August 2009 Archives
Aug 31, 2009
Q & A
Richard Thaler observes "Efficient market guys have to be willing to claim that the NASDAQ is efficiently priced at 5,000 and at 1,400. That's a tough sell." Comments?
EFF: Stock prices depend on two factors: expected profitability and the expected returns investors require to hold stocks. Both can vary dramatically through time. Thus, widely different levels of the market at different times are quite consistent with market efficiency. Indeed, they are required for market efficiency. This might well be a tough sell, but it's Finance 101.
KRF: Dick is referring to the behavior of stock prices during the tech boom and bust of 1995-2001. Gene is certainly right that market efficiency requires prices to adjust to new information about future cashflows and discount rates. (Read the full entry)
Aug 27, 2009
Q & A
We often hear that the investment world must adjust to a "new normal", reflecting a permanent shift to greater market volatility worldwide. How should investors revise their portfolios in response to these developments?
EFF: There has always been lots of variation through time in market volatility, and volatility tends to be mean-reverting. (See our white paper, "How Unusual Was the Stock Market of 2008?") If investors can't tolerate periods of high volatility in stocks, this should affect their decisions about stocks, whether or not volatility is currently high.
KRF: It is certainly true that stock market volatility is higher now than it was two or three years ago. At the end of 2006, the VIX, a measure of the annual stock market volatility implied by S&P 500 option prices, was below 12%. (Read the full entry)
Aug 25, 2009
Q & A
Long-term government bonds outperformed the S&P 500 Index by 0.12% per year for the forty-year period ending March 2009. Does a negative risk premium for stocks vs. bonds over such a long period challenge conventional thinking about risk and return?
EFF/KRF: It is important to distinguish between the expected equity premium, which should be positive, and the realized premium, which is the expected premium plus the unexpected premium. Investing in stocks is risky because we do not know what the unexpected premium will be.
(Read the full entry)
Aug 20, 2009
Q & A
U.S. budget deficits keep expanding and some of our largest trading partners have begun to question the dollar's role as the world's reserve currency. Both trends suggest a dim future for the purchasing power of the U.S. dollar. Does a diversified equity / fixed income strategy represent the soundest way to address this challenge?
EFF/KRF: Recent Government actions, both fiscal and monetary have created lots of uncertainty about future inflation. Stocks may compensate for inflation in the long-term, but in the short-term they are not very good. And there is so much other uncertainty in stock returns, stocks are not in any case a good specific inflation hedge. TIPS and short-term bonds are good inflation hedges. If you are concerned about inflation risk, you may want to allocate more to them, probably in the tax-sheltered components of client portfolios.
(Read the full entry)
Aug 17, 2009
Q & A
Stock market analysts often claim that hedge funds represent a significant percentage of trading volume in securities markets. What effect, if any, do hedge funds have on stock and bond prices?
EFF/KRF: Good question, but we know of no evidence on the matter. For example, hedge funds might make markets more efficient or they might reduce the accuracy of financial prices.
Aug 11, 2009
Videos
Widely cited as the father of the efficient market hypothesis and one of its strongest advocates, Professor Eugene Fama examines his groundbreaking idea in the context of the 2008 and 2009 markets. He outlines the benefits and limitations of efficient markets for everyday investors and is interviewed by the Chairman of Dimensional Fund Advisors in Europe, David Salisbury.
(View the video)
(View the video)
Aug 6, 2009
Links
KRF: Professor Robert Lucas of the University of Chicago has an interesting guest article in The Economist, "In defense of the dismal science."
Aug 6, 2009
Q & A
A buy-and-hold for stocks appears to work well for long periods (such as 1975 - 1999) but then does poorly for extended periods as well, such as the most recent ten years. Isn't it clear that there are "seasons" for stocks that make the climate favorable or unfavorable for investors?
EFF: We always emphasize that ten years is not a long period for stock returns, and ten-year periods with negative market premiums are common. A long period is basically an investment lifetime (35+ years).KRF: After the fact it is easy to identify periods in which stocks did well and periods in which they did poorly. But if you want to use these "seasons" to build an investment strategy, you have to identify them before they occur - and that is not so easy. The seasons analogy creates the false impression that, like spring, summer, fall, and winter, the favorable and unfavorable periods follow a regular and predictable cycle. Droughts in Australia might be a better analogy. We don't know when the next one will occur and we don't know how long it will last when it does.
Aug 4, 2009
Q & A
Index funds buy stocks "blind" without regard to company fundamentals. Do their activities contribute to mispricing of securities?
EFF: Index funds typically buy cap-weighted portfolios so they do not contribute to mispricing. KRF: We analyze a general version of this question in "Disagreement, Tastes, and Asset Pricing" (Journal of Financial Economics, 2007). Suppose index fund investors hold a passive market portfolio. Then from a pricing perspective they are sitting on the sideline. They are not overweighting or underweighting any securities, so they do not affect (relative) prices. As a result, it is hard to argue that they contribute to mispricing. (Read the full entry)
Aug 3, 2009
Links
EFF/KRF: For an interesting and colorful economic analysis of the proposed U.S. Healthcare Bill we recommend "Health Care Mythology" by Cliff Asness, a Chicago Booth Ph.D.
ABOUT FAMA AND FRENCH
Eugene F. Fama
The Robert R.
McCormick Distinguished
Service Professor of
Finance at the University
of Chicago Booth School
of Business
Kenneth R. French
The Roth Family Distinguished Professor of
Finance at the Tuck
School of Business at
Dartmouth College
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Dimensional Fund Advisors Ltd. is authorised and regulated in the United Kingdom by the Financial Services Authority (FRN: 150100), is registered in England and Wales under Company No. 02569601 and VAT No. 577327607. The registered office address of Dimensional Fund Advisors Ltd. is 7 Down Street, London, W1J 7AJ, United Kingdom. Dimensional Fund Advisors Ltd. is a subsidiary of Dimensional Fund Advisors.