Articles on Investments
Aug 4, 2010
Q & A
Does an equity strategy focusing on stocks with above-average dividend yield offer an appealing risk/reward tradeoff? Have dividend-paying stocks outperformed non-dividend payers in the U.S.?
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Jul 28, 2010
Q & A
Does the deteriorating financial condition of the U.S. government diminish the appeal of U.S. Treasury securities as a risk-free asset? Should investors consider adding government securities from other countries to diversify?
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Jul 7, 2010
Q & A
Should investors expect higher returns from private equity investments as compensation for the lack of liquidity? Does private equity offer a useful diversification benefit in a balanced portfolio?
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Jun 30, 2010
Q & A
Can put or call options be used to achieve a more predictable risk-return tradeoff? For example, should I purchase put options to minimize equity portfolio losses?
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Apr 28, 2010
Q & A
Some economists argue that prohibiting insider trading does more harm than good by reducing the flow of useful information. Do you agree?
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Apr 21, 2010
Q & A
Is semi-variance a more useful measure of downside risk than standard deviation? My clients aren't worried about market surges, they're worried about market crashes.
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Apr 14, 2010
Q & A
Based on spot price data from January 1970 through February 2010, the average return on gold bullion was almost exactly the same as the S&P 500 at 88 basis points per month. Volatility was significantly greater for gold, but since gold prices tended to zig when equity prices zagged over this period, a portfolio composed of 80% stocks and 20% gold (rebalanced annually) had lower volatility than either of its component parts. Doesn't portfolio theory suggest that gold can make a useful contribution?
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Feb 10, 2010
Q & A
In their book Valuing Wall Street published in early 2000, Andrew Smithers and Stephen Wright claim that the q ratio popularized by Nobel laureate James Tobin reliably identifies periods of extreme overvaluation and undervaluation in stock prices. Can investors use this indicator to implement a successful market timing strategy?
EFF/KRF: This proposition has been tested in several papers, and the answer is no. The market-to-book ratio for the market (a proxy for q) shows some ability to predict stock returns during the 1930s, but not thereafter.
Feb 3, 2010
Q & A
A prominent money management firm has recently launched several mutual funds that seek to exploit the positive momentum effect in stock prices. Why does this well-publicized anomaly persist and under what circumstances can investors expect to profit from it?
EFF/KRF: The momentum anomaly has been observed in most major markets (Japan is the exception). Many academics claim that trading costs will wipe out any benefits of trying to trade actively on momentum. This will now be tested by live funds. The results will be interesting.
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Jan 22, 2010
Q & A
How do TIPS and one-month Treasury bills compare as inflation hedges?
EFF: TIPs are obviously a great hedge against inflation, but there is still uncertainty about the short-term real return on long-term TIPS. A long-term TIPS is a long-term loan to the Government at a fixed real interest rate. Variation through time in the expected real return that investors require to make this long-term commitment leads to capital gains and losses that affect short-term real returns.
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Dec 14, 2009
Q & A
Lubos Pastor and Robert Stambaugh argue that long-horizon stock investors actually face more volatility than short-horizon investors. How should investors interpret this evidence?
KRF: The Pastor-Stambaugh result is driven by uncertainty about the true expected return. The volatility or standard deviation of returns is usually defined as the expected variation relative to the true mean of the process generating returns - as if we knew the true expected return. But, as Pastor and Stambaugh emphasize, we never actually know the true mean. When they include uncertainty about the true mean (as well as uncertainty about other true parameters) in the analysis, they find that long-run returns are indeed more volatile than short-run returns.
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Nov 30, 2009
Essays
By Eugene F. Fama and Kenneth R. French
Our paper, "Luck versus Skill in the Cross Section of Mutual Fund Returns," examines the performance during 1984-2006 of actively managed US mutual funds that invest primarily in US equities. It is an academic paper with lots of technical detail. The purpose of this white paper is to provide a summary of the results that are relevant for investors. We begin by examining the overall α for aggregate wealth invested in actively managed mutual funds. We then turn to the performance of individual funds.
(Read the full entry)Nov 9, 2009
Q & A
The realized equity premium for U.S. stocks relative to long-term government bonds has been negative for the 5, 10, 15, 20, and 25-year periods ending in 2008 despite substantially greater standard deviation for stocks. How do I use this information to develop a sensible portfolio based on mean-variance optimization?
EFF: We have emphasized in previous posts that there is substantial uncertainty about the size of the expected equity premium, that is, the true expected return on stocks less the expected return on riskless bonds. Whatever estimate you use, 5, 10, or even 15 years of recent evidence should not change your estimate much. 20 or 25 years of data are more serious, but then there is another issue.
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Sep 15, 2009
Q & A
How useful was Monte Carlo-type analysis in preparing for the recent downturn in the economy and stock market? Is there an alternative approach that investors should consider in an effort to address the uncertainty of future returns?
EFF: Monte Carlo analysis is overkill here. All one really needs is good historical perspective on the volatility of volatility. Our white paper, "How Unusual Was the Stock Market of 2008?", is a good start.
KRF: Monte Carlo analysis is often worse than overkill because it gives many users a false sense of precision. If used right, it can provide some perspective about the payoff on a long-term investment. Investors who do Monte Carlo simulations, however, often assume returns are drawn from a normal distribution with a constant volatility. In fact, a normal distribution produces far fewer extreme returns than we see in the market. Moreover, it is easy to forget that the inputs for the analysis - the estimated expected returns, variances, and covariances - are almost certainly grossly imprecise.
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.
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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.
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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.
Jul 14, 2009
Videos
The answer depends on why stockholders want to leave the market. During the financial crisis, some investors discovered that their tolerance for risk is lower than they thought, so it might make sense for them to permanently reduce their exposure to equities. Investors who wish to avoid the price impact of the recession, however, are probably too late. Today's stock prices already reflect the anticipated effects of the slowdown, as well as any effects the recession has on expected future returns.
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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 Carl E. and Catherine
M. Heidt Professor of
Finance at the Tuck
School of Business at
Dartmouth College
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This article is distributed for educational purposes and should not be considered investment advice or an offer of any security for sale. This article contains the opinions of the author but not necessarily Dimensional Fund Advisors and does not represent a recommendation of any particular security, strategy or investment product. Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. Past performance is not indicative of future results and no representation is made that the stated results will be replicated.
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.
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.