Does active fund management pay off?

Brendan Burgess

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Marc Westlake had an excellent article in the Sunday Times which is reproduced on his blog [broken link removed]

and

 
Brendan Burgess said:
Marc Westlake had an excellent article in the Sunday Times which is reproduced on his blog [broken link removed]
Click to expand...

Let me start by saying that I do not subscribe to the efficient market hypotheses, I'm a value investor and I have done very well by that!

That aside, I don't believe for a minute that active fund management pays off, but for a different set of reasons than Marc! The dice is always stacked against the manager of an active fund:
  • A certain amount of the fund has to be kept in cash to cover withdrawals and so on, so they have to achieve the returns without being fully invested
  • Investors want instant gratification - if they read an article about some great must have stock the first think they do is check to see if their fund holds it, so managers are often forced to buy at the top of the market in case they loose the client
  • For the same reason, fund managers often sell entire positions before the quarterly results are announced in case it is bad news and they don't want to be caught holding and risk loosing the client. If it turns out OK, they'll buy it back in the afternoon. All leading to high transaction costs.
  • There is the management fees and expenses to top it off
With all that baggage it is no surprise that most managers fail to beat or even achieve the benchmark they are being measured against.
 
Neil Osborne has replied to Marc's articel in last Sunday's Times.

I can't find it on the Covestone Asset Management website (which is the most appallingly designed website).

Brendan
 
I have looked back at Marc's article and I found this bit interesting.


I would have always assumed that value stocks were less risky?

Brendan
 
Brendan I agree value stocks are less risky and the evidence shows this. I'm doing a phd at moment on a related topic. I must admit most accepted financial theory is hogwash. Im also an actual investor (small one) so I read the debate between the pair with interest and I have to say that graph Neil showed on Sunday was a knockout blow to the Efficient Market theory. I went onto the covestone website and couldn't find the Sunday times article but I found Thst graph explained on their quarterly newsletters. I'd love to know exactly what goes into it cos I agree with his points. Is there Any more
value mangers In Ireland does anyone know?? Wayne
 
Well accepted financial theory is the typical theory that gets thought in colleges and business schools the world over, it dictates how most of the investments in the world are managed, it also influences how policy makers and central bankers look at the world, all this boils down to theories such as Modern Portfolio Theory, CAPM and Efficient Market Hypothesis with their implications such as risk is volatility so high volatile stocks will outperform low volatile stocks etc, Those theories are plainly rotten to the core. Risk is not volatility, how could it be? It is only is if you define it that way. High beta stocks do not outperform low beta stocks over time there are many academic papers on this, the opposite is actually the case. When volatility is high, traditional theories will tell you risk is high but that is not true you get the best risk adjusted long term returns when you buy volatility spikes, similarly when volatility is low you tend to get complacency so risk is present but people ignore it (think 2007). Value investing works particularly well as the studies show and value strategies are actually less risky not more risky. This is what that guy in the paper was saying, though I think what he was saying is that one should use value strategies for the market as a whole and not for individual stocks (as in use it as an asset allocation tool) which is something I need to look into more but makes intuitive sense to me. For a different perspective on risk try Mandelbrot and that annoying guy Taleb or look at way famous value investors like Benjamin Graham and Warren Buffet think about risk. The behavioural schools fill a lot of the gaps that traditional theory leaves yet they still don't teach them in business schools, they just stick with the traditional theories, which are very deficient IMHO. Wayne
 

Fantastic post.

I would add James Montier to the list of excellent behavioural economists.

The academic efficient market school ignores any attempt at looking at behaviour in the markets.

The belief that all investors are rational all of the time and acting with perfect information and hence all price are efficient is falling away as the correct approach. It works some of the time but not always.

Howard Marks in 'The Most Important Thing: Uncommon Sense for the Thoughtful Investor: Uncommon Sense for Thoughtful Investors' sets a truely excellent analysis of when markets are efficient and when they are not. A truely great book.
 

Great post, I especially agree on the risk comment. What is generally ignored is that level of risk is a totally subjective observation by an individual. My personal portfolio would probably send many mainstream investment advisor gasping, but based on my economic views I have reduced my risk, especially for the long term. I sleep better at night precisely because I do not follow a mainstream approach.

ringledman said:
Howard Marks in 'The Most Important Thing: Uncommon Sense for the Thoughtful Investor: Uncommon Sense for Thoughtful Investors' sets a truely excellent analysis of when markets are efficient and when they are not. A truely great book.
Click to expand...

