Eugene Fama: efficient market hypothesis

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The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox

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Warren Buffett Student of value-investing legend Benjamin Graham at Columbia Business School who went on to great success as an investor. Outspoken critic of the efficient market hypothesis and the academic approach to finance. Alfred Cowles III Chicago Tribune heir who, while convalescing from tuberculosis in Colorado in the 1920s, decided to research the effectiveness of various stock market forecasters. The 1933 paper in which he documented that most of the forecasts weren’t very good was a landmark in stock market research, and led him—by way of Irving Fisher—to bankroll much early mathematical economic research. Eugene Fama Finance professor at the University of Chicago who in the late 1960s formulated the efficient market hypothesis. Later, in a series of empirical studies with Kenneth French in the 1990s, he showed that the evidence didn’t support his original hypothesis.

More often than not, in the markets designed by Smith, Plott, and others, prices converged toward that value—but not always. Bubbles developed; markets failed. Much depended on the rules that governed the market, and the greatest impact of experimental economics has been on market design. Plott had even grander ambitions. During an academic year spent at the University of Chicago in the late 1970s, he asked Eugene Fama for advice on testing his efficient market hypothesis in an experimental setting. “He said his theory has nothing to do with experiments; it has to do with the U.S. stock market,” Plott recalled. “‘But don’t general principles apply?’ ‘No, it only applies to the U.S. stock market.’” It was against actual financial market data that the hypothesis would have to be tested. And in the late 1970s, it began to fail those tests.

All research proceeded from the assumption that “pervasive market forces” invariably pushed security prices toward their correct, fundamental values. This had been well established empirically back in the 1960s, after all. Or had it? THE 1970 BOOK Predictability of Stock Prices, by Clive Granger and Oskar Morgenstern, reads as a sort of alternate-universe version of Eugene Fama’s far better known distillation of the efficient market hypothesis. Granger and Morgenstern had been members in good standing of the 1960s random walk fellowship. They were also big-time economists. Granger went on to win a Nobel Prize in Economics, for unrelated work, in 2002. Morgenstern was coauthor (if not quite cocreator) of the von Neumann-Morgenstern model for decision making under uncertainty that dominated economics and finance.

 

pages: 263 words: 75,455

Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors by Wesley R. Gray, Tobias E. Carlisle

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Albert Einstein, Andrei Shleifer, asset allocation, Atul Gawande, backtesting, Black Swan, capital asset pricing model, Checklist Manifesto, cognitive bias, compound rate of return, corporate governance, correlation coefficient, credit crunch, Daniel Kahneman / Amos Tversky, discounted cash flows, Eugene Fama: efficient market hypothesis, forensic accounting, hindsight bias, Louis Bachelier, p-value, passive investing, performance metric, quantitative hedge fund, random walk, Richard Thaler, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, statistical model, systematic trading, The Myth of the Rational Market, time value of money, transaction costs

At first blush, each man's strategy seems diametrically opposed to the other, and irretrievably so. They agreed, however, on one very important point: both believed it was possible to outperform the stock market, a belief that flew in the face of the efficient market hypothesis. While it is true that Thorp's strategy was grounded in the random walk, a key component of the efficient market hypothesis, he disagreed with the efficient market believers that it necessarily implied that markets were efficient. Indeed, Thorp went so as far as to call his book Beat the Market. Buffett also thought the efficient market hypothesis was nonsense, writing in his 1988 Shareholder Letter15: This doctrine [the efficient market hypothesis] became highly fashionable—indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices.

The numbers illustrate that value strategies have been very successful (Chapter 7 has a detailed discussion of our method of our investment simulation procedures). TABLE 1.1 Long-Term Performance of Common Price Ratios (1964 to 2011) The counterargument to the empirical outperformance of value stocks is that these stocks are inherently more risky. In this instance, risk is defined as the additional volatility of the value stocks. Prolific finance researchers and founders of modern quantitative asset management analysis Eugene Fama and Ken French made this argument most forcefully in their 1992 paper, “The Cross-Section of Expected Stock Returns.” Behavioral finance researchers Joseph Lakonishok, Andrei Shleifer, and Robert Vishny argue in their 1994 paper, “Contrarian Investment, Extrapolation, and Risk,”25 that value strategies produce better returns, not because they are fundamentally riskier, but because they are contrarian to the “naïve” strategies followed by other investors.

IT's ALL ACADEMIC: IMPROVING QUALITY AND PRICE We have created a generic, academic alternative to the Magic Formula that we call “Quality and Price.” Quality and Price is the academic alternative to the Magic Formula because it draws its inspiration from academic research papers. We found the idea for the quality metric in an academic paper by Robert Novy-Marx called “The Other Side of Value: Good Growth and the Gross Profitability Premium.”10. The price ratio is drawn from the early research into value investment by Eugene Fama and Ken French. The Quality and Price strategy, like the Magic Formula, seeks to differentiate between stocks on the basis of … wait for it … quality and price. The difference, however, is that Quality and Price uses academically based measures for price and quality that seek to improve on the Magic Formula's factors, which might provide better performance. Finding Quality, Academically Recall that the Magic Formula uses Greenblatt's version of return on capital (ROC) as a proxy for a stock's relative quality.

 

pages: 345 words: 87,745

The Power of Passive Investing: More Wealth With Less Work by Richard A. Ferri

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asset allocation, backtesting, Bernie Madoff, capital asset pricing model, cognitive dissonance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, endowment effect, estate planning, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, index fund, Long Term Capital Management, passive investing, Ponzi scheme, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, too big to fail, transaction costs, Vanguard fund, yield curve

It extended his theory of minimum variance as a factor in portfolio construction. This work spawned many new ideas among academics and market researchers. Eugene Fama Eugene Fama was another early pioneer in portfolio theory. He received his undergraduate degree from Tufts University in 1960, and his Masters and Ph.D. from the University of Chicago in 1965. Fama’s meticulously researched Ph.D. thesis was published in 1965 and titled “The Behavior of Stock Market Prices.” The purpose of the paper was to test the theory that stock market prices are random and follow what’s commonly referred to today as a random walk.8 Fama’s work led to the formation of the efficient market hypothesis (EMH), which is a theory of efficient security pricing in free and open markets. The theory states that all known and available information is already reflected in current securities prices.

A portfolio of actively managed funds has a lower probability of outperforming a portfolio of index funds than a single active fund has of outperforming a single index fund. As the number of actively managed funds increases, the odds that a portfolio will outperform decreases. In addition, the longer active funds are held, the worse the odds become for the active fund portfolio, until eventually there’s practically no chance of outperformance. Efficient Portfolios Eugene Fama coined the term efficient market hypothesis in his landmark 1965 thesis on the behavior of stock prices. Fama said that an efficient market exists when (1) information about the securities trading on a market is widely and cheaply available to all, (2) all known and available information is already reflected in security prices, (3) the current price of a security is agreed upon by a buyer and seller in a market, and it is the best estimate of the investment value of that security at the time, and (4) security prices will almost instantaneously change as new information about them appears in the market.1 Fama’s paper sparked a long debate over whether markets are efficient, and index fund advocates were naturally dragged into this debate.

See Dow Jones Industrial Average (DJIA) Dodd, David Dollar weighted returns: as real profits/losses time weighted returns and “Double dipping” Dow, Charles Henry Dow Jones Industrial Average (DJIA) 30-stock composition of Cowles Commission report and formation of Dow Theory Dreyfus Dubious Achievement Award Dumb money: definition of how it gets divided Dumping stocks Dunn, Steve Dunn’s Law EAFE. See Europe, Australasia, and Far East (EAFE) Early performance studies: Cowles Commission report mutual funds, rise of Nobel Prizes for quiet period and in roaring 60s Econometrica EDHEC Risk and Asset Management Research Centre Educator, advisor as Efficient Frontier Efficient market hypothesis Efficient market hypothesis (EMH) Ehrbar, A.F. Eisenhower, Dwight D. Ellis, Charles D. Ellison, Glenn Elton, Edwin EMH. See Efficient market hypothesis (EMH) Emotions, human Employee-directed retirement accounts Employee Retirement Income Securities Act (ERISA): breaches under, litigation and delegation of responsibility under fiduciary advisor types under purpose of safe harbor to 401(k) trustees section 3(38) Investment Manager small plans and Employer-sponsored retirement plans Endowment effect Endowment funds Equal-weighted index Equity mutual funds ERISA.

 

pages: 425 words: 122,223

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein

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Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buy low sell high, capital asset pricing model, debt deflation, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, full employment, implied volatility, index arbitrage, index fund, interest rate swap, invisible hand, John von Neumann, Joseph Schumpeter, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, new economy, New Journalism, profit maximization, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, stochastic process, the market place, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, transfer pricing, zero-coupon bond

The title of their new draft, dated January 1971, reflected their effort to beam their ideas to economists. They titled the paper “Capital Market Equilibrium and the Pricing of Corporate Liabilities.” At this point they received help from another quarter. Eugene Fama and Merton Miller had been aware of their work, had given them extensive comments on it, and were following their publishing ordeal. Now these two Chicago professors put in a good word for them at the Journal of Political Economy. That did the trick. Throughout this story, Merton Miller has played the role of power-broker. He had encouraged Eugene Fama, still a novice, to teach entirely new material. He had guided Scholes into finance. He had introduced Treynor to Modigliani. He had immediately recognized Sharpe’s talent. And finally he was instrumental in providing Black and Scholes with the notice that their work surely deserved.

Hamilton repeatedly stressed a central idea of Dow Theory that prices on the New York Stock Exchange are “sufficient in themselves” to reveal everything worth knowing about business conditions. Here Hamilton was anticipating a radical concept that was to appear long after his death. In the 1960s, a group of college professors would develop the Efficient Market Hypothesis, based on the notion that stock prices reflect all available information about individual companies and about the economy as a whole. The Efficient Market Hypothesis, however, also looks back to Bachelier, for it assumes that information is so rapidly reflected in stock prices that no single investor can consistently know more than the market as a whole knows. Hamilton, on the contrary, believed that the market itself revealed what stock prices would do in the future.

ISBN-13 978-0-471–73174-0 ISBN-10 0-471–73174-9 For Barbara What is history all about if not the exquisite delight of knowing the details and not only the abstract patterns? ••• –Stephen Jay Gould Acknowledgments All authors who undertake projects like this need help from others. I have been unusually fortunate in having had such generous and essential assistance from the people named below. The book could never have taken shape without the participation of the people whose work it describes: Fischer Black, Eugene Fama, William Fouse, Hayne Leland, Harry Markowitz, John McQuown, Robert C. Merton, Merton Miller, Franco Modigliani, Barr Rosenberg, Mark Rubinstein, Paul Samuelson, Myron Scholes, William Sharpe, James Tobin, Jack Treynor, and James Vertin. Each of them spent long periods of time with me in interviews, and most of them engaged in voluminous correspondence and telephone conversations as well. All of them read drafts of the chapters in which their work is discussed and gave me important criticisms and suggestions that enrich virtually every page of the book.

 

pages: 374 words: 114,600

The Quants by Scott Patterson

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Albert Einstein, asset allocation, automated trading system, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, Gordon Gekko, greed is good, Haight Ashbury, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Nash: game theory, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, NetJets, new economy, offshore financial centre, Paul Lévy, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise

The two professors collaborated on a 1967 book that described their findings. It was called Beat the Market: A Scientific Stock Market System. A quant touchstone, it soon became one of the most influential how-to books on investing ever written. It also flew in the face of an increasingly popular theory in academia that it was impossible to consistently beat the market. Spearheaded by University of Chicago finance professor Eugene Fama in the late 1960s, this theory was known as the efficient-market hypothesis (EMH). At bottom, EMH was based on the idea, as Bachelier had argued, that the market moves in a random fashion and that current prices reflect all known information about the market. That being the case, it’s impossible to know whether the market, or an individual stock, currency, bond, or commodity, will rise or fall in the future—the future is random, a coin flip.

Convertible bonds: Securities issued by companies that typically contain a fixed-income component that yields interest (the fixed part), as well as a “warrant,” an option to convert the security into shares at some point in the future. In the 1960s, Ed Thorp devised a mathematical method to price warrants that anticipated that Black-Scholes option-pricing formula. Efficient-market hypothesis: Based on the notion that the future movement of the market is random, the EMH claims that all information is immediately priced into the market, making it “efficient.” As a result, the hypothesis states, it’s not possible for investors to beat the market on a consistent basis. The chief proponent of the theory is University of Chicago finance professor Eugene Fama, who taught Cliff Asness and an army of quants who, ironically, went to Wall Street to try to beat the market in the 1990s and 2000s. Many quants used similar Fama-derived strategies that blew up in August 2007.

His first words came as a shock to the students in the room. “Everything I’m about to say isn’t true,” said Fama in a gruff voice tinged with the accent of his Boston youth. He walked to his chalkboard and wrote the following: Efficient-market hypothesis. “The market is efficient,” Fama said. “What do I mean by that? It means that at any given moment, stock prices incorporate all known information about them. If lots of people are drinking Coca-Cola, its stock is going to go up as soon as that information is available.” Students scribbled on their notepads, taking it all in. The efficient-market hypothesis, perhaps the most famous and long-lasting concept about how the market behaved in the past half century, was Fama’s baby. It had grown so influential, and had become so widely accepted, that it was less a hypothesis than a commandment from God in heaven passed down through his economic prophet of the Windy City.

 

pages: 500 words: 145,005

Misbehaving: The Making of Behavioral Economics by Richard H. Thaler

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Albert Einstein, Amazon Mechanical Turk, Andrei Shleifer, Apple's 1984 Super Bowl advert, Atul Gawande, Berlin Wall, Bernie Madoff, Black-Scholes formula, capital asset pricing model, Cass Sunstein, Checklist Manifesto, choice architecture, clean water, cognitive dissonance, conceptual framework, constrained optimization, Daniel Kahneman / Amos Tversky, delayed gratification, diversification, diversified portfolio, Edward Glaeser, endowment effect, equity premium, Eugene Fama: efficient market hypothesis, experimental economics, Fall of the Berlin Wall, George Akerlof, hindsight bias, Home mortgage interest deduction, impulse control, index fund, invisible hand, Jean Tirole, John Nash: game theory, John von Neumann, late fees, law of one price, libertarian paternalism, Long Term Capital Management, loss aversion, market clearing, Mason jar, mental accounting, meta analysis, meta-analysis, More Guns, Less Crime, mortgage debt, Nash equilibrium, Nate Silver, New Journalism, nudge unit, payday loans, Ponzi scheme, presumed consent, pre–internet, principal–agent problem, prisoner's dilemma, profit maximization, random walk, randomized controlled trial, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Coase, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, technology bubble, The Chicago School, The Myth of the Rational Market, The Signal and the Noise by Nate Silver, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, transaction costs, ultimatum game, Walter Mischel

Most economists hypothesized—and it was a good starting hypothesis—that even if some people made mistakes with their money, a few smart people could trade against them and “correct” prices—so there would be no effect on market prices. The efficient market hypothesis, mentioned in chapter 17 about the conference at the University of Chicago, was considered by the profession to have been proven to be true. In fact, when I first began to study the psychology of financial markets back in the early 1980s, Michael Jensen, my colleague at the Rochester business school, had recently written: “I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.” The term “efficient market hypothesis” was coined by University of Chicago economist Eugene Fama. Fama is a living legend not just among financial economists, but also at Malden Catholic High School near Boston, Massachusetts, where he was elected to their athletic hall of fame, one of his most prized accomplishments.* After graduating from nearby Tufts University with a major in French, Fama headed to the University of Chicago for graduate school, and he was such an obvious star that the school offered him a job on the faculty when he graduated (something highly unusual), and he never left.

Late that decade, accounting professor Sanjoy Basu published a thoroughly competent study of value investing that fully supported Graham’s strategy. However, in order to get such papers published at the time, one had to offer abject apologies for the results. Here is how Basu ended his paper: “In conclusion, the behavior of security prices over the fourteen-year period studied is, perhaps, not completely described by the efficient market hypothesis.” He stopped just short of saying “I am sorry.” Similarly, one of Eugene Fama’s students at the University of Chicago, Rolf Banz, discovered another anomalous finding, namely that portfolios of small firms outperformed portfolios of large firms. Here is his own apologetic conclusion in his paper published in 1981: “Given its longevity, it is not likely that it is due to a market inefficiency but it is rather evidence of a pricing model misspecification.”

The results of this condition lie between the other two. 23 The Reaction to Overreaction With the facts confirmed—that “Loser” stocks did earn higher returns than the market—there was only one way to save the no-free-lunch component of the EMH, which says it is impossible to beat the market. The solution for the market efficiency folks was to fall back on an important technicality: it is not a violation of the efficient market hypothesis if you beat the market by taking on more risk. The difficulty comes in knowing how to measure risk. This subtlety was first articulated by Eugene Fama. He correctly pointed out that all tests of the no-free-lunch component of market efficiency were actually “joint tests” of two hypotheses: market efficiency and some model of risk and return. For example, suppose someone found that new firms have higher returns than old firms. This would seemingly be a rejection of market efficiency; because the age of a firm is known, it cannot be used to “beat” the market.

