by Robert Litan
The accounting of this exchange comes from Buffett’s unofficial and widely celebrated biography, Snowball, whose author, Alice Schroeder, reports that the audience applauded Buffett’s answer.9 And for what it’s worth, most money managers side with Buffett; how could they not, for to embrace EMH would deny the value of their profession, picking stocks?
Schroeder goes on to say, however, that EMH may still have provided a valuable function by discouraging the average investor from managing his or her own money. In addition, she notes that there are now multiple versions of EMH that essentially say that EMH works for the most part, but not always.10
The third, strong form of EMH is that even traders with private information cannot consistently outperform the market. Silver states that not even most EMH supporters believe this extension of the theory.
Silver also adds an important caveat to the three forms of EMH that Fama himself would insist on. Each applies only to risk-adjusted returns. Some investors willing to take above-average risks may be able to outperform the market, but only because of their risk taking, not because they have superior stock-picking ability. Their annual returns also will fluctuate more widely than a market-wide portfolio.
EMH critics, and there are many, cite the stock market’s sharp occasional falls as disproving the hypothesis. EMH defenders respond that market fluctuations do not refute the core proposition of the theory: namely, that no one can consistently outperform the market, except by taking more risk, or by chance.
Eugene Fama
Eugene Fama didn’t start out wanting to be an economist when he enrolled in college at Tufts University. His first interest was in Romance languages, but like many who get turned on to something else, Fama’s life was changed after working as an assistant to a professor who ran a stock market forecasting service.
Fama’s work interested him in poring through past stock market data to discover patterns that might support a profitable investment strategy. The professor told him to test each strategy on a forward-looking basis, taking into account the costs of buying and selling the stocks—what economists call transactions costs—and as Nate Silver describes it, “almost always” the strategies failed.11
But the work and the hunting changed Fama’s intellectual interests entirely. He abandoned any thought of pursuing Romance languages and instead went to the University of Chicago’s business school to earn his PhD in finance (or what I have been calling financial economics). His dissertation focused on whether one could extrapolate the investment performance of mutual funds from their past performance (analogous to stock-picking exercises of his undergraduate years), based on data from the decade of the 1950s.
Lo and behold, the striking answer was that one couldn’t! Just because a fund had a good run in the past, an investor could not count on a continuation of that performance in the future. Fama also established the same result for the wide number and variety of technical analysts—those who attempt to divine the future movement of stock prices from their past patterns charted on a graph.
In short, Fama found that no one actively managing money, not even the best mutual fund managers, could consistently beat the market, or the performance turned in by an average of all stocks.
In 2013, Fama was awarded the Nobel Prize for his pioneering financial research. As discussed shortly in the text, he shared the prize with two other researchers.
If picking stocks is a losing proposition, and indexing is the way to go, can anyone make money using the insights of EMH? The answer is yes, and one of the clearest examples is Dimensional Advisers, founded by one of Fama’s former Chicago graduate students, David Booth.
Booth got the idea for his company after being an adviser to pension plans for large companies in the late 1970s, which then were heavily invested in large-capitalization stocks. He eventually wondered why these companies’ treasurers were not also investing in small-cap stocks, or those of small or young public companies, as well.
Booth didn’t wait for the answer, or for anyone else to implement the idea. In 1981, he and a graduate school colleague, Rex Sinquefeld, launched Dimensional Advisers with the explicit objective of building what was, in effect, an index fund of small-caps, even before such indices existed—in other words, the reverse of Vanguard’s innovation of building the funds to replicate existing indices. Dimensional added value stocks, or those with low ratios of price to book value, to the mix of its portfolios for its investors.
The EMH theory was not the only basis, however, for Dimensional’s success. Booth and his colleagues introduced several important trading innovations, which the fund also credits for its success. One innovation was to buy stocks throughout the day, rather than only at the closing, when index funds are priced. This saved trading costs and enhanced the funds’ performance. A second innovation was to parcel out orders to different brokers and tell them to be patient, and not to buy unless there was plenty of volume, or when many sellers were around. The founders did not want orders being executed when only a few sellers were able to command higher prices than in thicker markets. These instructions created competition among brokers for getting stock at the cheapest prices, which increased returns for Dimensional’s fund investors.12
This second practice has changed with the advent of high frequency trading, conducted by computers using trading algorithms for buying and selling stocks. Dimensional has adapted by developing its own ordering systems that bypass brokers. Later in the company’s history, Dimensional used the research findings of the company’s academic advisers (see box on David Booth that follows) to develop funds that invested in large-cap stocks, including companies in international markets, and fixed-income funds as well. As the firm’s investment vehicles diversified, Dimensional broadened its marketing strategies, opening foreign offices and seeking funds from individuals with defined contribution pension plans. Dimensional’s official history makes clear that its economic advisers were critical to each stage of the company’s success and expansion.13
David Booth: Putting EMH to Work in the Investment World
David Booth is one of the humblest billionaires you’ll ever meet, and also a very generous one. I met him while we happened to be sitting next to each other on a shuttle bus ride at an event at Dallas several years ago. After introducing ourselves, and he said his name was David Booth, I thought a moment and then blurted out, “Are you the David Booth who just bought the Naismith papers (the original rules of basketball) and donated them to the University of Kansas?” He said yes.