Thanks for posting, I must look it up.
 
Brendan,

Thank you for the question about value investing.

So, to address some of the comments made above first.

The Wisdom of Crowds is a book written by James Surowiecki which sets out the simple but powerful idea that under the right circumstances groups can make better decisions than could have been made by any single member of the group. Examples include the odds at a racetrack which almost perfectly predict how likely a horse is to win (this despite the fact that my mother bets on horses based on their name!), Google’s search engine is another example of a process powered by collective wisdom. In a recent BBC TV documentary Professor Marcus du Sautoy asked a group of participants to guess how many jelly beans were in a jar and the average of all the guesses was within 0.1% of the true number. Another good example of the combined wisdom of crowds is the stock market.

However, critics of market efficiency in financial markets claim that much of the blame for the recent financial meltdown is attributable to a misguided faith in market efficiency that encouraged market participants to accept security prices as the best estimate of value rather than conduct their own investigation.
We asked some leading commentators to join the debate and to share their thoughts with us, first the Father of the Efficient Markets Hypothesis Professor Eugene Fama at the University of Chicago.

“The premise is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis, which posits that market prices reflect all available information. The claim is that the world's investors and their advisers bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. This premise is fantasy. Most investing is done by active managers who don't believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finance, financial markets, and financial institutions are in disrepute. The popular story is that together, they caused the current recession. I think one can take an entirely different position: financial markets and financial institutions were casualties rather than the cause of the recession.”

I doubt any finance professor believes the efficient market hypothesis is completely and literally true. As Fama has pointed out, “the extreme version of the EMH is surely false.” The EMH is an abstraction that allows us to construct a framework for rigorous thinking about how capital markets work. Like any model, it must be false to some degree. The relevant question for investors is “How well do relatively simple asset-pricing models explain a very complicated reality?” Are they perfect? No. But current models do a good job of explaining differences in stock returns as well as money manager results. And researchers such as Fama and his colleague at Dartmouth College, Ken French continue to try and come up with better ways to distinguish high-expected-return securities from low-expected-return securities. If critics can present a superior asset-pricing model, let’s see it so we can subject it to critical review from other financial researchers.

What about the behavioural finance studies which claim that individuals are not rational and are prone to biases in their behaviour?

Fama again; “My academic friends in behavioural finance almost always end up concluding that passive investing is the right choice for almost all investors. In my view, this is an admission that the Efficient Markets Hypothesis provides a good view of the world for almost all practical purposes. “

It is often suggested that investors’ behavioural biases contribute to pricing mistakes which can be exploited by other investors. Many money managers claim to pursue such strategies, but if they were successful in this effort we would see the results in money manager performance studies. We don’t. The results of money managers, including those who claim to apply a “behaviourist” strategy, are well-explained by the same asset-pricing models that critics of market efficiency are so quick to condemn. One of the most prominent economists associated with behavioural finance is Richard Thaler of the Univ. of Chicago. He and Fama don’t agree on much, except when it comes to practical advice for investors. There, his conclusion is essentially indistinguishable from card-carrying market enthusiasts: diversify, keep your costs down, and don’t read your monthly statement. Daniel Kahneman, the Princeton psychology professor who received the Nobel Prize in Economics for his work on behavioural biases, strikes a similar note. Humans often exhibit irrational behaviour, he observes, and, among investors, an example of this irrationality is the persistent delusion that they can outwit the market in the face of overwhelming evidence to the contrary.

Another attack on modern portfolio theory comes from commentators such as Nassim Nicholas Taleb the author of the "The Black Swan" and a fan of the mathematics of Benoit Mandlebrot who attack the use of Gaussian (normal bell curve) mathematics as the foundation of finance. They argue that the bell curve doesn't reflect reality and is critical of academics who teach modern portfolio theory because it is based on the assumption that returns are normally distributed.

Gene Fama again, “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. For passive investors, none of this matters, beyond being aware that outlier returns are more common than would be expected if return distributions were normal.”

We asked Larry Swedroe author of Quest for Alpha; what about market timing, surely investors should try to avoid buying just before a market crash?

“Clearly expected returns are based on current valuations, and have nothing to do with historical returns since prices move independently in a random walk. Yes, it is true that high valuations mean low expected returns and vice versa, but that doesn’t mean you can time the market! All high valuations mean is that the Equity Risk Premium is relatively Low, not that it is non-existent.”