 

pages: 226 words: 59,080

Economics Rules: The Rights and Wrongs of the Dismal Science by Dani Rodrik

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airline deregulation, Albert Einstein, bank run, barriers to entry, Bretton Woods, butterfly effect, capital controls, Carmen Reinhart, central bank independence, collective bargaining, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, distributed generation, Edward Glaeser, Eugene Fama: efficient market hypothesis, Fellow of the Royal Society, financial deregulation, financial innovation, floating exchange rates, fudge factor, full employment, George Akerlof, Gini coefficient, Growth in a Time of Debt, income inequality, inflation targeting, informal economy, invisible hand, Jean Tirole, Joseph Schumpeter, Kenneth Rogoff, labor-force participation, liquidity trap, loss aversion, low skilled workers, market design, market fundamentalism, minimum wage unemployment, oil shock, open economy, price stability, prisoner's dilemma, profit maximization, quantitative easing, randomized controlled trial, rent control, rent-seeking, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, school vouchers, South Sea Bubble, spectrum auction, The Market for Lemons, the scientific method, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, Thomas Malthus, trade liberalization, trade route, ultimatum game, University of East Anglia, unorthodox policies, Washington Consensus, white flight

All the steps in between—the reduction in interest rates as demand for dollar assets went up, the incentive of poorly supervised financial institutions to seek riskier instruments to maintain profits, the building up of financial fragility as portfolios expanded through short-term borrowing, the inability of shareholders to properly rein in bank CEOs, the bubble in housing prices—could be readily explained by existing frameworks. But economists had placed excessive faith in some models at the expense of others, and that turned out to be a big problem. Many of the favored models revolved around the “efficient-markets hypothesis” (EMH).7 The hypothesis had been formulated by Eugene Fama, a Chicago finance professor who would subsequently receive the Nobel Prize, somewhat awkwardly, in the same year as Robert Shiller. It says, in brief, that market prices reflect all information available to traders. For an individual investor, the EMH means that, without access to inside information, beating the market repeatedly is impossible. For central bankers and financial regulators, the EMH cautions against trying to move the market in one direction or another.

American Economic Review: Papers & Proceedings 103, no. 3 (2013): 629–35. † Fama concedes that he doesn’t have a reason for why future economic prospects would have worsened so drastically, but he adds that he isn’t a macroeconomist, and macroeconomics has never been good at discerning when recessions are coming on. John Cassidy, “Interview with Eugene Fama,” New Yorker, January 13, 2010, http://www.newyorker.com/news/john-cassidy/interview-with-eugene-fama. ‡ Ninety percent of economists reportedly agree with the following proposition: “Fiscal policy (for example, tax cut and/or government expenditure increase) has a significant stimulative impact on a less than fully employed economy.” Greg Mankiw, “News Flash: Economists Agree,” February 14, 2009, Greg Mankiw’s Blog, http://gregmankiw.blogspot.com/2009/02/news-flash-economists-agree.html

., 13n Hunting Causes and Using Them: Approaches in Philosophy and Economics (Cartwright), 22n import quotas, 149 incentives, 7, 170, 172, 188–92 income: functional distribution of, 121 military service and, 108 personal distribution of, 121 income inequality, 117, 124–25, 138–44, 147–49 deregulation in, 143 factor endowments theory in, 139–40 Gini coefficient and, 138 globalization in, 139–41, 143 in manufacturing, 141 offshoring in, 141 skill premium in, 138–40, 142 skill upgrading in, 140, 141, 142 technological change in, 141–43 trade in, 139–40 India, 107, 154 Indonesia, 166 industrial organization, 201 industrial revolution, 115 industry: developing economies and policies on, 75–76, 87, 88 government intervention and, 34–35 inflation, 185 in business cycles, 126–27, 130–31, 133, 135, 137 public spending and, 114 infrastructure, 87, 91, 111, 163 Institute for Advanced Study (IAS), xii–xiii, xiv School of Social Science at, xii Institute for International Economics, 159 institutions: development economics and, 98, 161, 202, 205–7 labor productivity and, 123 insurance, banking and, 155 interest rates, 39, 64, 110, 129–30, 156, 161 internal validity, 23–24 International Bank for Reconstruction and Development, 2 see also World Bank international economics, 201–2 International Monetary Fund (IMF), 1n, 2 Washington Consensus and, 160, 165 Internet, big data and, 38 “Interview with Eugene Fama” (Cassidy), 157n investment: business cycles and, 129–30, 136 foreign markets and, 87, 89, 90, 92, 165–67 income inequality and, 141 savings and, 129–30, 165–67 Invisible Hand Theorem, 48–50, 51n, 182, 186 Israel, 103, 188 day care study in, 71, 190–91 Japan: city growth models and, 108 income inequality and, 139 Jenkins, Holman W., Jr., 135n Jevons, William Stanley, 119 Kahneman, Daniel, 203 Kenya, 106–7 Keynes, John Maynard, 1–2, 31, 46, 165 on business cycles, 127–37 on liquidity traps, 130 see also models, Keynesian types of Klemperer, Paul, 36n Klinger, Bailey, 111n Korea, South, 163, 164, 166 Kremer, Michael, 106–7 Krugman, Paul, 136, 148 Kuhn, Thomas, 64n Kupers, Roland, 85 Kydland, Finn E., 101n labor markets, 41, 52, 56, 57, 92, 102, 108, 111, 119, 163 labor productivity, 123–24, 141 labor theory of value, 117–19 Lancaster, Kelvin, 59 Latin America, Washington Consensus and, 159–63, 166 Leamer, Edward, 139 learning, rule-based vs. case-based forms of, 72 Leijonhufvud, Axel, 9–10 Lepenies, Philipp H., 211n leverage, 154 Levitt, Steven, 7 Levy, Santiago, 3–4, 105–6 Lewis, W.

 

pages: 267 words: 71,123

End This Depression Now! by Paul Krugman

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airline deregulation, Asian financial crisis, asset-backed security, bank run, banking crisis, Bretton Woods, capital asset pricing model, Carmen Reinhart, centre right, correlation does not imply causation, credit crunch, Credit Default Swap, currency manipulation / currency intervention, debt deflation, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, full employment, German hyperinflation, Gordon Gekko, Hyman Minsky, income inequality, inflation targeting, invisible hand, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, low skilled workers, Mark Zuckerberg, moral hazard, mortgage debt, paradox of thrift, price stability, quantitative easing, rent-seeking, Robert Gordon, Ronald Reagan, Upton Sinclair, We are the 99%, working poor, Works Progress Administration

And Keynes considered it a very bad idea to let such markets, in which speculators spent their time chasing one another’s tails, dictate important business decisions: “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” By 1970 or so, however, the study of financial markets seemed to have been taken over by Voltaire’s Dr. Pangloss, who insisted that we live in the best of all possible worlds. Discussion of investor irrationality, of bubbles, of destructive speculation had virtually disappeared from academic discourse. The field was dominated by the “efficient-markets hypothesis,” promulgated by Eugene Fama of the University of Chicago, which claims that financial markets price assets precisely at their intrinsic worth, given all publicly available information. (The price of a company’s stock, for example, always accurately reflects the company’s value, given the information available on the company’s earnings, its business prospects, and so on.) And by the 1980s, finance economists, notably Michael Jensen of the Harvard Business School, were arguing that because financial markets always get prices right, the best thing corporate chieftains can do, not just for themselves but for the sake of the economy, is to maximize their stock prices.

The political scientist Henry Farrell, in a blog post, quickly responded by inviting readers to find other uses for the “notably rare exceptions” construction—for example, “With notably rare exceptions, Japanese nuclear reactors have been safe from earthquakes.” And the sad thing is that Greenspan’s response has been widely shared. There has been remarkably little rethinking on the part of finance theorists. Eugene Fama, the father of the efficient-markets hypothesis, has given no ground at all; the crisis, he asserts, was caused by government intervention, especially the role of Fannie and Freddie (which is the Big Lie I talked about in chapter 4). This reaction is understandable, though not forgivable. For either Greenspan or Fama to admit how far off the rails finance theory went would be to admit that they had spent much of their careers pursuing a blind alley.

In retrospect, however, I failed to see just how broad the problem was.) But the lesson was ignored. Right up to the crisis of 2008, movers and shakers insisted, as Greenspan did in the quotation that opened this chapter, that all was well. Moreover, they routinely claimed that financial deregulation had led to greatly improved overall economic performance. To this day it’s common to hear assertions like this one from Eugene Fama, a famous and influential financial economist at the University of Chicago: Beginning in the early 1980s, the developed world and some big players in the developing world experienced a period of extraordinary growth. It’s reasonable to argue that in facilitating the flow of world savings to productive uses around the world, financial markets and financial institutions played a big role in this growth.

 

pages: 662 words: 180,546

Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown by Philip Mirowski

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Andrei Shleifer, asset-backed security, bank run, barriers to entry, Basel III, Berlin Wall, Bernie Madoff, Bernie Sanders, Black Swan, blue-collar work, Bretton Woods, Brownian motion, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, constrained optimization, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, dark matter, David Brooks, David Graeber, debt deflation, deindustrialization, Edward Glaeser, Eugene Fama: efficient market hypothesis, experimental economics, facts on the ground, Fall of the Berlin Wall, financial deregulation, financial innovation, Flash crash, full employment, George Akerlof, Goldman Sachs: Vampire Squid, Hernando de Soto, housing crisis, Hyman Minsky, illegal immigration, income inequality, incomplete markets, invisible hand, Jean Tirole, joint-stock company, Kenneth Rogoff, knowledge economy, l'esprit de l'escalier, labor-force participation, liquidity trap, loose coupling, manufacturing employment, market clearing, market design, market fundamentalism, Martin Wolf, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Nash equilibrium, night-watchman state, Northern Rock, Occupy movement, offshore financial centre, oil shock, payday loans, Ponzi scheme, precariat, prediction markets, price mechanism, profit motive, quantitative easing, race to the bottom, random walk, rent-seeking, Richard Thaler, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, savings glut, school choice, sealed-bid auction, Silicon Valley, South Sea Bubble, Steven Levy, technoutopianism, The Chicago School, The Great Moderation, the map is not the territory, The Myth of the Rational Market, the scientific method, The Wisdom of Crowds, theory of mind, Thomas Kuhn: the structure of scientific revolutions, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, War on Poverty, Washington Consensus, We are the 99%, working poor

In other words, economics tells us that economists will never be good predictors: One thing we are not going to have, now or ever, is a set of models that forecasts sudden falls in the value of financial assets, like the declines that followed the failure of Lehman Brothers in September. This is nothing new. It has been known for more than 40 years and is one of the main implications of Eugene Fama’s “efficient-market hypothesis” (EMH), which states that the price of a financial asset reflects all relevant, generally available information. If an economist had a formula that could reliably forecast crises a week in advance, say, then that formula would become part of generally available information and prices would fall a week earlier . . . The Economist’s briefing also cited as an example of macroeconomic failure the “reassuring” simulations that Frederic Mishkin, then a governor of the Federal Reserve, presented in the summer of 2007.

In a different register, Jagdish Bhagwati accused his Columbia colleague Joseph Stiglitz of being one of “capitalism’s petty detractors” (www.worldafairsjournal.org/articles/2009-Fall). Eugene Fama in an interview with John Cassidy of The New Yorker: “Krugman wants to be czar of the world. There are no economists that he likes [laughs]. And Larry Summers? What other position could he take and still have a job?” (www.newyorker.com/online/blogs/johncassidy/chicago-interviews). Brad de Long on John Cochrane: “No one could be that ignorant . . . to fail to have noticed that commercial banks are more tightly regulated than investment banks. . . . Cochrane may be completely ignorant about the macro literature except for that recently written somewhere near a great lake, but he must know that investment banks suffered more dramatically than commercial banks” (October 9, 2009, at http://delong.typepad.com/sdj/). Paul Krugman: “Eugene Fama, at least, and perhaps Cochrane too, began this debate from a position of complete ignorance—not understanding at all the logic of Keynesian models (even for the purposes of debunking), and imagining that the savings-investment identity necessarily implies 100-percent crowding out.

This humorous example of economic logic gone awry strikes dangerously close to home for students of the Efficient Markets Hypothesis, one of the most important controversial and well-studied propositions in all the social sciences. It is disarmingly simple to state, has far-reaching consequences for academic pursuits and business practice, and yet is surprisingly resilient to empirical proof or refutation. Even after three decades of research and literally thousands of journal articles, economists have not yet reached a consensus about whether markets—particularly financial markets—are efficient or not. What can we conclude about the Efficient Markets Hypothesis? Amazingly, there is still no consensus among financial economists. Despite the many advances in the statistical analysis, databases, and theoretical models surrounding the Efficient Markets Hypothesis, the main effect that the large number of empirical studies have had on this debate is to harden the resolve of the proponents on each side [my italics].

 

pages: 389 words: 109,207

Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone

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Albert Einstein, anti-communist, asset allocation, Benoit Mandelbrot, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, Claude Shannon: information theory, computer age, correlation coefficient, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John von Neumann, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, New Journalism, Norbert Wiener, offshore financial centre, publish or perish, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, short selling, speech recognition, statistical arbitrage, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, traveling salesman, value at risk, zero-coupon bond

It follows that all the people who advise clients on which stocks to buy are quacks. The favored analogy was, you might as well choose stocks by throwing darts at the financial pages. This skepticism became formalized as the efficient market hypothesis. It claims that the market is so good at setting fair prices for stocks that no one can achieve better returns on their investment than anyone else, save by sheer luck. University of Chicago economist Eugene Fama developed the idea both theoretically and empirically. There is much truth in the efficient market hypothesis. The controversy has always been over just how far the claim can be pressed. Asking whether markets are efficient is like asking whether the world is round. The best way to answer depends on the expectations and sophistication of the questioner.

This breaks down into something like one and a quarter million individual ‘bets’ averaging about $65,000 each, with on average hundreds of ‘positions’ in place at any one time. Over all, it would seem to be a moderately ‘long run’ with a high probability that the excess performance is more than chance.” Hong Kong Syndicate AT A 1998 UCLA CONFERENCE, Eugene Fama “pointed to me in the audience and called me a criminal,” said Robert Haugen. Haugen’s “crime” was that he was a prominent academic critic of the efficient market hypothesis. Fama “then said that he believed that God knew that the stock market was efficient.” The efficient market hypothesis is far from dead. The rhetoric, as strident as ever, provides scant evidence that the track records of a few successful hedge funds have changed many minds. The story of the Kelly criterion began with bookies and horse races. The one milieu where Kelly’s system has attained the status of orthodoxy is neither Wall Street’s canyons nor the groves of academe.

Fama did not presume to measure the market’s information in bits, as Kelly did. Information was nonetheless a key feature of Fama’s analysis. In a 1970 article, Fama used information sources to distinguish three versions of the efficient market hypothesis. Fama’s “weak form” of the hypothesis asserts that you can’t beat the market by predicting a stock’s future prices from knowledge of its past prices. This takes aim at technical analysts, people who look at charts of stock prices and try to spot patterns predictive of future movements. The weak form (in fact, all the forms of the efficient market hypothesis) says that technical analysis is worthless. The “semistrong form” says that you can’t beat the market by using any public information whatsoever. Public information includes not only past stock prices but also every press release, balance sheet, Bloomberg wire story, analyst’s report, and pundit comment.

 

pages: 545 words: 137,789

How Markets Fail: The Logic of Economic Calamities by John Cassidy

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Albert Einstein, Andrei Shleifer, anti-communist, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black-Scholes formula, Bretton Woods, British Empire, capital asset pricing model, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, global supply chain, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, laissez-faire capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Network effects, Nick Leeson, Northern Rock, paradox of thrift, Ponzi scheme, price discrimination, price stability, principal–agent problem, profit maximization, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, unorthodox policies, value at risk, Vanguard fund

If financial markets work properly, they help the economy to prosper: if they fail to provide financing for worthwhile capital projects, if they divert money to the worthless objects of speculative bubbles and fads, they are a hindrance to the economy. During the 1960s and ’70s, a group of economists, many of them associated with the University of Chicago, promoted the counterintuitive idea that the central processor works perfectly, and that speculative bubbles don’t exist. The efficient market hypothesis, which Eugene Fama, a student of Friedman, popularized, states that financial markets always generate the correct prices, taking into account all of the available information. What does this mean? In the case of an individual company, it implies that the stock price accurately reflects the best guesses of analysts, investors, and even the firm’s management about its future earnings prospects. In the case of a commodity, such as crude oil or gold, spot prices take into account everything that is known about resource stocks, future demand, and the development of potential substitutes, such as biofuel.