That question came to me because just before this bus ride, the Kansas City Star, the largest newspaper in the city where I was then living, had just reported the multimillion-dollar purchase of these papers by Booth and his donation. I also realized that he was the same Booth for whom the University of Chicago’s Business School had been renamed after his very generous donation to the school where he received the training in finance that ultimately led to his great success.
Booth then briefly told me his life’s story, how he had grown up in a modest house on Naismith Drive near the University of Kansas and why he had purchased and then donated the Naismith papers because of his love of basketball and the University of Kansas, which he attended as an undergraduate (both parts of his background resonated with me since I am a Kansas native, and a huge fan of the basketball teams of all Kansas universities).
From Kansas, Booth went to Chicago’s business school with the intention of earning his PhD in finance studying under Fama. Booth greatly enjoyed learning from Fama and served as his teaching assistant, but ultimately came to the conclusion that he was better suited for the investment world than academia. So he left Chicago before getting his PhD and entered the world of money management, first at Wells Fargo working on index funds, and later at A.G. Becker.
Booth credits his teacher Fama with the inspiration for his hugely successful entrepreneurial career in money management. Fama, Kenneth French (another well-known financial economist at Dartmouth), and Robe
rt Merton (another Nobel Prize winner), along with a handful of other academic stars in financial economics, are consultants to Dimensional, illustrating another important principle Booth explained to me: Start with a good idea but surround yourself with a lot of other people who are smarter than you to help implement it.14
Behavioral Finance
The Nobel Prize for Economics has often gone to multiple economists in the same year. The year 2013 was one of those years, for not only did Gene Fama win for his work on EMH, but Robert Shiller of Yale University (see the following box) was a co-winner (along with Lars Hansen, Fama’s colleague at the University of Chicago) for his work on financial economics, too. But what was relatively rare in this award is that Fama’s and Shiller’s research reached opposite conclusions.
Whereas Fama argues that financial asset prices are efficiently determined, Shiller was recognized by the Nobel committee for his research going back to the early 1980s showing that stock prices vary far more frequently than dividends,15 suggesting stock prices can and do move for reasons that may have nothing to do with the fundamental earning power of their companies. This means that stock prices can overshoot in both directions, forming bubbles in good times (when, in Warren Buffett’s terms, investors are greedy) and being excessively deflated in bad times (when Buffett says that investors are fearful). To Fama and other proponents of at least one of the stronger forms of EMH, it makes no sense to talk of stock price bubbles because prices are always efficient.
Shiller was also in the vanguard of a school of financial economics called behavioral finance—a branch of a broader school of behavioral economics, discussed in the second chapter. Finance behaviorists, including not only many academics but also many professional and amateur stock pickers, believe there are too many ways in which stock price movements depart from one or more versions of EMH. Thus, some investors and hedge funds buy and sell on momentum, believing they can predict stock prices over some future period (which may be much shorter than a day) based on past prices. Other investors have observed and acted on past oddities in stock pricing—such as the tendency that persisted for some time for stock prices to rise during the first week in January (after professional investors have sold off some stocks at year-end for tax or other reasons), or the apparent tendency of the worst performing stocks in the Dow Jones Industrial Average or the worst performing mutual funds to outperform the market as a whole for some period ahead.16 Academic financial economists continue to debate the validity and importance of behavioral finance.
There is one proposition on which both Shiller and Fama very likely would agree, however: In the short run, stock prices are unpredictable and therefore it is prudent for most investors to buy and hold broad index-based instruments (mutual funds or ETFs). Shiller would be the first to tell the average investor that he or she cannot rely on some of the statistical oddities that some investigators may have found in the past that generated risk-adjusted returns, outperforming the market as a whole (what finance professionals call alpha). To this extent, then, Shiller’s work provides just as much intellectual support for the indexing movement as does Fama’s (Shiller would also argue, however, that in the long run it is fundamentals, namely the underlying earning power of companies, that determine stock prices and that such prices revert to a long-run average of price-to-earnings ratios).
EMH proponents, meanwhile, deny that the oddities various behaviorists claim to have discovered are stable, largely because once they have been identified for all investors to see, enough may jump on the opportunities until at least some of the oddities disappear, or, in finance language, are arbitraged away. Shiller and other behaviorists may agree with this to some degree, but would add that market misalignments or bubbles can persist for some time before they are corrected or punctured, a proposition that EMH proponents would not accept.
