively to others, will suffer a relative reduction in real wages, which is sufficient justification for them to resist it” – JM Keynes “The motive is emulation–the stimulus of an invidious comparison... especially in any community in which class distinctions are quite vague” – Thorsten Veblen Our wants and pleasures have their origin in society; we therefore measure them in relation to society; we do not measure them in relation to the objects which serve for their gratification.” – Karl Marx, Wage Labour and Capital, chapter 6 The Most Prominent Economists Can Be Read as Relative Utility Proponents 86Copyright 2013 Eric G Falkenstein

87 Hard Wired For Envy Relative Status makes more evolutionary sense than absolute wealth as a utility function Evidence for this instinct Copyright 2013 Eric G Falkenstein87

88 Evolutionary Biology genetic success is always relative, why spite works Copyright 2013 Eric G Falkenstein88

89 Evolutionarily Robust Special Utility needed for interest rate to be stable over generations But then, refinement really has to vary Eye cones and color Rayo and Becker (2007) Copyright 2013 Eric G Falkenstein89

90 Reverse Dominance Hierarchies Chris Boehm primates usually have dominant males With tools, easy to kill dominant males, so hierarchies are not ‘natural’ for humans Copyright 2013 Eric G Falkenstein90

91 Imitating Others Dominant Strategy We copy all the time: parents, then peers, then anyone doing well Mark Pagel: zero, soap, the wheel, language, iPads. – Division of labor, accumulation of science, implies innovating only after a lot of copying, and generally relying on others Copyright 2013 Eric G Falkenstein91

92 Social Context Hard Wired Specialized neural mechanisms process social information, empathy Can’t ‘not see’ context Mirror neurons tie others to us Copyright 2013 Eric G Falkenstein92

93 Relative Utility Matters more than Absolute Econometrics fMRI Psychologists rank in one’s peer group is more important than the level of income Copyright 2013 Eric G Falkenstein93

94 Endocrinology of Envy Robert Sapolsky found baboon status related to glucocorticoid levels Whitehall Studies found correlation between British civil servant grade level and mortality. Copyright 2013 Eric G Falkenstein94

95 Moderation in All Things Greek proverb too much, too little, both bad: – Vitamin A – Radiation – Oxygen – Politeness – Loyalty – Honesty Exposure 0  -- Risk Relative Standard Copyright 2013 Eric G Falkenstein95

96 Courage Premium Aristocracy asserted their privileged position came from battlefield courage The upper classes truly were courageous in battle, as WW1 showed, but no one will pay for that, and taxes on the rich went up Copyright 2013 Eric G Falkenstein96

97 Why Take Uncompensated Risk? Necessary, not sufficient condition for success Every irrevocable act entails some kind of risk – We all take risks (marriage, jobs) Taking the right risks, at the right time, given our particular strengths, is good Copyright 2013 Eric G Falkenstein97

98 Why a Negative Premium? With relative risk, an abnormal demand for highly volatile assets is not totally countered in equilibrium, leaving a price impact Higher demand, higher price, lower future return Without relative utility, one needs ad hoc constraints Copyright 2013 Eric G Falkenstein98

99 High Vol Demand: Winner’s Curse If no short selling….assets with higher valuation uncertainty will have higher prices, lower returns Copyright 2013 Eric G Falkenstein99

100 High Vol Demand: Overconfidence People are generally overconfident about their relative competency on socially desirable trates Overconfidence makes one happier, lowers mortality Copyright 2013 Eric G Falkenstein100

101 High Vol Demand: Risk-Loving Preference for positive skew Consistent with global risk aversion only if skew risk premium <15% of standard risk premium Risk loving looks like overconfidence Copyright 2013 Eric G Falkenstein101

102 High Vol Demand: Gambling Preferences Robert Sapolsky and dopamine generation based on rewards: – Higher for probabilistic payoffs Copyright 2013 Eric G Falkenstein102

103 High Vol Demand: Information Costs High volatility stocks generate more news – Easier to form opinion – Easier to sell a story Falkenstein (1996) looked at mutual fund ownership and news stories, stock age Copyright 2013 Eric G Falkenstein103

104 High Vol Demand: Representativeness Bias Great stocks of past had great risk…. “To get rich, you have to take risk.” Prob( higher return|higher risk)=Prob(big return|big risk ) >0 – So risk is correlated with higher returns (?) Copyright 2013 Eric G Falkenstein104

105 High Vol Demand: Alpha Discovery Many people jump in and want to know if they have ‘it’ Trade bio-techs, not utilities Copyright 2013 Eric G Falkenstein105

106 High Vol Demand: Convex Payoffs to Stock Pickers Top stock analysts often have 100% winners Mutual fund inflows highly convex – Greater value to greater volatility via call option Copyright 2013 Eric G Falkenstein106

107 High Vol Demand: Asset Buyers Bullish Most equity buyers tend to think the market is going to rise more than the ‘equity risk premium’ Given those beliefs, it Copyright 2013 Eric G Falkenstein107

108 Academic Confabulations Copyright 2013 Eric G Falkenstein108

109 ‘ it would be irresponsible to assume that [the CAPM] is not true’ William Sharpe ‘theoretical tour de force’ though ‘empirically vacuous’ Eugene Fama ‘stochastic discount factor(s) … so general, they place almost no restrictions on financial data’ John Campbell Finance is “the only part of economics that works” Andy Lo Praise for a Vacuous Theory 109Copyright 2013 Eric G Falkenstein

110 Oil prices Consumption growth Per-capita labor income Consumption/wealth ratio Statistical (latent) Factors Etc. Snipe hunt for factor that works 110Copyright 2013 Eric G Falkenstein

111 Implications Copyright 2013 Eric G Falkenstein111

112 Find weights with added constraints – No shorts – Cap on weight of 2% for S&P500, 4% for other indices – Stocks found generally at max limit for longs – Redo each 6 months based on daily data from prior year MVP Construction Copyright 2013 Eric G Falkenstein112

113 FTSE FTSE- MVP MSCI- Eur MSCI- MVPNikkei Nikkei- MVPS&P500 S&P500- MVP AnnRet 2.7%7.4%-0.6%2.6%-1.6%0.0%4.2%9.2% AnnStdev 15.0%12.0%19.5%13.1%19.8%13.5%16.5%12.3% Beta 0.650.59 0.500.47 Indexes are not near 'Efficient' Copyright 2013 Eric G Falkenstein113

114 Beta Strategies Data from Jul-1962 to Jun-2012 monthly returns, annualized used top 80% of NYSE market cap (about 1500 stocks today) Portfolios with 100 stocks Beta-LowBeta-05Beta-10Beta-15Beta-HighS&P500 GeoMean11.3%11.9%12.2%9.6%6.4%10.1% AnnStDev13.0%11.6%17.4%26.2%34.4%15.1% Sharpe0.450.560.390.160.030.31 Inf. Ratio0. SMB Beta0.530.340.691.451.780.26 HML Beta-0.060.10-0.29-0.96-1.35-0.39 Mkt Beta0.600.571.041.441.82 Copyright 2013 Eric G Falkenstein114

115 Total Vol vs. Beta vs. IdioVol VolatilityBetaIdio lowhighlowhighlowhigh Arith10.3%7.9%12.1%11.1%10.5%9.0% Geo10.2%2.2%12.0%5.3%10.5%3.7% Stdev10.2%33.5%11.9%34.1%10.2%32.5% Sharpe* Top 2000 stocks, extrapolated backward, 1952-2008, Sorted differently Copyright 2013 Eric G Falkenstein115

116 Assume people want to do what everyone else is doing – Appealing asset allocation based on consensus, not volatility Sell idea of trading envy for greed MVPs Beta Arbitrage Will deviate from the benchmark Investment Advisor Copyright 2013 Eric G Falkenstein116

117 Focus on payoffs and probabilities – not expected returns – Not discount rates Don’t derive an expected return from a covariance or factor loading Implication 117Copyright 2013 Eric G Falkenstein

118 Implications Don’t expect to be rewarded for risk taking per se Accept some envy; moderation in all things People like being appreciated: it shows they are relatively competent, a status maximizing metric Copyright 2013 Eric G Falkenstein118

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