Arrow and Debreu had never intended for their work to be used in policy analysis: it was a purely theoretical analysis that explored the conditions under which a free market economy would display Pareto efficiency. Lucas and his followers claimed that a slightly modified version of the Arrow-Debreu model could be used to represent reality. It is in this sense that Lucas adopted the efficient market hypothesis to the entire economy. Eugene Fama and others had depicted the stock exchange and other financial exchanges as perfectly functioning markets. Lucas assumed that the market for consumer goods, the market for workers, and practically every other market were equally efficient and stable. The only imperfection in the entire economy that Lucas allowed for was a somewhat implausible one: he assumed that, for short periods, individual workers couldn’t distinguish between rises in their own wages and increases in the overall price level.

The way things turned out, Druckenmiller would have done better sticking to his original judgment. When the bubble burst, in March and April 2000, the Soros funds lost close to $2.5 billion; soon after that, Druckenmiller resigned. If rational herding is a big factor in financial markets, the prices of stocks and other securities should display some predictable patterns. As I explain in Part I, Eugene Fama and other defenders of the efficient market hypothesis claimed that stocks moved randomly, but during the 1980s and ’90s, strong evidence emerged that this wasn’t the case. Researchers showed that stocks did better in January than in other months, and did better on Mondays than on other days of the week. They also showed that small cap stocks outperform large cap stocks; and that value stocks—those with a low price-to-dividend ratio or price-to-earnings ratio—outperform growth stocks.

 

pages: 206 words: 70,924

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

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Albert Einstein, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John von Neumann, Joseph Schumpeter, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, naked short selling, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk tolerance, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

Its founder, Alfred Cowles III, was a prominent Colorado businessman and financial advisor whose financial instincts convinced him of the need to improve the level of science and quantitative rigor in economics and finance. His mission was especially relevant following the economic discipline’s colossal inability to predict the Great Crash in 1929 or to solve the Great Depression during the 1930s. He actually produced original work on the random walk and lamented whether stock prices could be forecast.2 He was pondering the efficient market hypothesis as early as 1933, well before Eugene Fama helped coin the expression and a new finance paradigm in the 1960s. The grandson of Alfred Cowles, the founder of the Chicago Tribune newspaper, and the son of newspaperman and corporate board director Alfred Cowles Jr., Cowles III’s insights and his wealth motivated him to 14 The Rise of the Quants form the Econometric Society and fund its journal, Econometrica.

If the market is assumed to be mean-variance efficient, then the CAPM model, which is also derived from the assumption of mean-variance efficiency, simply becomes a re-statement of the efficiency market hypothesis. Perhaps most significantly, just as Markowitz’s Modern Portfolio Theory was the inspiration for CAPM, CAPM motivated the more powerful Black-Scholes options pricing theory. In a fateful collaboration, Fischer Black and Myron Scholes, described later in this book, and Michael Jensen noted that variations in securities returns do not seem to follow the CAPM model. In particular, low-risk and low-beta stocks seem to offer higher returns than the model would predict. If finance wishes to preserve the belief that markets are efficient, then the CAPM model does not seem to work. On the other hand, if the CAPM model is preserved, then the efficient market hypothesis does not hold, despite Applications 73 the notion that the CAPM model is tautologically similar to the efficient market approach.6 The efficient market hypothesis will be described in greater detail in the next volume in this series.

To help in the analysis and development of a ranking system, he assembled William Sharpe, then at the University of Washington and an obvious advocate of the CAPM way of viewing funds, and the young professor Michael Jensen, who brought to the mix the notion of the new efficient market hypothesis approach from his home institution, the University of Chicago. Obviously, three great minds bringing to bear three different techniques on one problem would release a great deal of intellectual energy. At the end of their collaboration, the efficient market hypothesis prevailed and they agreed that no strategy could consistently beat the market, even though their client wished to be told otherwise. Black wrote up his reasoning by building on insights from his collaboration and from past files, notes, and papers Treynor had left at Arthur D.

 

pages: 416 words: 118,592

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing by Burton G. Malkiel

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accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, Bernie Madoff, BRICs, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial innovation, fixed income, framing effect, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Long Term Capital Management, loss aversion, margin call, market bubble, mortgage tax deduction, new economy, Own Your Own Home, passive investing, pets.com, Ponzi scheme, price stability, profit maximization, publish or perish, purchasing power parity, RAND corporation, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, The Myth of the Rational Market, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond

Nor does the unprecedented bubble and bust in house prices during the first decade of the 2000s drive a stake through the heart of the efficient-market hypothesis. If individuals are given an opportunity to buy houses with no money down, it can be the height of rationality to be willing to pay an inflated price. If the house continues to escalate in value, the buyer will profit. If the bubble bursts and the house price declines, the buyer walks away and leaves the lender (and perhaps ultimately the government) with the loss. Yes, the incentives were perverse. And in retrospect, regulation was lax and some government policies were ill considered. But in no sense was this sorry episode and the deep recession that followed caused by a blind faith in the efficient-market hypothesis. Part Two HOW THE PROS PLAY THE BIGGEST GAME IN TOWN TECHNICAL AND FUNDAMENTAL ANALYSIS A picture is worth ten thousand words.

Moreover, whatever mispricing there is usually is recognizable only after the fact, just as we always know Monday morning the correct play the quarterback should have called. The real estate bubble in the United States during 2006 and 2007 appeared to present convincing evidence that markets are not efficient. An increasing number of arguments against the efficient-market hypothesis appeared after the sharp sell-off in the real estate markets during 2008, and the associated collapse of the bonds that had been securitized by mortgages on single-family homes and on other real estate assets. In 2009, George Soros wrote that “the Efficient Market Hypothesis has been well and truly discredited by the crash of 2008.” The EMH was blamed as the villain for the financial crisis and was written off for dead by countless financial commentators. For example, the respected market strategist Jeremy Grantham opined that the EMH “is more or less directly responsible for the financial crisis.”

Is it true that high-beta portfolios will provide larger long-term returns than lower-beta ones, as the capital-asset pricing model suggests? Does beta alone summarize a security’s total systematic risk, or do we need to consider other factors as well? In short, does beta really deserve an alpha? These are subjects of intense current debate among practitioners and academics. In a study published in 1992, Eugene Fama and Kenneth French divided all traded stocks into deciles according to their beta measures over the 1963–90 period. Decile 1 contained the 10 percent of all stocks that had the lowest betas; decile 10 contained the 10 percent that had the highest betas. The remarkable result, shown in the chart below, is that there was essentially no relationship between the return of these decile portfolios and their beta measures.

 

Trend Commandments: Trading for Exceptional Returns by Michael W. Covel

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Albert Einstein, Bernie Madoff, Black Swan, commodity trading advisor, correlation coefficient, delayed gratification, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, family office, full employment, Lao Tzu, Long Term Capital Management, market bubble, market microstructure, Mikhail Gorbachev, moral hazard, Nick Leeson, oil shock, Ponzi scheme, prediction markets, quantitative trading / quantitative finance, random walk, Sharpe ratio, systematic trading, the scientific method, transaction costs, tulip mania, upwardly mobile, Y2K

It attracted elite Wall Street investors and initially reaped fantastic profits with secret money-making strategies. Ultimately, its theories collided with reality. To understand the LTCM debacle, it starts with two academic legends: Merton Miller and Eugene F. Fama who developed the Efficient-Markets Hypothesis. The premise of their hypothesis was that stock prices were always right so you could not divine the market’s future direction. It assumed that everyone was rational.2 Miller and Fama believed that perfectly rational people would never pay more or less for a financial instrument than it was actually worth. A colleague, and fervent supporter of the Efficient-Markets Hypothesis, Myron Scholes was also certain that markets could not make mistakes. He and his associate, Robert Merton, saw the finance universe as tidy and predictable. They assumed that the price of IBM would never go directly from 80 to 60 but would always stop at 79 3/4, 79 1/2, and 79 1/4 along the way.3 LTCM’s founders believed the market was a perfect normal distribution with no outliers, no fat tails, and no unexpected events.

He would rather die with honor than fall into the hands of superior market wisdom.6 If you don’t know who you are, the markets are an expensive place to find out.8 Having lived through the financial crisis of 2007–08, the man in the street knows markets are not efficient. But the Efficient-Market Hypothesis, like a Hollywood monster, has proved very hard to kill off.7 Fortunately for you, there is a way out. There is inspiration. The great trend followers are not academics, magicians, charlatans, or pedigreed investment bankers. They are self-starter entrepreneurs who, through concentration, drive, and fierce independent streaks, have cultivated that rare knowledge to mint money. Trend following proves daily that the Efficient-Markets Hypothesis has more in common with Scientology, versus any useful trading enlightenment. Understand the comparisons made herein. It’s all part of you interpreting the puzzle.

Nearly all share the common assumption: When it comes to money, we are highly rational.3 One of the foremost champions of that view is Gary Becker: “The most powerful theory we have, and I think it’s the most powerful theory in the social sciences, is economics as a theory of rational behavior at an individual level, and that’s the theory we rely on.”4 Other academics are not on board for obvious reasons: “The 2008 crash really matters because much of the behavior that led up to the crash is unexplained by the discipline of economics.”5 Beware of consensus. More Chicago academics ignore the 2008 crash: “I’m sorry, that’s such an empty argument. That’s just an insult, a pointless insult.”6 Eugene Fama, the father of so-called efficient markets, smirked: “I don’t see this as a failure of economics, but we need a whipping boy, and economists have always been whipping boys, so they’re used to it. It’s fine.”7 26 Tre n d C o m m a n d m e n t s Those economists defend their view no matter what. People and markets are rational? Small children now know that is not true. However, university professors have convinced themselves human beings only use robotlike logic.

 

pages: 355 words: 92,571

Capitalism: Money, Morals and Markets by John Plender

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Andrei Shleifer, asset-backed security, bank run, Berlin Wall, Big bang: deregulation of the City of London, Black Swan, bonus culture, Bretton Woods, business climate, Capital in the Twenty-First Century by Thomas Piketty, central bank independence, collapse of Lehman Brothers, collective bargaining, computer age, Corn Laws, corporate governance, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, discovery of the americas, diversification, Eugene Fama: efficient market hypothesis, eurozone crisis, failed state, Fall of the Berlin Wall, fiat currency, financial innovation, financial intermediation, Fractional reserve banking, full employment, Gordon Gekko, greed is good, Hyman Minsky, income inequality, inflation targeting, invention of the wheel, invisible hand, Isaac Newton, James Watt: steam engine, Johann Wolfgang von Goethe, John Maynard Keynes: Economic Possibilities for our Grandchildren, joint-stock company, Joseph Schumpeter, labour market flexibility, London Interbank Offered Rate, London Whale, Long Term Capital Management, manufacturing employment, Mark Zuckerberg, market bubble, market fundamentalism, means of production, Menlo Park, moral hazard, moveable type in China, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, paradox of thrift, Plutocrats, plutocrats, price stability, principal–agent problem, profit motive, quantitative easing, railway mania, regulatory arbitrage, Richard Thaler, rising living standards, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, shareholder value, short selling, Silicon Valley, South Sea Bubble, spice trade, Steve Jobs, technology bubble, The Chicago School, The Great Moderation, the map is not the territory, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, too big to fail, tulip mania, Upton Sinclair, We are the 99%, Wolfgang Streeck

These high priests of capitalism have had a potent influence on the behaviour of the financial community. Among the chief strands of their work has been the so-called efficient markets hypothesis, pioneered by Eugene Fama in the 1960s and 1970s. There are differing versions of the thesis, but the most potent of them holds that financial assets are always correctly priced because competition between profit-seeking market participants ensures that any divergence between price and value will be quickly eliminated. Prices in financial markets are said to be an accurate reflection of all available information. In effect, the efficient markets hypothesis asserts that the level of the stock market represents a good forecast of the present value of the future earnings of all the companies quoted there. Implicit in the theory is the notion that capital markets are self-correcting.

The ‘Bubble Lady’, as the press called her, spent years in jail, along with her bank manager patrons.85 When markets reach astonishing heights with the help of a toad, and the bursting of a property bubble precipitates the biggest recession in history, as happened in 2008, it might seem that the efficient markets hypothesis has a problem – namely, that it asserts, like Dr Pangloss in Voltaire’s Candide, that all is for the best in the best of all possible worlds. Yet in an interview with John Cassidy in the New Yorker magazine, Eugene Fama, chief architect of the theory, flatly denies it.86 He even argues that the financial crisis was not the cause of the recession, while saying he has no idea what the real cause was. That is a macro-economic issue and since Fama claims not to be a macro-economist the admission does not bother him.

While he has expressed shock and told the US Congress he has come to doubt the models of rational behaviour on which he relied, Greenspan has yet to offer fulsome apologies for the flaws in Fed policy. But he has offered revisionism. In an extraordinary U-turn in a recent interview in the Harvard Business Review, he declared: ‘You can spot a bubble. They’re obvious in every respect.’ But he added that it was impossible to quash a bubble in a democratic society because it would lead to the Fed’s independence being curtailed.76 As for efficient market theorists such as Eugene Fama, they, too, remain unrepentant. How do they justify themselves? Consider this, first, from the perspective of financial history. In an academic paper, the economist Peter Garber has examined three great bubbles in detail: the Dutch tulip mania, in which contract prices for bulbs soared to astronomical heights and then collapsed; the Mississippi Bubble in France, a scheme engineered by the Scottish adventurer John Law which enjoyed a monopoly over French colonial trade and ended in a speculative frenzy fuelled by the issue of paper money; and the South Sea Bubble in England, where speculation hinged on the South Sea Company’s modest trading rights in the West Indies and South America, together with its purchase of the national debt in exchange for an annual payment from the Exchequer.77 On the seventeenth-century tulip euphoria, Garber argues that Charles Mackay failed to discuss what the fundamental price of tulips should have been, pointing out that there is a standard pricing pattern for new varieties of flowers that holds even today.

 

pages: 295 words: 66,824

A Mathematician Plays the Stock Market by John Allen Paulos

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Benoit Mandelbrot, Black-Scholes formula, Brownian motion, business climate, butterfly effect, capital asset pricing model, correlation coefficient, correlation does not imply causation, Daniel Kahneman / Amos Tversky, diversified portfolio, Donald Trump, double entry bookkeeping, Elliott wave, endowment effect, Erdős number, Eugene Fama: efficient market hypothesis, four colour theorem, George Gilder, global village, greed is good, index fund, invisible hand, Isaac Newton, John Nash: game theory, Long Term Capital Management, loss aversion, Louis Bachelier, mandelbrot fractal, margin call, mental accounting, Nash equilibrium, Network effects, passive investing, Paul Erdős, Ponzi scheme, price anchoring, Ralph Nelson Elliott, random walk, Richard Thaler, Robert Shiller, Robert Shiller, short selling, six sigma, Stephen Hawking, transaction costs, ultimatum game, Vanguard fund, Yogi Berra

In the Rorschach blot that chance provides us, we often see what we want to see or what is pointed out to us by business prognosticators, distinguishable from carnival psychics only by the size of their fees. Confidence, whether justified or not, is convincing, especially when there aren’t many “facts of the matter.” This may be why market pundits seem so much more certain than, say, sports commentators, who are comparatively frank in acknowledging the huge role of chance. Efficiency and Random Walks The Efficient Market Hypothesis formally dates from the 1964 dissertation of Eugene Fama, the work of Nobel prize-winning economist Paul Samuelson, and others in the 1960s. Its pedigree, however, goes back much earlier, to a dissertation in 1900 by Louis Bachelier, a student of the great French mathematician Henri Poincare. The hypothesis maintains that at any given time, stock prices reflect all relevant information about the stock. In Fama’s words: “In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future.”

If the vast majority of investors believe the Sluggish Market Hypothesis, then they all would believe that looking for trends and analyzing companies is well worth their time and, by so exercising themselves, they would bring about an efficient market. Thus, if most investors believe the Sluggish Market Hypothesis is true, they will by their actions make the Efficient Market Hypothesis true. We conclude that if the Efficient Market Hypothesis is false, then it’s not the case that most investors believe the Sluggish Market Hypothesis to be true. That is, if the Efficient Market Hypothesis is false, then most investors believe it (the EMH) to be true. (You may want to read over the last few sentences in a quiet corner.) In summary, if the Efficient Market Hypothesis is true, most investors won’t believe it, and if it’s false, most investors will believe it. Alternatively stated, the Efficient Market Hypothesis is true if and only if a majority believes it to be false. (Note that the same holds for the Sluggish Market Hypothesis.)

Warped perhaps by my study of mathematical logic and its emphasis on paradoxes and self-reference, I’m naturally interested in the paradoxical and self-referential aspects of the market, particularly of the Efficient Market Hypothesis. Can it be proved? Can it be disproved? These questions beg a deeper question. The Efficient Market Hypothesis is, I think, neither necessarily true nor necessarily false. The Paradoxical Efficient Market Hypothesis If a large majority of investors believe in the hypothesis, they would all assume that new information about a stock would quickly be reflected in its price. Specifically, they would affirm that since news almost immediately moves the price up or down, and since news can’t be predicted, neither can changes in stock prices. Thus investors who subscribe to the Efficient Market Hypothesis would further believe that looking for trends and analyzing companies’ fundamentals is a waste of time.