Behavioral finance has important implications for policy makers, which is why the debate over its merits has an importance that extends beyond the world of investing. If it is true that financial markets are prone to manias and bubbles, as not only the behaviorists believe but as one of their intellectual godfathers, the late Hyman Minsky, argued in his many writings, then there is a case for preemptive government policies aimed at thwarting these tendencies.
In the aftermath of the financial crisis, such policies have been called macro-prudential regulation, to distinguish them from the traditional micro regulation and supervision of individual financial institutions. Macro-prudential regulation was legitimized by the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, which created an interagency committee (the Financial Stability Oversight Committee or FSOC) to monitor the economy for signs of bubbles in different asset markets and to take steps to keep them from growing too large. It will be quite a trick if regulators can pull this off, but the intellectual underpinnings of the effort clearly lie in behavioral finance.
Robert Shiller
Robert Shiller is a native of Michigan, and earned his undergraduate degree from one of the state’s flagship universities, the University of Michigan. His master’s and PhD degrees in economics are from MIT, where he wrote his thesis on interest rate determination under the supervision of another Nobel laureate, Franco Modigliani. Shiller’s Nobel came in 2013, as noted in the text.
Ironically, Shiller is one of the few economists of recent years who was widely known even before he won the prize. That is because Shiller predicted the deflation of not one, but two asset bubbles. His widely popular book, Irrational Exuberance, which focused on the excesses in the stock market, was published in March 2000, or just one month before stock prices, especially those of newly public Internet companies, crashed. Later in the decade, but well before housing prices began to turn down in 2006 and 2007, Shiller presciently warned in both writing and in media appearances of an emerging bubble in residential real estate prices, fueled by the excessively liberal extension of subprime mortgages.
Shiller is not your typical ivory tower economist. He has long displayed a strong interest in applying his ideas to the real world. One of his best-known endeavors is his partnership with Wellesley economist Carl Case in forming and publishing the Case–Shiller index of residential real estate prices, which was purchased and is being maintained by Standard & Poor’s. Unlike other such indices, which report average prices of all homes sold within a given time period and geographic area, Case–Shiller follows the prices of the same homes in 20 cities around the country and thus doesn’t change when the mix of lower and higher priced homes changes.
Valuing Options: Upsides and Downsides
This book began with the observation that economists suffered a hit to their prestige on account of the financial crisis of 2007 to 2008 and the subsequent Great Recession. In many popular accounts, financial derivatives played an important role in these events and, by implication, derivatives have taken on the characteristics of an unprintable (at least in this kind of book) four-letter word.
I address derivatives in more detail in Chapter 12, which discusses the impact of economists on policies affecting the financial sector. Here, I want to discuss both the positive and not-so-positive impacts that one economic advance relating to a particular derivative, the tradable financial option contract, has had on the financial industry, and business more broadly.
An option is just one form of a derivative, or a financial instrument whose value is derived from the value of some other more fundamental financial contract. For example, a futures contract is one that requires the holder to buy or sell a particular commodity, or more recently an index of stocks, at a particular price before the end of some time period (typically six months). In contrast, an option contract simply gives the holder the right to buy or sell that instrument—let’s use a stock—at a given price before some maturity date. An option to buy is a call and an option to sell is a put. The price at which the option is exercised is called the strike price.
For example, consider IBM selling at $200 per share. A
n investor could buy a range of calls at different strike prices, from below $200 (in which case the option is said to be in the money because the market price is above the strike price) to well above $200 (in which case the option is out of the money). You would buy a call if you thought IBM’s price was going up. If you did this because you had shorted IBM (bet against it), you would be hedging that position (since the gains on the option if IBM’s price increase would be offset by your loss on the short). If you bought the call simply because you wanted to bet on IBM’s stock price increasing but didn’t want to shell out the full $200 per share, then you’d be speculating.
Options also allow purchasers to take advantage of leverage, since the price of an IBM option with a strike price of $210 may be $5 a share, which may double if IBM’s market price rises by $5. In contrast, a $5 increase in a stock with a base price of $200 would represent only a 2.5 percent gain (5/200). Better yet, the option limits your downside loss, which is only the cost of the option itself. In effect, an option is like paying an insurance premium for a limited time on the value of a stock.
I ran through this example for a call, but the same analysis applies, in reverse, to put options, which purchasers would buy if they thought the price of stock was going to fall. As with calls, purchasers could buy a put as a hedge or for speculative reasons.
Speculation: A Practice Much Misunderstood
Some readers may see the word speculation and immediately have a negative gut reaction. After all, weren’t speculators somehow responsible for the financial crisis? And don’t speculators add to market volatility, which somehow is bad for the market?