KRF: If you are looking for historical returns on our three factors and many other interesting portfolios, you can find them on my web site.

EFF: Half of my 1964 Ph.D. thesis is tests of market efficiency, and the other half is a detailed examination of the distribution of stock returns. Mandelbrot is right. The distribution is fat-tailed relative to the normal distribution. In other words, extreme returns occur much more often than would be expected if returns were normal.

EFF: Theoretically, derivatives increase the range of bets people can make, and this should help to wipe out potential inefficiencies. Whether this actually happens is a difficult, perhaps impossible, empirical question. The "problem" is that markets seemed rather efficient before Black-Scholes (which initiated the derivatives industry), so there wasn't much for derivatives to do.

EFF/KRF: When overall market volatility increases, idiosyncratic (security-specific) volatility also tends to increase. For example, market volatility is currently quite high, and the dispersion of the cross section of stock returns (which is idiosyncratic volatility) is also unusually high. Diversification has no effect on the volatility of the overall market, but it reduces the effect of idiosyncratic volatility on a portfolio's return. To put it differently, active investment is a riskier strategy when volatility is high because active portfolios are, almost by definition, poorly diversified.

In short, diversification is now more important than usual.

EFF/KRF: In the past, other countries have had recessions that the U.S. has not shared. But the U.S. is big, and every U.S. recession has been global. Thus, the global aspect of the current U.S. recession is characteristic of past U.S. recessions. Every past recession has ended. This one will too.

EFF/KRF: As far as I can tell, the government bailout of AIG has gone largely to prop up its $2 trillion of credit default swaps. The fear of the Treasury and the Fed is that if AIG is forced to default on its credit default swaps, the "insurance" they provide to the value of bank assets will disappear, the value of the assets will fall, and lots of big banks will be insolvent. I agree that this is likely to be the eventual outcome, in other words, the Fed and the Treasury will eventually say "uncle" and let AIG and the bad banks fail. I think this is what they should have done from the beginning, and if they had we would be in better shape now. The stockholders and the bondholders of AIG and the failed banks will lose big time, but this will allow the banking sector as a whole to emerge in a stronger state. (See also my little paper "Bailouts and Stimulus Plans.")

EFF/KRF: Even in good times, economic systems are often changed dramatically by political decisions. (Think about South America over the last 30 years.) Capitalism is always under threat in the U.S., and the threat is higher when the legislative and executive branches are both in the control of liberal Democrats, who seem to be big admirers of the European system of high social welfare expenditures and "managed" (or better, mismanaged) capitalism. Unfortunately, the current political period may result in stagnation of the sort that other managed capitalist economies (Japan and most of Europe) have experienced. But we hope the pioneering free enterprise spirit of the U.S. can quickly reassert itself.

EFF/KRF: Government intervention affects the market in two ways. First, it affects the level of expected future profitability, which has direct effects on stock prices. Second, government intervention and uncertainty about the government's future actions change the risk of expected future profits, which affects stock prices by raising or lowering the discount rates for expected future profits, and thus raising or lowering expected stock returns. Our view is that the rhetoric and sweeping initiatives of the new administration have lowered market expectations of future profitability, and the uncertainty about government policies has increased the risk of expected future profits. Both effects have contributed to the lower stock prices we have seen as the policies of the new administration have unfolded. If the market has it right (that is, if the market is efficient) all this is built into current stock prices, and expected returns are higher going forward. (See also the answers to Expected Return in a Bad Economy, Expected Return and Stimulus Efforts, Hedging Inflation with Bonds.)

EFF/KRF: Short-term high grade bonds are a good hedge against inflation. If hedging inflation is your overriding goal, short-term high grade bonds are the route for you. (Gene has been saying this for about 40 years.) But don't expect much in the way of a real return. Short-term bonds maintain purchasing power, but they don't enhance it, since the real returns they produce are quite low (for example, less than %1 per year on T-bills). In other words, if you don't take much real risk, you can't expect much real return.

EFF/KRF: The recent sharp decline in prices suggests that the market does not think the actions of the government (including the stimulus plan) are, in aggregate, good for the economy. If you think the market has it right, then expected stock returns are high, for the reasons outlined above. If you are more pessimistic than the market about the effects of government actions, then (at least on this score) you think prices are too high, which means expected returns are low. Conversely, if you are more optimistic than the market about the effects of government actions, then you think prices are too low, which means expected returns are quite high. Keep in mind, however, that the empirical evidence says you are on thin ice when you decide your forecast of the future is better than the market's.

EFF/KRF: The market has declined sharply in response to rough times and forecasts of future rough times. The decline in market prices combines two effects: (i) lower current and expected future profits, and (ii) higher discount rates for the expected future profits. The discount rate, in turn, has increased because uncertainty about future profits (in other words, risk) has increased and, apparently, because investors have become more risk averse. Higher discount rates for expected profits translate into higher expected stock returns.