 

pages: 407 words: 114,478

The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein

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asset allocation, Bretton Woods, British Empire, buy low sell high, carried interest, corporate governance, cuban missile crisis, Daniel Kahneman / Amos Tversky, Dava Sobel, diversification, diversified portfolio, Edmond Halley, equity premium, estate planning, Eugene Fama: efficient market hypothesis, financial independence, financial innovation, fixed income, German hyperinflation, high net worth, hindsight bias, Hyman Minsky, index fund, invention of the telegraph, Isaac Newton, John Harrison: Longitude, Long Term Capital Management, loss aversion, market bubble, mental accounting, mortgage debt, new economy, pattern recognition, quantitative easing, railway mania, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, South Sea Bubble, transaction costs, Vanguard fund, yield curve

When it comes to newsletter writers, remember Malcolm Forbes’s famous dictum: the only money made in that arena is through subscriptions, not from taking the advice. The late John Brooks, dean of the last generation of financial journalists, had an even more cynical interpretation: when a famous investor publishes a newsletter, it’s a sure tip-off that his techniques have stopped working. Eugene Fama Cries “Eureka!” If Irving Fisher towered over financial economics in the first half of the twentieth century, there’s no question about who did so in the second half: Eugene Fama. His story is typical of almost all of the recent great financial economists—he was not born to wealth, and his initial academic plans did not include finance. He majored in French in college and was a gifted athlete. To make ends meet, he worked for a finance professor who published—you guessed it—a stock market newsletter.

Thus, the logic of the market suggests that: Good companies are generally bad stocks, and bad companies are generally good stocks. Is this actually true? Resoundingly, yes. There have been a large number of studies of the growth-versus-value question in many nations over long periods of time. They all show the same thing: unglamorous, unsafe value stocks with poor earnings have higher returns than glamorous growth stocks with good earnings. Probably the most exhaustive work in this area has been done by Eugene Fama at the University of Chicago and Kenneth French at MIT, in which they examined the behavior of growth and value stocks. They looked at value versus growth for both small and large companies and found that value stocks clearly had higher returns than growth stocks. Figure 1-18 and the data below summarize their work: Fama and French’s work on the value effect has had a profound influence on the investment community.

International Funds There are two other options to consider when looking at international vehicles. First, iShares does offer indexed ETFs for single nations. I’d recommend against them because of complexity and cost—these funds carry expense ratios of nearly 1%, far higher than those of the open-end funds. Second, there is Dimensional Fund Advisors (DFA). These folks are among the best and brightest in finance, with a strong connection to Eugene Fama and the University of Chicago. DFA indexes just about any asset class you might want, including small, value, and even small value foreign markets. They also have individual funds for small stocks from the U.K., Continental Europe, Japan, Pacific Rim, and emerging markets. Better yet, their index funds for the U.S. market have much more focused exposure to value and small stocks than Vanguard or the other indexers.

 

pages: 162 words: 50,108

The Little Book of Hedge Funds by Anthony Scaramucci

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Andrei Shleifer, asset allocation, Bernie Madoff, business process, carried interest, Credit Default Swap, diversification, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, fear of failure, fixed income, follow your passion, Gordon Gekko, high net worth, index fund, Long Term Capital Management, mail merge, margin call, merger arbitrage, NetJets, Ponzi scheme, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, risk/return, Ronald Reagan, Saturday Night Live, Sharpe ratio, short selling, Silicon Valley, too big to fail, transaction costs, Vanguard fund, Y2K, Yogi Berra

We also believe that hedge fund investors will continue to commit capital to mortgage strategies to seek out uncorrelated return streams, improve portfolio diversification, and achieve high risk-adjusted returns. Chapter Six Ironing Out Inefficiencies Exploiting the Efficient Market Theory If the efficient markets hypothesis was a publicly traded security, its price would be enormously volatile. —Andrei Shleifer and Lawrence H. Summers, The Noise Trader Approach to Finance In 1990, Andrei Shleifer and Larry Summers mockingly made the comment that begins this chapter, adding that the “stock in the efficient markets hypothesis—at least as it has been traditionally formulated—crashed along with the rest of the market on October 19, 1987 . . . and its recovery has been less dramatic than that of the rest of the market.”1 Pretty fun for a pair of economists from Harvard, especially for one who would serve as President Clinton’s Secretary of the Treasury and President Obama’s Director of the White House National Economic Council.

This finding has a huge impact on hedge funds, because in a world of inefficiency there seems to be endless ways to make money and maximize returns. It simply requires the ability to look at things in a different way . . . a contrarian way. A Kid in a Candy Store From the time of A.W. Jones until the mid 1980s, the overall sentiment in the marketplace was that hedge fund performance was mainly dictated by luck rather than strategy or skill. Why? The world of finance was operating under Eugene Fama’s efficient market theory, which was developed in the 1960s at the University of Chicago. Here is the gist of it. If markets were rendered efficient, it followed that prices would move in a random pattern, and consequently those who achieved high levels of success would be investors who most quickly acted upon the fundamental news that was available to everybody. In other words, the only thing that moved a stock price was new information; any other changes were random and not predictable.

Hedge fund managers, being the contrarian investors that they are, would not just sit there and allow themselves to be the victim of such erratic behavior—especially in moments of crisis like that of Black Monday. Instead, they would discover ways in which to iron out the kinks . . . albeit with a little help from the same academics who told them the market was efficient in the first place! Living on the Edge Considered the father of the efficient market theory, Professor Eugene Fama ironically led the charge against it, diving headfirst into a theory that postulated that markets were—you guessed it—inefficient. Along with fellow economist Kenneth French, he discovered nonrandom patterns in the market that traders could pounce on to generate positive returns. And as they continued to study the long-term returns from the stock market, their research exposed certain market anomalies that hedge fund managers could exploit in order to correct inefficiencies and produce absolute returns. 1.

 

The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk by William J. Bernstein

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asset allocation, backtesting, capital asset pricing model, computer age, correlation coefficient, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, fixed income, index arbitrage, index fund, Long Term Capital Management, p-value, passive investing, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, South Sea Bubble, the scientific method, time value of money, transaction costs, Vanguard fund, Yogi Berra, zero-coupon bond

Noted author, analyst, and money manager David Dreman, in Contrarian Market Strategy: The Psychology of Stock Market Success, painstakingly tracked expert opinion back to 1929 and found that it underperformed the market with 77% frequency. It is a recurring theme of almost all studies of “consensus” or “expert” opinion that it underperforms the market about three-fourths of the time. Mr. Dreman argues that this is a powerful argument against the efficient market hypothesis: how can the markets be efficient when the experts lose with such depressing regularity? All of this evidence falls under the rubric of what is known as market efficiency. A detailed discussion of the efficient market hypothesis is beyond the scope of this book, but what it means is this: it’s futile to analyze the prospects for an individual stock (or the entire market) on the basis of publicly available information, since that information has already been accounted for in the price of the stock (or market).

This is actually better than we’d expect from a fund with a 1.5% expense advantage in a category with 8% SD of annual active-manager scatter (兹15 苶 ⫻ 1.5/8 ⫽ 0.73 SD above the mean, which is about 23rd percentile). We’ll come to the reason why in a minute. 98 The Intelligent Asset Allocator Math Details: The Ultimate Benchmark If you’re really serious about benchmarking a fund, as well as looking for skill, you perform a three-factor regression on fund returns. Here’s how it works. Developed by Ken French of MIT and Eugene Fama of University of Chicago, the regression starts with monthly returns for the broad stock market, as well as monthly return contributions for small-stock and value-stock exposure. You then lay the monthly returns for the fund or manager in question side by side with these three benchmark series and perform a multiple regression.This statistical technique, available on most spreadsheet packages, produces the “best fit” of the three factors to the manager returns series and spits out a blizzard of output numbers.The most- important of these is the residual return (the intercept of the regression),or alpha.The alpha is the excess return left after exposure to the market, size, and value have been taken into account.

In practical terms, this means rebalancing no more than once per year. Yin, Yang Rather than being polar opposites, momentum investing and fixedasset allocation with contrarian rebalancing are simply two sides of the same coin. Momentum in foreign and domestic equity asset classes exists, resulting in periodic asset overvaluation and undervaluation. Eventually long-term mean reversion occurs to correct these excesses. Over 2 decades ago, Eugene Fama made a powerful case that security price changes could not be predicted, and Burton Malkiel introduced the words “random walk” into the popular investing lexicon. Unfortunately, in a truly random-walk world, there is no advantage to portfolio rebalancing. If you rebalance, you profit only when the frogs in your portfolio turn into princes, and vice versa. In the real world, fortunately, there are subtle departures in random-walk behavior that the asset allocator-investor can exploit.

 

Investment: A History by Norton Reamer, Jesse Downing

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Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, Brownian motion, buttonwood tree, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, moral hazard, mortgage debt, Network effects, new economy, Nick Leeson, Own Your Own Home, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve

Jensen’s initial study of mutual funds from 1945 to 1964 revealed that very few managers had effectively produced a greater return than one would expect, given the level of risk of the portfolio.40 Investors finally had a mechanism by which they could parse out the riskadjusted effects of active money management. Samuelson and Fama: Formalizations of the Efficient Market Hypothesis The question of whether managers can successfully add alpha remains a consistent and contentious debate in the academic literature. There are many who believe managers cannot consistently add value over the long term because markets are efficient. One of the theorists behind this “efficient market hypothesis” was Eugene Fama, discussed previously in the context of his three-factor model with French. In his 1970 paper entitled “Efficient Capital Markets: A Review of Theory and Empirical Work,” Fama effectively defined three different types of efficiency.

Last is strong-form efficiency, which implies that all information, both public and private, is reflected in stock prices.41 (Of course, a multitude of legal constraints exist in most regulatory environments to prevent the purest incarnation of strong-form efficiency, particularly laws prohibiting insider trading. Indeed, it is the divergence of the market from strong-form efficiency that makes insider trading profitable.) The critical implication of the efficient market hypothesis is that the market cannot be beaten if it is truly efficient. 250 Investment: A History To understand the efficient market hypothesis more completely, it is worth discussing perhaps one of its staunchest opponents: the school of value investing, which began with Benjamin Graham and David Dodd’s publication of the famed book Security Analysis in 1934. Graham and Dodd posited that one could, in fact, outperform the market by concentrating on value stocks.

He went on to say that he agreed instead with those who believed the market had almost always priced securities correctly: “To that very limited extent I’m on the side of the ‘efficient market’ school of thought now generally accepted by the professors.”44 While Benjamin Graham may have given up on his work, many adherents of the philosophy of value investing have not. One may consider Warren Buffett’s primary objection to the efficient market hypothesis to illustrate this point: value investors, he claims, seem to have outperformed the market over time. The response of most proponents of the efficient market hypothesis has been that given the The Emergence of Investment Theory 251 number of money managers in the market, statistically some will seem to outperform the market. Buffett’s response in a 1984 speech to the Columbia Business School was to discuss the records of nine investors he had known since fairly early in his career who did value investing and who he said had consistently outperformed the market on a riskadjusted basis.

 

Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies by Jeremy J. Siegel

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asset allocation, backtesting, Black-Scholes formula, Bretton Woods, buy low sell high, California gold rush, capital asset pricing model, cognitive dissonance, compound rate of return, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fixed income, German hyperinflation, implied volatility, index arbitrage, index fund, Isaac Newton, joint-stock company, Long Term Capital Management, loss aversion, market bubble, mental accounting, new economy, oil shock, passive investing, prediction markets, price anchoring, price stability, purchasing power parity, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, technology bubble, The Great Moderation, The Wisdom of Crowds, transaction costs, tulip mania, Vanguard fund

If beta is greater than 1, the stock requires a return greater than the market, and if it is less than 1, a lesser return is required. Risk that can be eliminated through diversification (called diversifiable or residual risk) does not warrant a higher return. The “efficient market hypothesis” and the CAPM became the basis for stock return analysis in the 1970s and 1980s. Unfortunately, as more data were analyzed, beta did not prove successful at explaining the differences in returns among individual stocks or portfolios of stocks. In 1992, Eugene Fama and Ken French wrote an article, published in the Journal of Finance, which determined that there are two factors, one relating to the size of the stocks and the other to the valuation of stocks, that are far more important in determining a stock’s return than the beta of a stock.4 After further analyzing returns, they claimed that the evidence against the CAPM was “compelling” and that “the average return anomalies . . . are serious enough to infer that the [CAPM] model is not a useful approximation” of a stock’s return, and they suggested researchers investigate “alternative” asset pricing models or “irrational asset pricing stories.”5 2 The capital asset pricing model was developed by William Sharpe and John Lintner in the 1960s.

See William Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance, vol. 19, no. 3 (September 1964), p. 442, and John Lintner, “The Valuation of Risk Assets and the Selection of Risky Investment in Stock Portfolios and Capital Budgets,” Review of Economics and Statistics, vol. 47, no. 1 (1965), pp. 221–245. 3 Greek letters are used to designate the coefficients of regression equations. Beta, the second coefficient, is calculated from the correlation of an individual stock’s (or portfolio’s) return with a capitalization-weighted market portfolio. The first coefficient, alpha, is the average historical return on the stock or portfolio above the return on the market. 4 Eugene Fama and Ken French, “The Cross Section of Expected Stock Returns,” Journal of Finance, vol. 47 (1992), pp. 427–466. 5 Eugene Fama and Ken French, “The CAPM Is Wanted, Dead or Alive,” Journal of Finance, vol. 51, no. 5 (December 1996), pp. 1947–1958. CHAPTER 9 Outperforming the Market 141 Fama and French’s findings have prompted financial economists to classify the stock universe along two dimensions: size, measured by the market value of the stock, and valuation, or the price relative to “fundamentals” such as earnings and dividends.

[s]ome indexes, such as the Standard & Poor’s (S&P) 500 Stock Index, have become so popular that entry to the index carries with it a price premium that may reduce future returns.” Further research has supported this contention. The chapter on the history of the S&P 500 Index shows that the new firms added to the index have generally had lower returns than the original firms that were chosen in 1957. In this edition, I introduce the “noisy market hypothesis,” an alternative to the efficient market hypothesis that explains why value stocks outperform growth stocks. In Chapter 20, I describe “fundamentally weighted” indexes as an efficient alternative to capitalization-weighted indexes for capturing the value premium. Any analysis of the stock market today must be international in scope, and in this edition I have greatly expanded the material on international markets. I detail the role of the developing economies in mitigating the aging crisis that will soon envelop the United States, Europe, and Japan as the ranks of retirees swell.

 

pages: 484 words: 136,735

Capitalism 4.0: The Birth of a New Economy in the Aftermath of Crisis by Anatole Kaletsky

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bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Black Swan, bonus culture, Bretton Woods, BRICs, Carmen Reinhart, cognitive dissonance, collapse of Lehman Brothers, Corn Laws, correlation does not imply causation, credit crunch, currency manipulation / currency intervention, David Ricardo: comparative advantage, deglobalization, Deng Xiaoping, Edward Glaeser, Eugene Fama: efficient market hypothesis, eurozone crisis, experimental economics, F. W. de Klerk, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, George Akerlof, global rebalancing, Hyman Minsky, income inequality, invisible hand, Isaac Newton, Joseph Schumpeter, Kenneth Rogoff, laissez-faire capitalism, Long Term Capital Management, mandelbrot fractal, market design, market fundamentalism, Martin Wolf, moral hazard, mortgage debt, new economy, Northern Rock, offshore financial centre, oil shock, paradox of thrift, peak oil, pets.com, Ponzi scheme, post-industrial society, price stability, profit maximization, profit motive, quantitative easing, Ralph Waldo Emerson, random walk, rent-seeking, reserve currency, rising living standards, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, sovereign wealth fund, special drawing rights, statistical model, The Chicago School, The Great Moderation, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, too big to fail, Washington Consensus

See Frank Knight, Risk, Uncertainty, and Profit. 9 David Ricardo, “Essay on the Funding System,” in The Works of David Ricardo , 513-548. 10 David Viniar quoted in Emiko Terazono, “Bean in Barcelona,” Financial Times, August 26, 2009. 11 When asked by John Cassidy of the New Yorker how the theory of efficient markets had held up in the crisis, Chicago economist Eugene Fama responded, “I think it did quite well in this episode. . . . [This] was exactly what you would expect if markets are efficient.” He went on to suggest, “I don’t know what a credit bubble means. . . . I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.” Eugene Fama quoted in John Cassidy, “After the Blowup: Laissez-faire Economists Do Some Soul-searching—and Finger-pointing,” New Yorker ( January 11, 2010): 30. 12 The Joint Hypothesis problem arises because any test of market efficiency is actually a simultaneous test of two hypotheses: One, that markets are efficient, and two, that our models of the market are accurate.