But this doesn’t mean that equity returns are more predictable even over the long term. Ask any Japanese investor for last twenty years. All we can say is that current valuations lead us to have a certain expectation of a mean return around a wide potential dispersion of returns.”

We regularly read that investors should follow some form of value strategy. Well here is a newsflash. We are value investors and all our portfolios include an allocation to the value premium. Where we differ from some value investors is that we say that “value” is not a pricing mistake by the market allowing investors to profit from some “unloved” security but rather a risk factor – or compensation for risk. Value stocks are more risky than growth stocks and have a higher expected return as compensation for this additional risk. Legendary investor and Warren Buffet’s mentor, Ben Graham suggested that investors should seek a “margin of safety” when selecting stocks and today many still cite Graham’s 1934 classic Security Analysis. However, just before his death in an interview with Charles Ellis Graham said;” I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors.”

The key to any market timing strategy is that stock returns are predictable based on observation of various fundamental variables such as P/E, dividend yield, etc. To a degree, academic research supports this assertion: there is some degree of return predictability. The practical question for investors, however, is whether the “signal” from these variables is strong enough relative to the “noise” in the data to develop a useful timing strategy. The evidence here is not compelling. It’s easy to find patterns or variables that have worked in the past. It’s hard to find strategies that continue to work after they are discovered. Many papers have explored this topic, for example A Comprehensive Look at The Empirical Performance of Equity Premium Prediction by Ivo Welch and Amit Goyal which surveys a wide range of variables which allegedly offer useful timing signals. The paper concludes that the evidence of success is weak: “These models would not have helped an investor with access only to available information to profitably time the market.”

The bad news is that, unfortunately, it remains just as difficult to predict where different asset classes will go from here; of course this will not stop many industry experts from trying. In the words of renowned economist, JK Galbraith, "We have two classes of forecasters; those who don’t know and those who don’t know they don’t know."

So, what recommendations do we have for investors when uncertainty is great and emotions are running high?

A final word from Warren Buffett “Most investors ... will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” It seems that following the wisdom of crowds rather than an investment guru is the practical recommendation for most investors.

By Marc Westlake CFP®,TEP, Grad Dip, Dip PFS, QFA
CERTIFIED FINANCIAL PLANNER TM AND REGISTERED TRUST & ESTATE PRACTITIONER
www.globalwealth.ie
 
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Hi Marc

There is a lot there to digest.

I agree that active fund management does not pay off
All the statistics support this. Very few people can pick winners or losers. Warren Buffett is extraordinary because he is so rare.

However I would make two points

Volatility is not risk
Wayne makes a point which I have made before.
Risk is not volatility, how could it be? It is only is if you define it that way.
Click to expand...

It's very difficult to measure risk. In fact, I don't think you can. But people like measuring things, and they can measure volatility.

Value shares are not more risky than growth shares
we say that “value” is not a pricing mistake by the market allowing investors to profit from some “unloved” security but rather a risk factor – or compensation for risk.
Click to expand...

This seems like a circular argument to me.

The EMH says that the share price reflects the risk.
The price of value stocks are lower than growth stocks
Therefore value stocks are more risky.

I would suggest that value stocks are less risky than growth stocks and therefore the EMH is wrong in this regard.

The dot.com stocks were extraordinarily risky. I remember at the time being laughed at for my holdings in CRH and DCC which were growing at "only" 10% a year. The holders of the dot.com shares did not accept that they were taking risks.
 
Brendan,

One of the original counters to the Fama French research (Journal of Finance 1992) into the value effect was that it looked like an arbitrage opportunity. If you go long the value stocks and short the growth stocks you should end up with a portfolio with no variance.

Well, it turns out that isn't true. The variance of the difference is essentially the High Book to market low book to market risk factor and the variance of that is on the order of that of the market. Both ends of the portfolio include everything you can buy in those asset classes so you are diversifying and the variance doesn't go away. There is therefore something about the covariance in the returns that you just can't get rid off - which is the sign of a true risk factor. Like the Equity Risk Premium that says that stocks are more risky than T-bills and have a higher expected return as compensation for this risk. But, and this is really important, to demonstrate statistically that this is true, you need 30 or 40 years of returns. Stocks can underperform for long periods (14 years in the 1960s and 1970s) so looking at a small sample period like 2000 doesn't allow anyone to draw any meaningful conclusions.

In "contrarian investment, extrapolation and risk" Journal of Finance 1994 Lakonishock, Shliefer and Vishny postulate that value strategies outperform because they expolit the suboptimal behaviour of investors and not because the strategies are fundamentally more risky.

But the evidence in several papers shows that value is a risk factor (Common Risk factors in Bonds and Stocks Journal of Financial Economics 1993) Size and Book to market factors in Earnings and returns Journal of Finance 1996 and Multifactor explanations of Asset pricing anomalies Journal of Finance 1996.

The explanation that we tend to use with value stocks is that this is a risk story based on the premise that risk and expected return are related. Value does better on average than growth and therefore HAS to be more risky. Where academics disagree is with the reason for this outperformance.

The market price is the key to "book to market" ratio. Stocks that have high book to market ratios are those companies where the accountants think that the business is worth more than the market does. The market price is the key and almost any price yield ratio works. Stocks that have high book values tend to be more distressed and distress is a form of risk. So, we tend to conclude that this is a risk story.

However, investors are naturally drawn to healthy companies or growth stocks. They are looking for a stock with good earnings potential. But expected returns for investors are driven by the firms cost of capital (Merton Miller) a healthy company has a low cost of capital and therefore a lower expected return than stocks with a high cost of capital.

If you are a company in poor shape (or banks as we call them today) then the company is going to have to pay a higher interest rate to raise capital. So, when a company issues stock in the market, it has to offer a discount to embed investors with a higher expected return. So, the price of distressed company's stocks is lower than that of a growth company so that (adjusted for risk) an investor is indifferent between an investment in say Apple Inc or AIB plc.

The concept of healthy vs unhealthy companies was explored by an academic Michelle Clayman who decided to investigate the findings of a book "in search of excellence" by Tom Peters and Bob Waterman. They looked at various measures of an excellent company such as profitability and management techniques.

She analysed the criteria of the 40 companies in the book the excellent companies against 40 unhealthy companies and found that the Stock of unhealthy companies performed better than the healthy companies.

So, by these measures value is a rational pricing reaction by the market to additional risk. Importantly this risk does not show up in the volatility or standard deviation of the returns of value stocks. So, again I agreed that volatility is not the only measure of risk. You need a multifactor model to identify and expolit it.

So the conclusion is that there is no optimal portfolio (it depends on the choices an investor makes based on their own personal tastes) so I agree that risk is difficult to measure. Some investors may decide that they prefer the growth story.

From a portfolio perspective I have no quarrel with that decision. It is a matter of taste. But the evidence from the last 80 or so years says that an investor who increases their exposure to high book to market stocks can expect to outperform most of the time (perhaps 18 years out of 20) but as with everything in investing there are no guarantees - that is why it is a risk.
 
Very interesting discussion, thanks for all the lengthy posts.

I would agree with Brendan on the issue of risk and its definition; I would actually take it a step further and say that it is impossible to find a single measurable definition of risk. Risk is a purely subjective evaluation. For example, US treasuries are mentioned as being lower risk than equities and therefore earn a lower income/gain. In my personal opinion there is very little in this world that is of higher risk than 30 year US treasuries; absolutely nothing could convince me to invest a penny in them. But their prices command an incredibly high price.

It is similar with rationality of investors. Rationality is not something that can be measured, but some people are better at judging how rational the behaviour of investors is. In hindsight it is of course very easy to point to the dot com and housing bubble as examples of irrationality, but even then it cannot be measured. Bottom line is though that people are far more often irrational and wrong in the evaluations than EMH seems to accept.
 
Chris

A common misconception of the EMH is that agents have to act rationally. The EMH does not say this.

The efficient-market hypothesis requires that agents have rational expectations; that on average the population is correct (even if no one person is) and whenever new relevant information appears, the agents update their expectations appropriately. Note that it is not required that the agents be rational. EMH allows that when faced with new information, some investors may overreact and some may underreact. All that is required by the EMH is that investors' reactions be random and follow a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal profit, especially when considering transaction costs (including commissions and spreads). Thus, any one person can be wrong about the market—indeed, everyone can be—but the market as a whole is always right.
 
Chris

When you talk about t bills you need to distinguish two issues.

Return of money and return on money.

US T bills guarantee a return of your money but not necessarily a return on your money.

Having stood on the deck of the USS Nimitz I am pursuaded of the USA's ability to guarantee a return of my money.

You may however define risk as a risk of negative real returns after inflation. Or sensitivity risk associated with long duration bonds during a period of generally rising real interest rates. These are different risks.

In this sense I agree that risk is subjective to the individual.

As Bill Sharpe says when questioned on the best portfolio for an individual "I'd want to know what they do for a living"

The concept of Human Capital is well understood by professional advisers and should always feature in the risk return trade off.

But irrespective of all that, it is still true that short term high credit fixed interest instruments are still a low risk investment and a good hedge against inflation.

But again these are differerent to 30 year bonds which still might be appropriate for a specific asset liability matching exercise such as an Insurance Company.

It's important not to generalise here as there is always someone for whom an investment could be suitable.
 
Marc,

How does the EMH deal with speculative bubbles?

Nikkei 1990
Nasdaq 2000
Irish property 2007
etc, etc

http://www.nytimes.com/2009/06/06/business/06nocera.html?pagewanted=all

“There are incredible aberrations,” he told me over lunch not long ago. “The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 percent. In an efficient world, you wouldn’t have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable.”


I would also be interested in your views on beavioural theory. Do you dismiss it in its entirety or do you think it has a place to sit alongside the EMH?

Cheers.
 
Markets don’t have to be RIGHT to be EFFICIENT

The tech collapse of 2000 and more recently the focus on "behavioral finance" have people really questioning the Efficient Markets Hypothesis (EMH). This is nothing new. The EMH has been contested since its debut.
The very fact that the hypothesis still comes under assault is stronger testimony to its deep relevance. People don't argue about irrelevant ideas.
The core ideas of the EMH are all too often misunderstood.

The EMH purports that markets are full of people trying to maximize profit by predicting the future values of securities based on freely available information. Many intelligent participants compete to trade at a profit. The price they strike in trading a stock is the consensus of their opinions about the stock's value. This is based on all their information about the stock, everything they know that has happened in the past and everything they predict will happen in the future. The end result is that the current price of the stock is usually a good estimate of its intrinsic value.

Critics often challenge the notion that investors on the whole are informed enough to price stocks correctly by consensus. Most investors can't possibly know that much about any given stock. But market efficiency doesn't require that most investors have information. It only requires that "many intelligent participants" have information. In fact, no single investor has that much information. Even the smartest people have only a tiny fraction of all the information out there. Information isn't a big secret squirreled away somewhere; it is widely distributed in little pieces. The market functions as a mechanism that gathers the information, evaluates it, and builds it into prices.
This is what it means to say prices are a consensus view of a stock's value. At some level every investor includes (or doesn't include) a security in his or her portfolio until the stock's value to the investor is about equal to its market price. Since the price is the same for everyone, so is the value.

Now granted, if everybody investing is wrong, prices might conceivably be poor estimates of value. For this to happen on any scale, the ignorant investors would have to be overly optimistic or overly pessimistic as a group. Otherwise, the optimists will cancel out the pessimists and the price struck will be rational. Since stocks are more likely to trade when the person selling is pessimistic and the person buying is optimistic, prices on average are more likely to represent rational consensus.
Admittedly, sometimes it can be hard to view prices as rational. The Tech boom was an example of this where we saw companies with no assets other than a website and with little or no profit suddenly rush up in price only to melt down a year later. How can such prices be good estimates of value? They seem so illogical.

Let's suppose for the sake of argument that investors behave like lemmings and that the market systematically misprices stocks. Such a market would surely be child's play for any smart investor with any real analytical skills.
The reason such successes are hard to identify is that there's more than just one or two smart investors out there. There are thousands of savvy analysts looking for over- or under-valued securities. The opportunities to generate excess profit are diminished when these investors trade away disparities between a stock's price and its intrinsic value.

The EMH does not claim markets are always perfectly rational or that the information reflected in prices is always correct. The consensus view of investors can temporarily result in prices well above or well below a stock's intrinsic value. The only condition efficient markets require is that a disproportionate number of market participants does not consistently profit over other participants.

After taking risk into account, do more managers than you'd see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding "no." Mike Jensen in the Sixties and Mark Carhart in the Nineties both conducted exhaustive studies of professional investors. They each concluded that in general a manager's fee, and not his skill, plays the biggest role in performance. Since mutual funds report performance after deducting fees, the bigger the fee, the worse the performance. Aside from that, expert investors with nearly unlimited resources working around the clock can't seem to outsmart the market.

This means investors are better off avoiding active managers—especially pricey active managers. History shows that in the long run a thoughtfully designed, diversified strategy of "passive" funds typically beats all but a few active managers. It's not easy to structure and maintain such a strategy. It requires some initial research and discipline to stay the course. But it's much easier than predicting which active managers will randomly beat this approach.
 
Lots of interesting stuff here. I just want to pick up on one aspect - are Value stocks riskier than Growth stocks? The following definition is taken from Investopedia:
To me this definition points in either direction.

At one level a Value stock is one which looks cheap. On the well worn adage that "if it looks to good to be true then..." that would point to there being some higher risk associated with Value stocks.

But I'm with Brendan, I interpret Value stocks using the other characterisations of the above definition - a boring old stock with solid dividend and earnings performance and other good "fundamentals" and thus lacking scope for spectacular future growth. A growth stock on the other hand boasts its lack of dividends and its negative earnings! Intuitively, to me, a Value stock is a bird in the hand whilst Growth stocks are two in the bush, and Brendan's example clearly illustrates this.

It is indeed circular to argue that since Value stocks have outperformed Growth stocks ergo they were more risky. This states that risk must always be rewarded. A more correct interpretation is that the risk in Growth stocks didn't pay off and one would have been better off in boring old Value stocks after all.
 
Marc, the very fact that speculative bubbles are forever present in asset classes is a sign of the extent to which price and value can be so far removed from each other as to represent huge inefficiencies in the markets.

http://www.ritholtz.com/blog/2009/08/six-impossible-things-before-breakfast/

'Prima facie case against EMH — Forever blowing bubbles

Let me now turn to the prima facie case against the EMH. Oddly enough it is one that doesn’t attract much attention in academia. As Larry Summers pointed out in his wonderful parody of financial economics “Traditional finance is more concerned with checking that two 8oz bottles of ketchup is close to the price of one 16oz bottle, than in understanding the price of the 16oz bottle”.

The first stock exchange was founded in 1602. The first equity bubble occurred just 118 years later – the South Sea bubble. Since then we have encountered bubbles with an alarming regularity. My friends at GMO define a bubble as a (real) price movement that is at least two standard deviations from trend. Now a two standard deviation event should occur roughly every 44 years. Yet since 1925, GMO have found a staggering 30 plus bubbles. That is equivalent to slightly more than one every three years!

In my own work I’ve examined the patterns that bubbles tend to follow. By looking at some of the major bubbles in history (including the South Sea Bubble, the railroad bubble of the 1840s, the Japanese bubble of the late 1980s, and the NASDAQ bubble1), I have been able to extract the following underlying pattern. Bubbles inflate over the course of around three years, with an almost parabolic explosion in prices towards the peak of the bubble. Then without exception they deflate. This bursting is generally slightly more rapidly than the inflation, taking around two years.

Whilst the details and technicalities of each episode are different, the underlying dynamics follow a very similar pattern. As Mark Twain put it “History doesn’t repeat but it does rhyme”. Indeed, the first well documented analysis of the underlying patterns of bubbles that I can find is a paper by J.S. Mills in 1867. He lays out a framework that is very close to the Minsky/Kindleberger model that I have used for years to understand the inflation and deflation of bubbles. This makes it hard to understand why so many amongst the learned classes seem to believe that you can’t identify a bubble before it bursts. To my mind the clear existence and ex ante diagnosis of bubbles represent by far and away the most compelling evidence of the gross inefficiency of markets.'

Taking a value based approach to investing is not so much about beating the market (although emperical evidence shows that value does beat growth) but more about reducing the risk of incuring large future losses.

Investing in boring value in which dividend yields are present, low P/Es and P/B is a less risky approach than investing in growth stocks or asset classes that are is a speculative boom that will one day pop as every bubble does.

Value investing is less risky for the long term investor.

As Montier eloquently sums up the EMH -

'The EMH would have driven Sherlock Holmes to despair. As Holmes opined “It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts”.

The EMH, as Shiller puts it, is “one of the most remarkable errors in the history of economic thought”. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brain washing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH – pretty much everyone’s hand was up. Then he asked how many of them believed in it….only two hands remained up!'
 
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