May 14, 2008
RETHINKING MODERN PORTFOLIO THEORY
The investment universe is filled with surprises, and perhaps the biggest shocker of all is the idea that the value strategies of Ben Graham and his disciples are in general agreement with modern portfolio theory (MPT).
Granted, it sounds absurd. MPT, after all, is the suite of financial theories that spawned index funds and the view that market prices are the best estimate of intrinsic value. Meanwhile, Graham's value strategy asserts the opposite, advising that savvy investors on the hunt for bargains can do a better job of calculating fundamental value, a strategy that boosts the odds of generating market-beating returns.
MPT and value investing, it would seem, are natural adversaries. That was true, but the two ideas have become similar thanks to the evolution of MPT. But while the academic interpretation of MPT has changed, the popular perception remains stuck in the 1960s and 1970s, when two of its major components--the efficient market hypothesis (EMH) and indexing--first arrived on the financial scene. Recognized or not, there's been a slow but steady accumulation of empirical research since the 1980s that's altered financial economists' view of capital markets. As a result, there's a new MPT in town and it's a lot closer in spirit to a Graham-inspired view of investing.
Ok, but why should investors care? Because if the classic strategies of active and passive investing are more closely aligned around value investing principles, the union lends more authority to value strategies generally. Indeed, if two formerly competing notions of money management--each commanding huge amounts of money under management--are now in basic agreement, it probably reflects a fundamental truth about how the capital markets function and how investors should build and manage portfolios.
The story of how these two ideas have become relatively complementary and why this meeting of the theoretical minds is relevant for investors starts in 1934, with the publication of Graham and Dodd's Security Analysis. The book (currently in its fifth edition) is widely hailed as the value investor's bible by teaching that market prices can and do deviate from a security's intrinsic value and that investors should exploit the mismatch whenever a bargain can be had. Buying securities at prices that offer a margin of safety improves the odds of capturing relatively higher expected returns, the book counsels. This is the definition of investing, Graham preached and anything else is speculation.
Meanwhile, MPT's founding research was published in the 1950s and 1960s. The early interpretation was based on a strict view of what's known as the random walk hypothesis, which argues that price changes are randomly distributed a la a standard bell curve. The practical lesson is that price changes are independent: yesterday's changes are unrelated to today's, which will be unrelated to tomorrow's. Securities prices are unpredictable if they follow a random walk. If so, investors are better off buying and holding index funds.
Unpredictability was the dominant view of MPT in the 1960s and 1970s, a view popularized by Burton Malkiel's best-selling 1973 book A Random Walk Down Wall Street. Three years later, Vanguard launched the first index mutual fund. The business of passive investing has been exploding with assets ever since.
But if there was a rush to embrace a random walk-view of MPT, it was premature. Even at the dawn of MPT, some academics warned that prices don't follow a random walk. Notably, Benoit Mandelbrot's 1963 Journal of Business paper—"The Variation of Certain Speculative Prices"—showed that securities prices didn't follow a random walk, which left open the possibility that prices may be at least partly predictable.
Nonetheless, the early readings of MPT conveniently overlooked such observations. But the truth has a way of emerging eventually. Indeed, a new generation of researchers took a fresh look at the random walk in the 1980s and 1990s and the accumulating tide of studies began to turn the academic tide. Even Eugene Fama, one of the founding fathers of the efficient market hypothesis, recanted, at least partially. In 1991, writing in the Journal of Finance, he recognized that the evidence was mounting that the "predictable component" of equity returns rises to "as much as 40% of the variance of 2- to 10-year returns."
If the empirical research was strong enough in 1991 to convince Fama, the academic smoking guns are more compelling (and numerous) in 2008. In fact, looking back over the past quarter-century of published research leads to what is now widely considered as strong evidence that the stock market's expected return is at least partly predictable over multi-year horizons. To be sure, studying prices alone still doesn't offer much insight into what's coming in the short term. But other observable variables, which were initially ignored by academics in the 1960s and 1970s, tell a different story.
Analyzing such factors as dividend yields, price-earnings ratios, book values and other fundamental metrics provides insight about future returns. One finance professor, writing in 1999, labeled academia's volte-face on the subject of return predictability as one of the "new facts" in finance. "Now we recognize that stock and bond returns have a substantial predictable component at long horizons," observed John Cochrane, a finance professor at the University of Chicago, in Economic Perspectives, published by the Chicago Federal Reserve. The old view of MPT is gone, he declared.
Card-carrying members of the Graham school of investing can rightfully say, "We told you so." Although academics are latecomers to the party, the fact that they've arrived only adds more credibility to what Graham taught: valuation matters. Indeed, Security Analysis instructs readers to analyze the balance sheet, study earnings trends, compare dividend yields to interest rates and so on for deciding if Mr. Market's prices are compelling or not. In fact, that sounds a lot like a 21st century reading of MPT.
In the May issue of Wealth Manager, your editor mused over how much has changed when it comes to portfolio strategy. At the same time, some aspects are eternal, including risk. Although there's more predictability in markets than previously recognized, the transparency is only partial. That's one reason why there's a risk premium in equities. It's also a reminder that you can still lose money in stocks, even if the markets are somewhat predictable. For more, read on...
Posted by jp at May 14, 2008 8:54 AM
In fact, depending on the finance professor you talk to (i.e., those professors familiar with the literature) cite a range of numbers as to the degree of predictability. But if the percentage is open to debate--and it most certainly is--a full reading of the Fama and French literature strongly suggest that returns are somewhat predictable. Of course, we could then debate if the Fama French research is valid, but that's a whole other issue. In short, there's still plenty of risk, even after all we've learned (or think we've learned).
Posted by: JP at May 27, 2008 10:01 AM
Great post though I must quibble with you reference to Fama's 1991 paper. On a closer re-reading of it you will see that Fama was reviewing new (between his original research and '91) research and literature and said that it seemed to point to claims of predictability of stock prices. In no way was he saying this was his own opinion; only the conclusion of those others who provided new research on the subject. In fact, his whole paper is about a review of the recent literature. Neither his ending conclusions, nor any other part of the paper, can be read as anything close to 'admitting' anything like the 40% reference you mention. Otherwise, a good read.
Posted by: Ember Martin at May 26, 2008 1:36 AM