This may sound obscure and academic, but like the methodology of rational expectations, the near-universal use of the Normal distribution in finance was a very important issue that led directly to the financial collapse in 2007-08. The Normal distribution is a wonderful mathematical construct because it can be analyzed with extraordinary precision. The assumptions made by the Efficient Market Hypothesis thus allowed very precise formulas to be developed for pricing options and complex financial instruments of all kinds. And these formulas, because of their mathematical precision, appeared to justify the enormous increases in leverage and reliance on risk-management systems that so spectacularly failed. In this sense, the 2007-09 crisis could fairly be described as a failure of mathematical economics and nothing more. If the Efficient Market Hypothesis had been valid, fairly simple and logically irrefutable mathematical calculations could have been used to show that most of the financial crises of the past twenty years were literally impossible.

By August 2007, David Viniar, the chief financial officer of Gold man Sachs, claimed to be seeing “twenty-five standard deviation events,” which in a normal distribution ought to occur only once every trillion years, “happening several days in a row.”10 And that was more than a year before the collapse of Lehman, when the financial markets really went wild. By normal intellectual standards, such spectacular empirical falsification would have completely demolished the Efficient Market Hypothesis as a serious scientific theory. But as in the case of rational expectations, most economists in the wake of the crisis have been so attached to their theories that the facts had to be rejected instead.11 The financial establishment, too, was quick to regroup in defense of EMH, since its abandonment would mean the collapse of some extremely profitable, though very risky, business models. Without the Efficient Market Hypothesis, most of the trading and risk models used by major financial institutions would have to be junked. The mark-to-market profits on which banks based their dividends and bonuses would have to be replaced by old-fashioned cash accounting, with profits recognized only as banks receive their money back from borrowers or sell assets to realize capital gains.

 

pages: 338 words: 106,936

The Physics of Wall Street: A Brief History of Predicting the Unpredictable by James Owen Weatherall

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Albert Einstein, algorithmic trading, Antoine Gombaud: Chevalier de Méré, Asian financial crisis, bank run, Benoit Mandelbrot, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, butterfly effect, capital asset pricing model, Carmen Reinhart, Claude Shannon: information theory, collateralized debt obligation, collective bargaining, dark matter, Edward Lorenz: Chaos theory, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial innovation, George Akerlof, Gerolamo Cardano, Henri Poincaré, invisible hand, Isaac Newton, iterative process, John Nash: game theory, Kenneth Rogoff, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, martingale, new economy, Paul Lévy, prediction markets, probability theory / Blaise Pascal / Pierre de Fermat, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical arbitrage, statistical model, stochastic process, The Chicago School, The Myth of the Rational Market, tulip mania, V2 rocket, volatility smile

If markets work the way Bachelier argued they must, then the random walk hypothesis isn’t crazy at all. It’s a necessary part of what makes markets run. This way of looking at markets is now known as the efficient market hypothesis. The basic idea is that market prices always reflect the true value of the thing being traded, because they incorporate all available information. Bachelier was the first to suggest it, but, as was true of many of his deepest insights into financial markets, few of his readers noted its importance. The efficient market hypothesis was later rediscovered, to great fanfare, by University of Chicago economist Eugene Fama, in 1965. Nowadays, of course, the hypothesis is highly controversial. Some economists, particularly members of the so-called Chicago School, cling to it as an essential and irrefutable truth.

But in fact, there were some others who either anticipated Bachelier in some ways (most notably Jules Regnault) or else did similar work within a few years of Bachelier (for instance, Vinzenz Bronzin). For more on these other pioneers in finance, see Poitras (2006) (especially Jovanovic [2006] and Zimmermann and Hafner [2006]) and Girlich (2002). “The efficient market hypothesis was later rediscovered . . .”: See Fama (1965). The efficient market hypothesis is now a central part of modern economic thought; it is described in detail in any major textbook, such as Mankiw (2012) or Krugman and Wells (2009). For a history of the efficient market hypothesis, see Sewell (2011) and Lim (2006). See also the dozens of recent books and articles attacking the idea that markets are in fact efficient, such as Taleb (2004, 2007a), Fox (2009), Cassidy (2010a, b), Stiglitz (2010), and Krugman (2009). “. . . called The Random Character of Stock Market Prices”: This is Cootner (1964).

Merton, meanwhile, held off on sending his alternative approach to journals, so that Black and Scholes could receive appropriate credit for their discovery. Despite the early setbacks, however, Black and Scholes were not destined to labor in obscurity. Powerful forces in academia, in finance, and in politics were aligning in their favor. And some of the then-reigning academic gods were ready to intervene. After the second rejection, University of Chicago professors Eugene Fama and Merton Miller, two of the most influential economists at the time and leaders of the then-nascent Chicago School of economics, successfully urged the Journal of Political Economy to reconsider, and in August 1971 the article was accepted for publication, pending revisions. In the meantime, Fischer Black had attracted attention at the University of Chicago. Economists there were familiar with his work with Scholes, both on options and at Wells Fargo; they’d seen him in action at the Wells Fargo conference.

 

pages: 364 words: 101,286

The Misbehavior of Markets by Benoit Mandelbrot

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Albert Einstein, asset allocation, Augustin-Louis Cauchy, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black-Scholes formula, British Empire, Brownian motion, buy low sell high, capital asset pricing model, carbon-based life, discounted cash flows, diversification, double helix, Edward Lorenz: Chaos theory, Elliott wave, equity premium, Eugene Fama: efficient market hypothesis, Fellow of the Royal Society, full employment, Georg Cantor, Henri Poincaré, implied volatility, index fund, informal economy, invisible hand, John von Neumann, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market microstructure, new economy, paper trading, passive investing, Paul Lévy, Plutocrats, plutocrats, price mechanism, quantitative trading / quantitative finance, Ralph Nelson Elliott, RAND corporation, random walk, risk tolerance, Robert Shiller, Robert Shiller, short selling, statistical arbitrage, statistical model, Steve Ballmer, stochastic volatility, transfer pricing, value at risk, volatility smile

., independently and identically distributed—like the coin game with each toss unaffected by the last. Evidence for short-term dependence has already been mounting. And now comes the increasingly accepted but still confusing evidence of long-term dependence. Some economists, when thinking about long memory, are concerned that it undercuts the Efficient Market Hypothesis that prices fully reflect all relevant information; that the random walk is the best metaphor to describe such markets; and that you cannot beat such an unpredictable market. Well, the Efficient Market Hypothesis is no more than that, a hypothesis. Many a grand theory has died under the onslaught of real data. Coda: Looney ’Toons of Long Dependence As an aid to understanding, it is cartoon time again. As shown in prior chapters, fractal geometry allows for synthesis that starts from some simple ideas and generates complex structures.

When Cootner of MIT reprinted my analysis in his book a year later, he wrote that it forced economists “to face up in a substantive way to those uncomfortable empirical observations that there is little doubt most of us have had to sweep under the carpet up to now.” The paper, one of the most widely read and cited in economics, sparked others to look at the price data with fresh eyes. Because of its import, I will come back to this tale. Stocks The inquiry quickly broadened beyond cotton. Whatever the stock index, whatever the country, whatever the security, prices only rarely follow the predicted normal pattern. My student, Eugene Fama, investigated this for his doctoral thesis. Rather than examine a broad market index, he looked one-by-one at the thirty blue-chip stocks in the Dow. He found the same, disturbing pattern: Big price changes were far more common than the standard model allowed. Large changes, of more than five standard deviations from the average, happened two thousand times more often than expected. Under Gaussian rules, you should have encountered such drama only once every seven thousand years; in fact, the data showed, it happened once every three or four years.

Because expressing a number in logarithms rescales it so that, rather than focusing on the size of the number as we normally do, we can more easily compare it to other numbers nearby. Thus, $1 price jumps from $10 to $11and from $1,000 to $1,001 are equal on the dollars scale but the logarithmic scale shows the former to be more important than the latter. 95 “When Cootner of MIT…” Cootner 1964. 96 “My student, Eugene Fama…” Fama 1964, revised and published as Fama 1965b. 96 “They call it kurtosis…” Kurtosis is one of the founders of the standard measures of a distribution curve’s shape, which are based on the first four “moments.” The first moment is the average value; the second is the variance; third is the skewness—a measure of how asymmetrically the data are distributed around the average; and fourth is kurtosis, a measure of how tall or squat the curve is.

 

pages: 584 words: 187,436

More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby

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Andrei Shleifer, Asian financial crisis, asset-backed security, automated trading system, bank run, barriers to entry, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, Bretton Woods, capital controls, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, currency peg, Elliott wave, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, full employment, German hyperinflation, High speed trading, index fund, Kenneth Rogoff, Long Term Capital Management, margin call, market bubble, market clearing, market fundamentalism, merger arbitrage, moral hazard, natural language processing, Network effects, new economy, Nikolai Kondratiev, pattern recognition, pre–internet, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical arbitrage, statistical model, technology bubble, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs

Before, the prevailing line from the academy had been that hedge funds would fail. After, lines of academics were queuing up to join them. If markets were inefficient, there was money to be made, and the finance professors saw no reason why they should not be the ones to profit. Cliff Asness was fairly typical of the new wave. At the University of Chicago’s Graduate School of Business, his thesis adviser was Eugene Fama, one of the fathers of the efficient-market hypothesis. But by 1988, when Asness arrived in Chicago, Fama was leading the revisionist charge: Along with a younger colleague, Kenneth French, Fama discovered non-random patterns in markets that could be lucrative for traders. After contributing to this literature, Asness headed off to Wall Street and soon opened his hedge fund. In similar fashion, the Nobel laureates Myron Scholes and Robert Merton, whose formula for pricing options grew out of the efficient-markets school, signed up with the hedge fund Long-Term Capital Management.

Meanwhile, other researchers acknowledged that markets were not perfectly liquid, as Steinhardt had discovered long before, and that investors were not perfectly rational, a truism to hedge-fund traders. The crash of 1987 underlined these doubts: When the market’s valuation of corporate America changed by a fifth in a single trading day, it was hard to believe that the valuation deserved much deference. “If the efficient markets hypothesis was a publicly traded security, its price would be enormously volatile,” the Harvard economists Andrei Shleifer and Lawrence Summers wrote mockingly in 1990. “But the stock in the efficient markets hypothesis—at least as it has traditionally been formulated—crashed along with the rest of the market on October 19, 1987.”8 The acknowledgment of the limits to market efficiency had a profound effect on hedge funds. Before, the prevailing line from the academy had been that hedge funds would fail.

“The theory of reflexivity can explain such bubbles, while the efficient market hypothesis cannot,” Soros wrote later, and broadly, he was right.65 It was surely no coincidence that efficient-market thinking had originated on American university campuses in the 1950s and 1960s—the most stable enclaves within the most stable country in the most stable era in memory. Soros, who had survived the Holocaust, the war, and penury in London, had a different view of life; and after the wild ride of Black Monday, the academic consensus began to come around to him. The crash had been a humiliation for Soros in investing terms. But in intellectual terms it was a vindication. The recasting of the academic consensus had three parts to it. The efficient-market hypothesis had always been based on a precarious assumption: that price changes conformed to a “normal” probability distribution—the one represented by the familiar bell curve, in which numbers at and near the median crop up frequently while numbers in the tails of the distribution are rare to the point of vanishing.

 

pages: 430 words: 109,064

13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson, James Kwak

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Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, banking crisis, Bernie Madoff, Bonfire of the Vanities, bonus culture, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Edward Glaeser, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, financial intermediation, financial repression, fixed income, George Akerlof, Gordon Gekko, greed is good, Home mortgage interest deduction, Hyman Minsky, income per capita, interest rate derivative, interest rate swap, Kenneth Rogoff, laissez-faire capitalism, late fees, Long Term Capital Management, market bubble, market fundamentalism, Martin Wolf, moral hazard, mortgage tax deduction, Ponzi scheme, price stability, profit maximization, race to the bottom, regulatory arbitrage, rent-seeking, Robert Shiller, Robert Shiller, Ronald Reagan, Saturday Night Live, sovereign wealth fund, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve

Thus academic finance produced important tools that would create new markets and vast new sources of revenues for Wall Street. But it was perhaps even more important for the ideology it created. A central assertion of the academic finance movement in the 1960s and 1970s became known as the Efficient Market Hypothesis: precisely because traders are looking for and exploiting inefficiencies in asset prices, those inefficiencies cannot last for more than a brief period of time; as a result, prices are always “right.” As outlined by Eugene Fama in 1970, the Efficient Market Hypothesis comes in a weak form, a semi-strong form, and a strong form. The weak form holds that future prices cannot be predicted from past prices; the semi-strong form holds that prices adjust quickly to all publicly available information (meaning that by the time you read the news in the newspaper, it is too late to make money on the news); and the strong form holds that no one has any information that can be used to predict future prices, so market prices are always right.

(Or, as Goldman Sachs CEO Lloyd Blankfein recently asserted in defense of his bankers’ high pay, “If you examine our practices on compensation, you will see a complete correlation throughout our history of having remuneration match performance over the long term.”)43 These were not mathematical consequences of the Efficient Market Hypothesis, but they flowed naturally from it. The basic belief was that if a financial transaction was taking place, it was a good thing. This belief reflects a general economic principle; given perfectly rational actors with perfect information and no externalities, all transactions should be beneficial for both parties. But few economists ever believed that these assumptions actually held in the real world. And over the next few decades, dozens of leading economists such as Joseph Stiglitz, Robert Shiller, and Larry Summers set about knocking holes in the Efficient Market Hypothesis.44 Brad DeLong, Andrei Shleifer, Summers, and Robert Waldmann created a model showing that “noise trading can lead to a large divergence between market prices and fundamental values.”45 Even Fischer Black (of Black-Scholes fame) agreed.

.… The more placid days of the past were gone forever.”39 There was still no coherent program or ideology that laid out what the financial services industry should look like and what its relationship to the government should be. But that was changing. At the time, a movement was growing in the halls of America’s leading universities that would help transform the financial sector. This movement was the discipline of academic finance, pioneered by economists such as Paul Samuelson, Franco Modigliani, Merton Miller, Harry Markowitz, William Sharpe, Eugene Fama, Fischer Black, Robert Merton, and Myron Scholes, most of whom went on to win the Nobel Prize. These scholars brought sophisticated mathematics to bear on such problems as determining the optimal capital structure of a firm (the ratio between debt and equity), pricing financial assets, and separating and hedging risks.40 Academic finance had a tremendous impact on the way business is done around the globe.

 

pages: 345 words: 86,394

Frequently Asked Questions in Quantitative Finance by Paul Wilmott

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Albert Einstein, asset allocation, Black-Scholes formula, Brownian motion, butterfly effect, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Norbert Wiener, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, urban planning, value at risk, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond

Marking to market will therefore put some rationality back into your trading. References and Further Reading Wilmott, P 2006 Paul Wilmott On Quantitative Finance, second edition. John Wiley & Sons What is the Efficient Markets Hypothesis? Short Answer An efficient market is one where it is impossible to beat the market because all information about securities is already reflected in their prices. Example Or rather a counter-example, “I’d be a bum in the street with a tin cup if the markets were efficient,” Warren Buffett. Long Answer The concept of market efficiency was proposed by Eugene Fama in the 1960s. Prior to that it had been assumed that excess returns could be made by careful choice of investments. Here and in the following the references to ‘excess returns’ refers to profit above the risk-free rate not explained by a risk premium, i.e., the reward for taking risk.

The work later won Markowitz a Nobel Prize for Economics but is rarely used in practice because of the difficulty in measuring the parameters volatility, and especially correlation, and their instability. 1963 Sharpe, Lintner and Mossin William Sharpe of Stanford, John Lintner of Harvard and Norwegian economist Jan Mossin independently developed a simple model for pricing risky assets. This Capital Asset Pricing Model (CAPM) also reduced the number of parameters needed for portfolio selection from those needed by Markowitz’s Modern Portfolio Theory, making asset allocation theory more practical. See Sharpe (1963), Lintner (1963) and Mossin (1963). 1966 Fama Eugene Fama concluded that stock prices were unpredictable and coined the phrase “market efficiency.” Although there are various forms of market efficiency, in a nutshell the idea is that stock market prices reflect all publicly available information, that no person can gain an edge over another by fair means. See Fama (1966). 1960s Sobol’, Faure, Hammersley, Haselgrove, Halton. . . Many people were associated with the definition and development of quasi random number theory or low-discrepancy sequence theory.

References and Further Reading What is Maximum Likelihood Estimation? References and Further Reading What is Cointegration? References and Further Reading What is the Kelly criterion? References and Further Reading Why Hedge? References and Further Reading What is Marking to Market and How Does it Affect Risk Management in Derivatives Trading? References and Further Reading What is the Efficient Markets Hypothesis? References and Further Reading What are the Most Useful Performance Measures? References and Further Reading What is a Utility Function and How is it Used? References and Further Reading What is Brownian Motion and What are its Uses in Finance? References and Further Reading What is Jensen’s Inequality and What is its Role in Finance? References and Further Reading What is Itô’s Lemma?

 

pages: 349 words: 134,041

Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

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accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mutually assured destruction, new economy, New Journalism, Nick Leeson, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk-adjusted returns, risk/return, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

The lecturer was a young man who had studied at the University of Chicago Graduate Business School, an emerging hotbed of financial thinking. Nuclear physicists of a different era had asked: ‘What is Copenhagen’s view of this?’ In the 1970s, financial economists around the globe wondered: ‘What is Chicago’s view of this?’ DAS_C02.QXP 8/7/06 22 4:22 PM Page 22 Tr a d e r s , G u n s & M o n e y In Chicago, Eugene Fama and his colleagues developed the efficient markets hypothesis. Merton Miller developed theories on dividends, borrowing by companies and the effect of taxes. Against this background of febrile activity, in 1973, three academics – Fischer Black, Myron Scholes and Robert Merton – developed a model to price options. Scholes and Merton were to receive the Swedish Central Bank’s Prize for achievement in economics (often mistakenly referred to as the Nobel Prize).

There are, in reality, only a few key principles for fund management: 1 Diversification – Harry Markowitz ‘proved’ that putting all your own eggs in one basket was risky. Warren Buffet continues to defy this DAS_C04.QXP 8/7/06 8:39 PM Page 111 3 N Tr u e l i e s – t h e ‘ b u y ’ s i d e 111 successfully. He argues that you are better off putting your money into a few things you know and understand, and that are cheap. He doesn’t like the thought of buying all the stuff you know nothing about. 2 Efficient markets – Eugene Fama and his colleagues hypothesized that prices follow a random walk. Prices do not follow specific discernible patterns, at least from past prices. All known information is already built into the price. Dealers and investors exist to exploit market inefficiency. If markets are truly efficient, then where is the boodle coming from? 3 Mean/variance – the risk of financial markets is reduced to two statistics: mean (average) return and variability of the returns, standard deviation or variance as measure of volatility.

Leading journals offered a variety of excuses – too specialized, too much finance not enough economics, not enough space to publish all the submissions received. Black believed that the the paper was rejected because he was not an academic – he had been a consultant at Arthur D. Little, a Boston consulting firm. Throughout his life, he remained deeply sceptical and cautious about scholarly life. Eventually, after the intervention of noted academics such as Merton Miller and Eugene Fama, Black and Scholes’ model was eventually published in 1973 as ‘The Pricing of Options and Corporate Liabilities’.4 Merton published a separate paper entitled ‘The Theory of Rational Option Pricing’5 shortly afterwards. The Black and Scholes option pricing model is the following equation: Pce = S. N(d1) – K e-Rf.T . N(d2) Where d1 = d2 = [ln (S/K) + ( Rf + ␴2/2) T]/ ␴ √T d1 – ␴ √T Where Pce S K T Rf ␴ N (d1) N (d2) ln e Ke-RfT = = = = = = = = = = = price of European call option asset price strike price time to maturity risk free interest rate volatility of returns from asset the cumulative normal distribution function for d1 the cumulative normal distribution function for d2 the natural logarithm of the relevant number the exponential term (approximately 2.7182) the amount of cash needed to be invested over period or time T at an interest rate of Rf in order to receive K at maturity.

 

pages: 523 words: 111,615

The Economics of Enough: How to Run the Economy as if the Future Matters by Diane Coyle

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accounting loophole / creative accounting, affirmative action, bank run, banking crisis, Berlin Wall, bonus culture, Branko Milanovic, BRICs, call centre, Cass Sunstein, central bank independence, collapse of Lehman Brothers, conceptual framework, corporate governance, correlation does not imply causation, Credit Default Swap, deindustrialization, demographic transition, Diane Coyle, disintermediation, Edward Glaeser, Eugene Fama: efficient market hypothesis, experimental economics, Fall of the Berlin Wall, Financial Instability Hypothesis, Francis Fukuyama: the end of history, George Akerlof, Gini coefficient, global supply chain, Gordon Gekko, greed is good, happiness index / gross national happiness, Hyman Minsky, If something cannot go on forever, it will stop, illegal immigration, income inequality, income per capita, invisible hand, Jane Jacobs, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, labour market flexibility, low skilled workers, market bubble, market design, market fundamentalism, megacity, Network effects, new economy, night-watchman state, Northern Rock, oil shock, principal–agent problem, profit motive, purchasing power parity, railway mania, rising living standards, Ronald Reagan, Silicon Valley, South Sea Bubble, Steven Pinker, The Design of Experiments, The Fortune at the Bottom of the Pyramid, The Market for Lemons, The Myth of the Rational Market, The Spirit Level, transaction costs, transfer pricing, tulip mania, ultimatum game, University of East Anglia, web application, web of trust, winner-take-all economy, World Values Survey

He points out that economics is not just a research discipline that seeks to understand the world but also, to paraphrase Karl Marx, changes the world though its impact on policy and decisions. Financial economics has been particularly influential in this respect. Mackenzie and his coauthors single out the influence of Eugene Fama’s efficient markets hypothesis, which says that stock market prices capture all available information about the value of the shares and investment managers can never consistently beat the market: The efficient market hypothesis is not simply an analysis of financial markets as “external” things but has become woven into market practices. Most important, it helped inspire the establishment of index tracking funds. Instead of seeking to “beat the market” (a goal that the hypothesis suggests is unlikely to be achieved except by chance), such funds invest in broad baskets of stocks and attempt to replicate the performance of market indexes such as the S&P 500.

Such funds have become major investment vehicles and their effects on prices can be detected when stocks are added to or removed from the indexes.11 Another example is the huge market for options (OTC derivatives), which were virtually nonexistent in 1990, small in 2000, and worth $604.6 trillion by the first half of 2009. Option pricing theory explains the growth—without the theory about what the prices of these derivative contracts ought to be, there could have been no trade in them. The theory created the reality of the market. Needless to say, the financial crisis has severely undermined belief in the validity of the efficient markets hypothesis—although its creator, Eugene Fama, remains adamant that the theory is empirically correct. In a 2009 interview, he said: Prices are good estimates of the underlying value of the asset. There are real risks of volatility in stocks, and this current episode is a good example. . . . This is not a financial recession. The financial problems are an offshoot. But nobody wants to believe that markets are efficient—especially not investment managers who proclaim that they know better.12 A wider question is whether the theory of financial markets has affected not only the reality of those markets, but the wider economy.

 

pages: 829 words: 186,976

The Signal and the Noise: Why So Many Predictions Fail-But Some Don't by Nate Silver

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airport security, availability heuristic, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, big-box store, Black Swan, Broken windows theory, Carmen Reinhart, Claude Shannon: information theory, Climategate, Climatic Research Unit, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, computer age, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, Daniel Kahneman / Amos Tversky, diversification, Donald Trump, Edmond Halley, Edward Lorenz: Chaos theory, en.wikipedia.org, equity premium, Eugene Fama: efficient market hypothesis, everywhere but in the productivity statistics, fear of failure, Fellow of the Royal Society, Freestyle chess, fudge factor, George Akerlof, haute cuisine, Henri Poincaré, high batting average, housing crisis, income per capita, index fund, Internet Archive, invention of the printing press, invisible hand, Isaac Newton, James Watt: steam engine, John Nash: game theory, John von Neumann, Kenneth Rogoff, knowledge economy, locking in a profit, Loma Prieta earthquake, market bubble, Mikhail Gorbachev, Moneyball by Michael Lewis explains big data, Monroe Doctrine, mortgage debt, Nate Silver, new economy, Norbert Wiener, PageRank, pattern recognition, pets.com, prediction markets, Productivity paradox, random walk, Richard Thaler, Robert Shiller, Robert Shiller, Rodney Brooks, Ronald Reagan, Saturday Night Live, savings glut, security theater, short selling, Skype, statistical model, Steven Pinker, The Great Moderation, The Market for Lemons, the scientific method, The Signal and the Noise by Nate Silver, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transaction costs, transfer pricing, University of East Anglia, Watson beat the top human players on Jeopardy!, wikimedia commons

I met with Thaler after we both spoke at a conference in Las Vegas, where we ate an overpriced sushi dinner and observed the action on the Strip. Thaler, although a friend and colleague of Fama’s, has been at the forefront of a discipline called behavioral economics that has been a thorn in the side of efficient-market hypothesis. Behavioral economics points out all the ways in which traders in the real-world are not as well-behaved as in the model. “Efficient-market hypothesis has two components,” Thaler told me between bites of toro. “One I call the No Free Lunch component, which is that you can’t beat the market. Eugene Fama and I mostly agree about this component. The part he doesn’t like to talk about is the Price Is Right component.” There is reasonably strong evidence for what Thaler calls No Free Lunch—it is difficult (although not literally impossible) for any investor to beat the market over the long-term.

Could FiveThirtyEight and other good political forecasters beat Intrade if it were fully legal in the United States and its trading volumes were an order of magnitude or two higher? I’d think it would be difficult. Can they do so right now? My educated guess21 is that some of us still can, if we select our bets carefully.22 Then again, a lot of smart people have failed miserably when they thought they could beat the market. The Origin of Efficient-Market Hypothesis In 1959, a twenty-year-old college student named Eugene Fama, bored with the Tufts University curriculum of romance languages and Voltaire, took a job working for a professor who ran a stock market forecasting service.23 The job was a natural fit for him; Fama was a fierce competitor who had been the first in his family to go to college and who had been a star athlete at Boston’s Malden Catholic High School despite standing at just five feet eight.

Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance, 25, 2 (1970), pp. 383–417. 32. Per interview with Eugene Fama. 33. Alan J. Ziobrowski, Ping Cheng, James W. Boyd, and Brigitte J. Ziobrowski, “Abnormal Returns from the Common Stock Investments of the U.S. Senate,” Journal of Financial and Quantiative Analysis, 39, no. 4 (December 2004). http://www.walkerd.people.cofc.edu/400/Sobel/P-04.%20Ziobrowski%20-%20Abnormal%20Returns%20US%20Senate.pdf. 34. Google Scholar search. http://scholar.google.com/scholar?hl=en&q=%22efficient+markets%22&as_sdt=0%2C33&as_ylo=1992&as_vis=0. 35. Google Scholar search. http://scholar.google.com/scholar?hl=en&q=%22efficient+markets+hypothesis%22&btnG=Search&as_sdt=1%2C33&as_ylo=2000&as_vis=0. 36. Google Scholar search. http://scholar.google.com/scholar?

 

pages: 385 words: 101,761

Creative Intelligence: Harnessing the Power to Create, Connect, and Inspire by Bruce Nussbaum

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3D printing, Airbnb, Albert Einstein, Berlin Wall, Black Swan, clean water, collapse of Lehman Brothers, Credit Default Swap, crony capitalism, crowdsourcing, Danny Hillis, declining real wages, demographic dividend, Elon Musk, en.wikipedia.org, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, follow your passion, game design, housing crisis, Hyman Minsky, industrial robot, invisible hand, James Dyson, Jane Jacobs, Jeff Bezos, jimmy wales, John Gruber, Joseph Schumpeter, Kickstarter, lone genius, manufacturing employment, Mark Zuckerberg, Martin Wolf, new economy, Paul Graham, Peter Thiel, race to the bottom, reshoring, Richard Florida, Ronald Reagan, shareholder value, Silicon Valley, Silicon Valley ideology, Silicon Valley startup, six sigma, Skype, Steve Ballmer, Steve Jobs, Steve Wozniak, supply-chain management, Tesla Model S, The Chicago School, The Design of Experiments, the High Line, The Myth of the Rational Market, thinkpad, Tim Cook: Apple, too big to fail, tulip mania, We are the 99%, Y Combinator, young professional, Zipcar

And even though the Great Recession would soon raise doubts about financial capitalism and its corporate correlate, shareholder capitalism, they have remained the dominant economic models in America. I may have witnessed the apogee of financial capitalism in Davos, but it got its start some four decades earlier in Chicago. In May of 1970, Eugene Fama, a professor at the Booth School of Business, published an article in the Journal of Finance called “Efficient Capital Markets: A Review of Theory and Empirical Work.” In it, Fama would take Adam Smith’s theory of the “invisible hand” to new levels. Along with that of Milton Friedman, Frank Knight, George Stigler, and other economists at Chicago, Fama’s work led to the economic model we now call the efficient market hypothesis or efficient market theory. In its purely financial form, EMT attempted to describe how stocks and markets functioned. Like all complex economic models, it relied on a handful of basic assumptions: 1.

NewsId=34502; “HP Still Has Top Market Share for PCs,” Forbes, October 13, 2011, accessed September 14, 2012, http://www.forbes.com/sites/marketnewsvideo/ 2011/10/13/hp-still-has-top-market-share-for-pcs/; Terrence O’Brien, “HP Reclaims Top Spot in PC Sales, Market as a Whole Climbs 21 Percent,” http://engadget.com, May 1, 2012, accessed September 14, 2012, http://www.engadget.com/2012/05/01/ hp-reclaims-top-spot-in-pc-sales-market-as-a-whole-climbs-21-pe/. 226 Even when its labs produced: http://www.polycom.com/products/polycom_halo.html, accessed September 14, 2012; Mark Speir, “Polycom Acquires HP’s Halo Video Conferencing for $89M,” RCR Wireless, June 1, 2011, accessed September 14, 2012, http://www.rcrwireless.com/austin/20110601/ components/polycom-acquires-hps-halo-video-conferencing-for-89m/. 227 sociologist Erving Goffman: Erving Goffman, Encounters: Two Studies in the Sociology of Interaction (Indianapolis, IN: Bobbs-Merrill, 1961), 78; referenced in Clifford Geertz, The Interpretation of Cultures (New York: Basic Books, 1973), 436. 227 Great Recession would soon: Michael Lind, “The Failure of Shareholder Capitalism,” http://Salon.com, March 29, 2011, accessed September 13, 2012, http://www.salon.com/2011/03/29/ failure_of_shareholder_capitalism/; “A New Idolatry,” Economist, April 22, 2010, accessed September 13, 2012, http://www.economist.com/node/15954434. 228 In May of 1970, Eugene Fama: Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance, vol. 25, no. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y., December 28 to 30, 1969 (May 1970), 383–417. Published by Wiley-Blackwell for the American Finance Association. 228 In it, Fama would take: Joe Nocera, “Poking Holes in a Theory on Markets,” New York Times, June 6, 2006, accessed September 13, 2012, http://www.nytimes.com/2009/06/06/business/ 06nocera.html?

Siegel, “Efficient Market Theory and the Crisis,” Wall Street Journal Online, October 27, 2009, accessed September 13, 2012, http://online.wsj.com/article/ SB10001424052748703573604574491261905165886.html. 228 Of course, what was missing: I am indebted to Ben Lee, who received his PhD from the University of Chicago, for highlighting the difference between uncertainty and risk in the economic analysis and theory formation that came out Chicago’s economics department. This distinction forms a major theme in the course we co-teach at Parsons. Ray Ball, “The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned?” University of Chicago, Journal of Applied Corporate Finance, vol. 21, no. 4, 2009; Siegel, “Efficient Market Theory and the Crisis”; Roger Lowenstein, “Book Review: The Myth of the Rational Market by Justin Fox,” Washington Post, June 7, 2009, accessed September 13, 2012, http://www.washingtonpost.com/wp-dyn/ content/article/2009/06/05/AR2009060502053.html. 228 “black swans”: Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (New York: Random House, 2007). 228 By excluding uncertainty: Frank H.

 

How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

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Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business process, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Nick Leeson, P = NP, pattern recognition, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

Way back in the 1930s, Benjamin Graham and David Dodd began to systematize security valuation, spawning the thought that investing had more in common with science than with the local numbers racket. By the 1950s, Harry Markowitz was turning portfolio construction into a disciplined endeavor. The academic scene exploded in the 1960s with seminal ideas like the capital asset pricing model, and in the 1970s with arbitrage pricing theory and the Black-Scholes-Merton option pricing formula. In 1965, the University of Chicago’s Eugene Fama published “The Behavior of Stock Prices,” which laid the foundation of the efficient market hypothesis. Fama theorized that stock prices fully and instantaneously reflect all available information. In the same year, Paul Samuelson at MIT published his “Proof that Properly Anticipated Prices Fluctuate Randomly,” which showed that, in an efficient market, price changes are random and thus inherently unpredictable. Burton Malkiel at Princeton later popularized these views in A Random Walk Down Wall Street, published in 1973.

I responded, “I’ve learned three things, and this is all there is to know about finance. First, there’s something called the efficient market hypothesis, which says that the markets are efficient and it’s impossible for an investor to outperform the market. Second, there’s something called the capital asset pricing model, which says that all you need to know about stocks to be an investor is a stock’s beta, its sensitivity to market moves. Third, there’s something called Modigliani-Miller, which says that the choice of a firm’s capital JWPR007-Lindsey 266 May 28, 2007 15:46 h ow i b e cam e a quant structure, its debt to equity ratio, doesn’t matter.” My father then asked me what I was going to do with this knowledge. “I haven’t the foggiest idea,” I said. The efficient market hypothesis was, of course, all the rage in academia at the time. Way back in the 1930s, Benjamin Graham and David Dodd began to systematize security valuation, spawning the thought that investing had more in common with science than with the local numbers racket.

While at Equitable, I began to participate in a variety of industry forums such as the Institute for Quantitative Research in Finance (the Q Group) and the Investment Technology Association, which is now JWPR007-Lindsey May 7, 2007 17:15 Mark Kritzman 253 called the Society for Quantitative Analysis (SQA). One year, in the early 1980s, I was responsible for the SQA conference program and lined up Fischer Black, Eugene Fama, Bob Merton, Stew Myers, Myron Scholes, Steve Ross, and Jack Treynor as speakers, among others. I also attended the CRSP conferences at the University of Chicago and the Berkeley Program in Finance. It was at these gatherings that my interest in quantitative methods gained momentum. In 1980, I accepted a position in the investment department of AT&T. At the time, AT&T was in the process of consolidating the pension funds of the regional telephone operating companies into a single fund to be administered centrally in New York.

 

pages: 240 words: 60,660

Models. Behaving. Badly.: Why Confusing Illusion With Reality Can Lead to Disaster, on Wall Street and in Life by Emanuel Derman

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Albert Einstein, Asian financial crisis, Augustin-Louis Cauchy, Black-Scholes formula, British Empire, Brownian motion, capital asset pricing model, Cepheid variable, crony capitalism, diversified portfolio, Douglas Hofstadter, Emanuel Derman, Eugene Fama: efficient market hypothesis, Henri Poincaré, Isaac Newton, law of one price, Mikhail Gorbachev, quantitative trading / quantitative finance, random walk, Richard Feynman, Richard Feynman, riskless arbitrage, savings glut, Schrödinger's Cat, Sharpe ratio, stochastic volatility, the scientific method, washing machines reduced drudgery, yield curve

Others rely on technical analysis, a combination of rational and magical thinking that involves spotting the repetition of patterns in the trajectory of stock prices. None of these models works well consistently. Jujitsu Finance It’s a fact, then, that no one is very good at predicting stock prices. Faced with this failure, a school of academics associated with Eugene Fama at the University of Chicago in the 1960s developed what has become known as the Efficient Market Hypothesis, which I prefer to call the Efficient Market Model (EMM), since it’s a model of a hypothetical world rather than a correct hypothesis about the one we inhabit. I was a persevering student of physics when the EMM became popular, though I knew nothing of it. Over the years many formulations have evolved, some more formal and rigorous, some less so.

De Morgan, Augustus debt markets debt securities deduction Deleuze, Gilles deliciousness: analogy with risk democracy derivative emotions derivatives, financial Derman, Chaim (father) Derman, Emanuel: childhood and youth of education of in England eyesight of four questions of graduate education of moth in refrigerator example and professional background of quantum dream of Derman, Joshua (son) Derman, Sonia (mother) Derman, Sonya (daughter) Descartes, René desires: definition of disappointment and freedom and money and Spinoza’s emotions theory and will and desperation: love and devotion; Spinoza’s emotions theory and diagrams, Feynman diffusion Dirac Equation: analogies and bare and dressed electrons and Dirac wave function and as explanation of reality idea of electrons and impact on physics of intuition and knowledge and matter and metaphors and nature of models and nature of theories and positrons and quantum electrodynamics and Standard Model and as successful theory Dirac, Paul Dirac sea distance: measurement of divergences: electromagnetic theory and diversification domino computer dressed electrons drift Du Fay, Charles “Ducks Ditty” (song) Dyson, Freeman Earth: as magnet earthquakes: probability of economic models See also financial models; specific model Eddington, A. S. Efficient Market Hypothesis. See Efficient Market Model Efficient Market Model (EMM): accuracy of as assumption about human behavior assumptions of Black-Scholes Model and CAPM as extension of as cause of financial crisis conceptual mismatches in development of function of futility of using financial models and hypothesis of ideology and ignoring of complexity by invalidation of results of Law of One Price and as metaphor popularity of price and QED and risk and return in Sharpe Ratio and Spinoza’s emotions theory and stock market crash and as theory or model uncertainty and value and volatility and efficient markets: definition of Einstein, Albert: as bird as Derman role model diffusion model and and Dirac’s work and intuition as making the unconscious conscious on Maxwell and models as gedankenexperiments quanta and relativity theory of electric generator, first electricity See also electromagnetic theory electrochemistry: discovery of electrodynamics: Maxwell’s laws of electromagnetic theory: absolutes and accuracy of Ampère’s contributions to analogies and confirmation of curls and divergences and EMM and Faraday’s contributions to field and function of history of intuition and light and Maxwell’s contributions to and Maxwell’s views about Ampère as metaphor phenomena and as predictor qualities of quantitative laws and Standard model and as success trajectory of discoveries of as triumph of mental over physical waves and electromagnetism.

 

pages: 586 words: 159,901

Wall Street: How It Works And for Whom by Doug Henwood

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accounting loophole / creative accounting, affirmative action, Andrei Shleifer, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, borderless world, Bretton Woods, British Empire, capital asset pricing model, capital controls, central bank independence, corporate governance, correlation coefficient, correlation does not imply causation, credit crunch, currency manipulation / currency intervention, David Ricardo: comparative advantage, debt deflation, declining real wages, deindustrialization, dematerialisation, diversification, diversified portfolio, Donald Trump, equity premium, Eugene Fama: efficient market hypothesis, experimental subject, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, George Akerlof, George Gilder, hiring and firing, Hyman Minsky, implied volatility, index arbitrage, index fund, interest rate swap, Internet Archive, invisible hand, Isaac Newton, joint-stock company, Joseph Schumpeter, kremlinology, labor-force participation, late capitalism, law of one price, liquidationism / Banker’s doctrine / the Treasury view, London Interbank Offered Rate, Louis Bachelier, market bubble, Mexican peso crisis / tequila crisis, microcredit, minimum wage unemployment, moral hazard, mortgage debt, mortgage tax deduction, oil shock, payday loans, pension reform, Plutocrats, plutocrats, price mechanism, price stability, prisoner's dilemma, profit maximization, Ralph Nader, random walk, reserve currency, Richard Thaler, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, shareholder value, short selling, Slavoj Žižek, South Sea Bubble, The Market for Lemons, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, transcontinental railway, women in the workforce, yield curve, zero-coupon bond

Here's one view of why it does, from some conventional economists: To reject the Efficient Market Hypothesis for the whole stock market.. .implies broadly that production decisions based on stock prices will lead to inefficient capital allocations. More generally, if the application of rational expectations theory to the virtually "ideal" conditions provided by the stock market fails, then what confidence can economists have in its application to other areas of economics...? (Marsh and Merton 1986, quoted in Fortune 1991). The answer to the confidence question, as we'll see, is not much. the view from 1970 Perhaps the easiest way to consider the vast literature on market efficiency is to focus on two reviews of the state of the art written by Eugene Fama of the University of Chicago, the first in 1970, when the theory was in high WALL STREET flower, and the second in 1991, when it had taken serious hits.

The same could be said about the stock market; if it really did discipline ineffective managers and reward good ones, then the governance debate would be pretty small beer. But obviously neither the product nor stock markets work as advertised. That means that capital is admitting that corporations must be subject to some kind of outside oversight. If that's the case, then the question becomes oversight by whom, in what form, and in whose interest. Few economists pay much attention to corporations, or how they're owned and run. As Eugene Fama (1991) noted, "many of the corporate-control studies appear in finance journals, but the work goes to the heart of issues in industrial organization, law and economics, and labor economics." He might have added politics and culture, since these too shape and are shaped by big business. Corporate governance is too important a matter to be left to finance theorists. Economists often analyze financial structures, if they look at them at all, in a fairly mechanistic fashion.

There's little room for sentiment, uncertainty, selflessness, and social institutions. Whether this is an accurate picture of the average human is open to question, but there's no question that capitalism as a system and economics as a discipline both reward people who conform to the model.^ After this overture, let's examine three of the most prominent theories that financial economists developed over the years — Tobin's q, the Modigliani-Miller theorem, and the efficient market hypothesis. The first is a theory of how finance influences the real world; the second, a vision of how finance is largely irrelevant to the real world; and the third, a deeply influential story about how markets are wondrous instruments of adjustment and allocation. Like all models, they tried to simplify the world in order to explain it. All are wrong. A footnote: high finance theory is often associated with the political right (the University of Chicago being virtually synonymous with both).

 

pages: 280 words: 79,029

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

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Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, implied volatility, income inequality, index fund, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, loss aversion, margin call, Mark Zuckerberg, McMansion, mortgage debt, mortgage tax deduction, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

His goal is to unlock billions of dollars of funding for early-stage drugs. And to drum up interest, he and others have formulated a provocative question: “Can financial engineering cure cancer?”2 Lo is not an ivory-tower zealot. Well before the financial crisis, he was struck by the failure of the “efficient-market hypothesis” to grapple with the basics of human behavior. The essence of the efficient-markets hypothesis, which was formulated in 1970 by a University of Chicago economist named Eugene Fama, who shared the 2013 Nobel Prize for Economics, is that markets are rational. The hypothesis posits that market prices incorporate all the publicly available information on a given security and that people respond rationally to this information. The desire to make simplifying assumptions is understandable in finance—“Can you imagine how hard physics would be if electrons had feelings?”

The desire to make simplifying assumptions is understandable in finance—“Can you imagine how hard physics would be if electrons had feelings?” is the question Richard Feynman, a physicist, once asked—but this one takes the cake. Humans are not always rational, and markets are swayed by sentiment as much as logic. Instead of the efficient-market hypothesis, Lo champions something called the “adaptive-market hypothesis,” which takes the world as it is rather than as it should be. The AMH accepts that some market behavior is hardwired. Our brains have been programmed by evolution to respond to emotions such as fear and greed. Financial markets are the perfect playground for these emotions, a theater that is dedicated to volatility and risk, to losing and winning. In one study of which parts of the brain become active in response to monetary rewards, volunteers were given a fifty-dollar opening stake and then shown a series of animated wheel-of-fortune spinners that either added to their cash or subtracted from it.

See Credit-default swap Cecchetti, Stephen, 79 Church-tower principle, 207 Cigarettes, as means of payment, 5 Clark, Geoffrey Wilson, 144 Clearinghouse, 39 ClearStreet, 210 Clinical drug trials, indemnification of, xii–xiii Coates, John, 116 Code, simplification of, 63 Cohen, Ronald, 91–95, 97, 106, 108, 112 Coins, history of, 4 Collateral, xiv, 7, 38, 65, 76, 150, 177, 185, 204–206, 215 Collateralized-debt obligations (CDOs), 43, 234–235 Collective Health, 104 College graduates, earning power of, 170–171 Commenda, 7–8, 19 Commercial paper, 185 Commodity Futures Trading Commission, 54 CommonBond, 182, 184, 197 Confusion de Confusiónes (de la Vega), 24 Congressional Budget Office, 99, 169 Consumer Financial Protection Bureau overdraft fees and prepaid cards, concern about, 203–204 report on reverse mortgages, 141 survey on payday borrowing, 200 CoRI, 132 Corporate debt, in United States, 120 Corporate finance, 237–238 Correlation risk, 165 Cortisol and testosterone, effect of on risk appetite and aversion, 116 Counterparty risk, 22 Credit, industrialization of, 206 Credit Card Accountability, Responsibility, and Disclosure (Credit CARD) Act of 2009, 203 Credit cards, 203 Credit-default swap (CDS), 37, 64–65, 75, 124, 169, 238 Credit ratings, 24, 120–121, 233–236 Credit-reporting firms, 24 Credit risk, 200, 201, 237, 238 Credit scores, 47–49, 201, 216–217 Creditworthiness, xiv, 10, 12, 47, 121, 197, 202, 204, 216 Crowdcube, 152–155, 158–159, 162 Damelin, Errol, 208 Dark Ages, banking in, 11 Dark pools, 60 DCs (defined-contribution schemes), 129, 131 DE Shaw, 163 Debit cards, 204 Debt, 6, 7, 70, 149, 164 Decumulation, 138–139 Defined-benefit schemes, 129, 131 Defined-contribution (DC) schemes, 129, 131 Dependent variable, 201 Deposit insurance, 13, 43–44 Derivatives, 3, 9–10, 29–32, 38, 40 Desai, Samir, 189 Development-impact bonds, 103 Diabetes, cost of in United States, 102 Dimensional Fund Advisors, 129 Direct lending, 184 Discounting, 19 Disposition effect, 25 Diversification, 8, 12, 20, 117–119, 196, 236 Doorways to Dreams (D2D), 213–214 Dot-com boom, 148 Dow Jones Industrial Average, 40 Dow Jones Transportation Average, 40 Drug development, investment in, vii-viii, 114–115 Drug-development megafund adaptive market hypothesis and, 115–117 Alzheimer’s disease, 122 credit rating, importance of, 120–121 diversification and, 117, 119–120, 122 drug research, improvement of economics of, 114–115 financial engineering, need for, 119 guarantors for, 121 orphan diseases and, 118–119, 122 reactions to, 118 securitization and, 117–119, 122 Dumb money, comparison of to smart money, 155–158 Dun and Bradstreet, 24 Durbin Amendment (2010), 204 Dutch East India Company (VOC), 14–15, 38 E-Mini contracts, 54–55 Eaglewood Capital, 183–184 Ebola outbreak (2014), mortality rate of, 230 Ebrahimi, Rod, 210–211 Ecology, finance and, 113 Economist 2013 conference, xv on railways, 25 on worth of residential property, 70 Educational equity adverse selection in, 174, 175, 182 CareerConcept, 166 differences in funding rates, 176 enforceability, 177 in Germany, 166 Gu, Paul, 172, 175–176 income-share legislation, US Senate and, 172 information asymmetry, 174 Lumni, 165, 168, 175 Oregon, interest in income-share agreements, 172, 176 Pave, 166–168, 173, 175, 182 peer-to-peer insurance, 182 problems with, 167–168, 173–174 providers and recipients, contact between, 160, 175 risk-based pricing model, 176 student loans, 169–171 Upstart, 166–168, 173, 175, 182 Yale University and, 165 Efficient-market hypothesis, 115 Endogeneity, 239 Epidemiology, finance and, 113 Eqecat, 222 Equity, 7–8, 149–150, 186–187 Equity-crowdfunding in Britain, 154 Crowdcube, 152–155, 158–159, 162 Friendsurance, 182–183 Equity-crowdfunding in Britain (continued) herding, 159–160 social insurance, 182–183 Equity-derivatives contracts, 29 Equity-sharing, 7–8 Equity-to-assets ratio, 186 Eren, Selcuk, 73 Eroom’s law, 114 Essex County Council, 95 Eurobond market, 32 European Bank for Reconstruction and Development, 169 Exceedance-probability curve, 231–232, 232 figure 3 Exxon, 169 Facebook, 174 Fair, Bill, 47 False substitutes, 44 Fama, Eugene, 115 Fannie Mae, 48, 78, 85, 168 Farmer, Doyne, 60, 63 Farynor, Thomas, 16 FCIC (Financial Crisis Inquiry Commission), 50 Federal Deposit Insurance Corporation (FDIC), 186, 200 Federal Reserve Bank of New York, 170, 204, 205 Feynman, Richard, 115 Fibonacci (Leonardo of Pisa), 19 FICO score, 47–49 Films to rent, study of hyperbolic discounting, 133–134 Finance bailouts, 35–36 banks, purpose of, 11–14 collective-action problem in, 62 computerization of, 31–32 democratization of, 26–28 economic growth and, 33–34 fresh ideas, need for, xviii, 38–39, 80, 85–86 globalization and, 30, 225 heuristics, use of in, 45–50 illiteracy, financial, 134–135 importance of, 10 information, importance of, 10–11 inherent failings in, 241 misconceptions about, xiii–xvi panic, consequences of, 44 regulatory activity, results of, 33 risk assessment, 24, 45, 77–78 risk management, 55, 117–118, 123 as solution to real-world problems, 114 standardization, 39–41, 45, 47, 51 unconfirmed trades, backlog of, 64–65 use of catastrophe risk modeling in, 233–239 See also High-frequency trading (HFT); Internet Finance, history of bank, derivation of word, 12 Book of Calculation (Fibonacci), 19 call options, 10 Code of Hammurabi, 8 coins, 4 commodity forms of exchange, 4–5 credit and debt, 5–7 in Dark Ages, 11 democratization, 26–28 deposits, 6 derivatives, 29–32, 38 Dutch East India Company (VOC), 14–15, 38 early financial contracts, 5 early forms of finance, 3 equity contracts, 7–8 fire insurance, 16–17 first futures market, 29, 39–40 forward contracts, 38 in Greece, 11 industrialization and, 3, 27–28 inflation-protected bonds, 26 insurance, 8–10, 16–17, 20–22 interest, origin of, 5 in Italy, 9, 14 life annuities, 20–22 maritime trade and, 7–8, 14, 17, 23 payment, forms of, 4–5 put options, 9–10 railways, effect of on, 23–25 in Roman Empire, 7, 8, 11, 36 securities markets, 14 stock exchanges, 14, 24–25 Finance, innovation in absence of, xvi–xvii credit and debt, 5–7 derivatives, 9–10, 29–32 diffusion, pattern of, 45 drivers of, 22–26 equity, 7–8 importance of, 66, 242–243 insurance, 8–9, 16–17, 20–22 lessons from, 32–34 mathematical insights, 18–20 payment, forms of, 4–5 risks of, 145 stock exchanges, 14–16 Finance and the Good Society (Shiller), 242 Financial Crisis Inquiry Commission (FCIC), 50 Financial crisis of 2007–2008 causes of, xv, 34, 69 effects of, xx–xi future of finance, effect on, 243 mortgage debt, role of in, 69–70 new regulations since, 185, 187 Financial Times, quote from Chuck Prince in, 62 Fire insurance, early, 16–17 Fitch Ratings, 24 Flash Boys (Lewis), 57 Flash crash, 54–56, 63 Florida, hurricane damage in, 223, 225 Florida, new residents per day in, 225 Foenus nauticum, 8 Forward contracts, 38 Forward transactions, 15 France collapse of Mississippi scheme in, 36 eighteenth century life annuities in, 20–21 government spending in, 99 Freddie Mac, 48, 85 Fresno, California, social-impact bond pilot program in, 103–104 Friedman, Milton, 165 Friendsurance, 182–183 Fundamental sellers, 54–55 Funding Circle, 181–182, 189, 197 Futures, 29, 39–40 Galton Board, 17, 18 figure 1 Gaussian copula, 235 Geithner, Timothy, 64–65 Genentech, xii General Motors, bailout of, xi Geneva, Switzerland, annuity pools in, 21–22 Gennaioli, Nicola, 42, 44 Ginnie Mae, 168 Girouard, Dave, 166 Glaeser, Edward, 74 Globalization, finance and, 30, 225 Goldman Sachs, 61, 98, 156, 235 Google Trends, 218 Gorlin, Marc, 218 Government spending, rise in, 99–100 Governments, support for new financial products by, 168–169 Grameen Bank, 203 Greece, forerunners of banks in, 11 Greenspan, Alan, 236 Greenspan consensus, 236 Grillo, Baliano, 9 Gu, Paul, 162–164, 166, 172, 175–176 Guardian Maritime, 151 Haldane, Andy, 188 Halley, Edmund, 19–20 Hamilton, Alexander, 35–36 Hammurabi, Code of, 5, 8 Health conditions, SIB early detection programs for, 102–104 Health-impact bonds, 103–104 Hedge funds, 123, 158, 183 Hedging, 30–31, 54, 124, 129, 131, 156, 206, 227 Heiland, Frank, 73 Herding, 24, 159–160 Herengracht Canal properties, Amsterdam, real price level for, 74 Heuristics, 45–50 HFRX, 157–158 High-frequency trading (HFT) benefits of, 58 code, simplification of, 63 flash crash, 54–56 latency, attempts to lower, 53 pre-HFT era, 59–61 problems with, 56–58, 62–63 Hinrikus, Taavet, 190–191 HIV infection rates, SIB program for reduction of, 103 Holland, tulipmania in, 33, 36 Home equity, 139–140 Home-ownership rates, in United States, 85, 170 Homeless people, SIB program for, 96–97 Housing boom of mid-2000s, 148–149 Human capital contracts, 165, 167, 173–174, 176, 177 defined, 6 as illiquid asset, 177 Hurricane Andrew, effect of on insurers, 223–224, 225 Hurricane Hugo, 223 Hyperbolic discounting, 133–134, 211 IBM, 169 If You Don’t Let Us Dream, We Won’t Let You Sleep (drama), 111 IMF (International Monetary Fund), 125–126 Impact investing, 92 Implied volatility, 116 Impure altruism, 109–110 Income-share agreements, 167, 172–178 Independent variables, 201 Index funds, 40 India, CDS deals in, 37 India, social-impact bonds (SIBs) in, 103 Industrialization, effect of on finance, 3, 27–28 Inflation-protected Treasury bills, 131 Information asymmetry, 174 Innovator’s dilemma, 189 Instiglio, 103 Insurance, 8–10, 16–17, 142, 223–225 Insurance-linked securities, 222 Interbank markets, x Interest, origin of, 5 Interest-rate swaps, 29 International Maritime Bureau Piracy Reporting Centre, 151 International Monetary Fund (IMF), 125–126 International Swaps and Derivatives Association (ISDA), 40 Internet, role of in finance creditworthiness, determination of, 172–173, 202, 218 direct connection of suppliers and consumers, xviii, 32 equity crowdfunding, 152–155 income-share agreements, 172–173 ROSCAs, 210 small business loans, 216 speed and ease of borrowing, 189 student loans, 166–167 Intertemporal exchange, 6 Intuit, 218 Investment grade securities, 121 Ireland, banking crisis in, xiv–xv, 69 Isaac, Earl, 47 ISDA (International Swaps and Derivatives Association), 40 ISDA master agreement, 40 Israel, SIBs in, 97 Italy discrimination against female borrowers in, 208 financial liberalization and, 34 first securities markets in, 14 maritime trade partnerships in, 7–8 J.

 

pages: 515 words: 132,295

Makers and Takers: The Rise of Finance and the Fall of American Business by Rana Foroohar

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3D printing, accounting loophole / creative accounting, additive manufacturing, Airbnb, algorithmic trading, Asian financial crisis, asset allocation, bank run, Basel III, bonus culture, Bretton Woods, British Empire, call centre, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, centralized clearinghouse, clean water, collateralized debt obligation, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, crowdsourcing, David Graeber, deskilling, Detroit bankruptcy, diversification, Double Irish / Dutch Sandwich, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial deregulation, financial intermediation, Frederick Winslow Taylor, George Akerlof, gig economy, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, High speed trading, Home mortgage interest deduction, housing crisis, Howard Rheingold, Hyman Minsky, income inequality, index fund, interest rate derivative, interest rate swap, Internet of things, invisible hand, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, knowledge economy, labor-force participation, labour mobility, London Whale, Long Term Capital Management, manufacturing employment, market design, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, new economy, non-tariff barriers, offshore financial centre, oil shock, passive investing, pensions crisis, Ponzi scheme, principal–agent problem, quantitative easing, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, Rana Plaza, RAND corporation, random walk, rent control, Robert Shiller, Robert Shiller, Ronald Reagan, Second Machine Age, shareholder value, sharing economy, Silicon Valley, Silicon Valley startup, Snapchat, sovereign wealth fund, Steve Jobs, technology bubble, The Chicago School, The Spirit Level, The Wealth of Nations by Adam Smith, Tim Cook: Apple, Tobin tax, too big to fail, trickle-down economics, Tyler Cowen: Great Stagnation, Vanguard fund

The key assumption of the Chicago School, one that Milton Friedman himself upheld devoutly, was that the purpose of the corporation was to maximize financial value. As Friedman famously said back in 1970, “the social responsibility of business is to increase its profits.”33 This went hand in hand with another idea, which was that the share price of a firm always perfectly reflected all known information, and thus stock prices were the best overall measure of corporate value. This idea, known as the “efficient-market hypothesis,” eventually won its creator, another Friedman disciple and Chicago academic, Eugene Fama, the Nobel Prize. Ironically, Fama won it jointly in 2013 with Robert Shiller, a Yale economist whose work basically said the opposite—that markets, and asset values, were influenced by a variety of things (emotions, biases, bad habits, and pure chance) that had little to do with efficiency, and that they didn’t always work well, or predictably.34 The joint prize to the two men, one representing the past and the other the future, expresses as well as anything the existential crisis that has beset the economics profession.

Its ascension eventually led another pair of Chicago-educated academics, Michael Jensen and William Meckling, to develop a management framework that would further reshape both business education and the corporate landscape: agency theory, or the notion that managers should be treated like owners, and paid in stock, to boost corporate performance. It’s a framework that is still front and center in MBA curriculums. Jensen and Meckling were, not surprisingly, disciples of Friedman and Eugene Fama. And ironically, given the damage it would do to any number of firms, their idea was a response to a growing worry, sparked in the 1970s, that American business actually wasn’t really all that healthy at its core. Despite the confidence of the “organization man” and the large, global enterprises that he ran, a series of events—from oil shocks to higher inflation to swift advances into manufacturing being made by emerging economies like China and India—made people fear that the United States was losing ground.

THE FUTURE OF BUSINESS EDUCATION The sense of value, defined only as economic value without higher moral or social purpose, is what most enraged MIT Sloan School professor Andrew Lo when he began investigating the business model of the pharmaceutical industry. Fortunately, as a business school professor himself, he was in a position to do something about it. While most economists still uphold the efficient-market hypothesis, which posits that all available information is reflected in a stock’s price and that investors are rational, Lo believes that markets are less like rule-based physics and more like messy biological systems. In fact, he’s come up with an entirely new way of teaching finance—it’s called the adaptive-markets hypothesis. In Lo’s world, market participants aren’t coldly rational creatures but squirmy, evolving species interacting with one another in a primordial sludge of money.

 

pages: 272 words: 64,626

Eat People: And Other Unapologetic Rules for Game-Changing Entrepreneurs by Andy Kessler

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23andMe, Andy Kessler, bank run, barriers to entry, Berlin Wall, British Empire, business process, California gold rush, carbon footprint, Cass Sunstein, cloud computing, collateralized debt obligation, collective bargaining, computer age, disintermediation, Eugene Fama: efficient market hypothesis, fiat currency, Firefox, Fractional reserve banking, George Gilder, Gordon Gekko, greed is good, income inequality, invisible hand, James Watt: steam engine, Jeff Bezos, job automation, Joseph Schumpeter, knowledge economy, knowledge worker, libertarian paternalism, low skilled workers, Mark Zuckerberg, McMansion, Netflix Prize, packet switching, personalized medicine, pets.com, prediction markets, pre–internet, profit motive, race to the bottom, Richard Thaler, risk tolerance, risk-adjusted returns, Silicon Valley, six sigma, Skype, social graph, Steve Jobs, The Wealth of Nations by Adam Smith, transcontinental railway, transfer pricing, Yogi Berra

Instead, millions of us provide input with our buying and selling decisions. When it’s at its most efficient, with buyers and sellers neatly matched up at the right price, it’s a pretty good predictor. When it’s not, chaos is sure to follow. In effect, the stock market is doing price discovery as well as a game of hot potato, getting stocks into the correct hands with the right risk profile. Eugene Fama, a University of Chicago business school professor, proposed an efficient-market hypothesis back in 1969. Fama suggested that a market in which prices always “fully reflect” available information is called “efficient.” Fama believed that a market that is liquid enough (lots of buyers and sellers meeting in the market and sharing price information) and that can be arbitraged easily (someone can quickly take advantage of price differentials by buying or selling) will be efficient enough so that any information and investor expectations will be quickly reflected in securities prices.

 

pages: 353 words: 81,436

Buying Time: The Delayed Crisis of Democratic Capitalism by Wolfgang Streeck

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banking crisis, Bretton Woods, capital controls, Carmen Reinhart, central bank independence, collective bargaining, corporate governance, David Graeber, deindustrialization, Deng Xiaoping, Eugene Fama: efficient market hypothesis, financial deregulation, financial repression, full employment, Gini coefficient, Growth in a Time of Debt, income inequality, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, labour market flexibility, labour mobility, late capitalism, means of production, moral hazard, Occupy movement, open borders, open economy, Plutonomy: Buying Luxury, Explaining Global Imbalances, profit maximization, risk tolerance, shareholder value, too big to fail, union organizing, winner-take-all economy, Wolfgang Streeck

Tomaskovic-Devy and K. Lin, ‘Income Dynamics, Economic Rents and the Financialization of the US Economy’, American Sociological Review, vol. 76/4, 2011, pp. 538–59. 71 Fig. 1.8 shows four countries where the compensation effect was especially marked. It is worth noting that Sweden too (along with other Scandinavian countries) belongs in this group. 72 Among the main names here are Eugene Fama (father of the ‘efficient market hypothesis’), Merton H. Miller (co-founder of the Modigliani-Miller theorem), Harry Markowitz, Robert Merton, Myron Scholes and Fischer Black. Most have taught at the University of Chicago and appear on the list of winners of the so-called Nobel Prize in economics, awarded by the Swedish central bank (Riksbank). 73 This became clear in summer 2012, during the discussions on an EU ‘rescue package’ for Spanish banks.

 

pages: 339 words: 109,331

The Clash of the Cultures by John C. Bogle

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asset allocation, collateralized debt obligation, corporate governance, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, estate planning, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, Flash crash, Hyman Minsky, income inequality, index fund, interest rate swap, invention of the wheel, market bubble, market clearing, mortgage debt, new economy, Occupy movement, passive investing, Ponzi scheme, principal–agent problem, profit motive, random walk, rent-seeking, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, statistical arbitrage, The Wealth of Nations by Adam Smith, transaction costs, Vanguard fund, William of Occam

It was a marriage made in heaven, strongly supported by the unequivocal data that I had assembled on fund performance relative to the S&P 500 over the previous three decades. Simple Arithmetic: An Unarguable Conclusion Few commentators have recognized that two distinct intellectual ideas formed the foundation for passive investment strategies. Academics and sophisticated students of the markets—“quants,” as they are known today—rely upon the EMH—the Efficient Market Hypothesis, first articulated by University of Chicago Professor Eugene Fama in the mid-1960s. This theory suggests that by reflecting the informed opinion of the mass of investors, stocks are continuously valued at prices that accurately reflect the totality of investor knowledge, and are thus fairly valued. But, as I’ve often noted, we didn’t rely on the EMH as the basis for our conviction. After all, sometimes the markets are highly efficient, sometimes wildly inefficient, and it’s not easy to know the difference.

See also Retirement system design problems with growth in passively managed index funds in simplifying speculative investment options in Delaware Democracy, corporate Derivatives Dimensional Fund Advisors Directors Diversification Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) “Do ETFs Badly Serve Investors?” (Tower and Xie) Domestic equity mutual funds Double-agency society Earnings, managed Econometric techniques “Economic Role of the Investment Company, The” (Bogle) Economics (Samuelson) Economist, The Efficient Market Hypothesis (EMH) Ellis, Charles D. Emerging markets stock funds Employee Retirement Income Security Act (ERISA) Employer, stock of Equity diversification Equity index funds Equity mutual funds. See also Actively managed equity funds assets costs domestic emerging markets expense ratio, average failure of large-cap number of returns small capitalization volatility, increase in Equity ownership, institutional ERISA (Employee Retirement Income Security Act) Essinger, Jesse Estrada, Javier Exchange traded funds (ETFs): assets Economist on future of growth in history of holding periods institutional versus individual investors in managers, leading number of problems with profile focus and selection risk profile of returns as speculation trading volumes traditional index funds versus turnover Vanguard Wall Street Journal listing of Exchange traded notes (ETNs) Executive compensation: average worker’s pay compared to cost of capital and highest increase in ratchet effect reform, progress on reform suggestions as “smoking gun,” tax surcharge on Exile on Wall Street (Mayo) Expectations, investment Expectations market Expenses.

 

pages: 385 words: 111,807

A Pelican Introduction Economics: A User's Guide by Ha-Joon Chang

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Affordable Care Act / Obamacare, Albert Einstein, Asian financial crisis, asset-backed security, bank run, banking crisis, banks create money, Berlin Wall, bilateral investment treaty, borderless world, Bretton Woods, British Empire, call centre, capital controls, central bank independence, collateralized debt obligation, colonial rule, Corn Laws, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deindustrialization, discovery of the americas, Eugene Fama: efficient market hypothesis, eurozone crisis, experimental economics, Fall of the Berlin Wall, falling living standards, financial deregulation, financial innovation, Francis Fukuyama: the end of history, Frederick Winslow Taylor, full employment, George Akerlof, Gini coefficient, global value chain, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, Haber-Bosch Process, happiness index / gross national happiness, high net worth, income inequality, income per capita, interchangeable parts, interest rate swap, inventory management, invisible hand, Isaac Newton, James Watt: steam engine, Johann Wolfgang von Goethe, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, knowledge economy, laissez-faire capitalism, land reform, manufacturing employment, