Weekend Reads for Finance Pros: Bubbles, Fama and French, and Executive Brains
Just as I was getting ready to file this week’s roundup of noteworthy articles and photographs, I spotted a tantalizing tweet:
The pleasures of purposeless walking http://t.co/CoqMxlD8Te (ht @nntaleb)
— Steven Strogatz (@stevenstrogatz) May 1, 2014
When I lived in New York City, you see, I walked relentlessly — to work, from work, to grocery stores, restaurants, play grounds, and Central Park. I walked whenever, and wherever, I could. My curiosity piqued, I clicked on the article: interestingly, Steven Strogratz aptly characterizes it as “the pleasures of purposeless walking” compared with the decidedly more downbeat BBC headline: “The Slow Death of Purposeless Walking.” I’m in the pleasures camp.
“There is something about the pace of walking and the pace of thinking that goes together. Walking requires a certain amount of attention but it leaves great parts of the time open to thinking. I do believe once you get the blood flowing through the brain it does start working more creatively,” Geoff Nicholson, author of The Lost Art of Walking, tells the reporter. People should go out and walk free of distractions, he says. “I do think there is something about walking mindfully. To actually be there and be in the moment and concentrate on what you are doing.”
Investing/Behavioral Economics/Trading
- A new quarter, a new GMO quarterly: “Looking for Bubbles, Part One: A Statistical Approach and Part Two: A Sentimental Approach” (GMO, PDF)
- Eugene Fama and Kenneth French’s November 2013 working paper, “A Five-Factor Asset Pricing Model, buries the value factor. What does it suggest about market efficiency? A come-to-Buffett moment. (Morningstar)
- In a recent post, “Reveling in the Messiness,” Tadas Viskanta notes that Tyler Cowen is no fan of behavioral economics. He excerpts a paragraph in Average Is Over: Powering America Beyond the Age of the Great Stagnation: “Behavioral economists themselves suffer from a lot of the same flaw that plagued the pre-computer grandmasters. They are looking for behavioral theories that are too elegant, too simple or too intuitive, such as the abstract strictures of mathematical decision theory.” In the book, says Viskanta, Cowen looks at the lesson we have learned about decision-making from studies of chess grandmasters. The five insights Cowen writes about, he adds, are also relevant to investing. (Abnormal Returns)
- Joe Nocera of the New York Times weighs in on Warren Buffett and Coke. (New York Times)
- “The best way to weather the stresses of trading is to have a rich and full life outside of trading. If P/L is all you have, you’ve set up a life that, at times, you’ll need to escape from.” (TraderFeed)
how to get an amazingly diversified ETF portfolio costing very close to nothing, nada, zilch, by @Matt_Hougan http://t.co/PN5KaD9NHa #WSJ
— Jason Zweig (@jasonzweigwsj) April 30, 2014
Piketty
- Have you wondered how an economics book written by a French professor — Thomas Piketty’s tome Capital in the Twenty-First Century with 577 pages of text and graphs plus 78 pages of notes — scaled the best-seller lists on Amazon and the New York Times? As with so many things in life, timing is a factor. “Mr. Piketty is by no means the first intellectual to have attained celebrity. But he may be the first to see his ideas — and his headshot — go viral . . . however original Mr. Piketty’s economic argument may be, he is the newest version of a familiar, if not exactly common specimen: the overnight intellectual sensation whose stardom reflects the fashions and feelings of the moment,” Sam Tanenhaus writes in “Hey, Big Thinker.” (New York Times)
Math
How Pythagoras' little theorem – and all sorts of other equations – are humanity's lifeblood: http://t.co/56DvfI4xaP pic.twitter.com/0cNC9rNPDG
— The Week (@TheWeek) April 24, 2014
Our brains
- The inner workings of the executive brain: New research shows the best business minds make decisions very differently than we thought. (Wall Street Journal)
Suitability vs. Fiduciary Standard
Incredibly, the SEC Sets Forth Its View: Suitability Standard is the Same as Fiduciary Standard http://t.co/Vt8LyeKXp4
— Ron Rhoades,JD,CFP® (@140ltd) April 28, 2014
And Now For Something Completely Different
- After the killing of Osama bin Laden three years ago, Joaquín Guzmán Loera, who was known as El Chapo, or Shorty, became perhaps the most wanted fugitive on the planet. El Chapo, head of the biggest drug-trafficking organization in history, Mexico’s Sinaloa cartel, was arrested recently. Here’s how the world’s most notorious drug lord was captured: “The Hunt for El Chapo.” (The New Yorker)
- Deep inside the US Supreme Court’s decision on affirmative action lies a fight about how we speak about race in America: “What We Talk about When We Talk about Talking about Race.” (Slate)
- “Expressive Black and White Long-Exposure Landscapes” (My Modern Met)
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
Photo credit: ©iStockphoto.com/JLGutierrez
Regarding Fama and French’s new working paper, I have long told clients that Professors Fama and French were likely wrong when they assumed that the value premium was due to the inherent riskiness of value businesses (http://amarginofsafety.com/ff-and-lsv/). As Fama and French concluded in their 1992 paper:
“The systematic patterns in fundamentals give us some hope that size and book-to-market equity (value) proxy for risk factors in returns, related to relative earnings prospects, that are rationally priced in expected returns.”
They could only go on hope. Two years later, Lakonishok, Shleifer, and Vishny (LSV) demonstrated that the value premium remained even when returns were measured in various periods (and types) of distress, which led LSV to conclude that the value premium was not due to greater risk. Now, it seems Fama and French are finally coming around to the same result, if not the same conclusion.
As every econometrician knows, when the independent variables in a regression are correlated, the results will be unreliable. Factors that were previously significant may be subsumed by additional independent variables that act as proxies for that previously significant factor. In their working paper, Fama and French added two factors to their 1992 three factor model, factors for profitability and capital investment. Specifically they found that profitability and investment are sufficient to account for the performance that was previously attributable to the value factor; the value factor is no longer needed. They concluded in their working paper:
“Finally, HML (the value factor) seems to be a redundant factor in the sense that its high average return is fully captured by its exposures to RM – RF (the equity premium), SMB (the small cap factor), and especially RMW (profitability) and CMA (investment).”
That is, it is fully captured “especially” by firms demonstrating high profitability and low investment that you would expect to find in low risk businesses.
As Morningstar’s Sam Lee wrote, “An efficient-market theorist would (have to) argue that profitable firms and firms with low capital intensity must therefore be riskier in unique ways in order to have commanded return premiums.”
Sometimes an obvious statement of contradiction like Lee’s is enough to make an argument crumble. So, why won’t Fama and French finally draw the conclusion that the value premium is not attributable to risk?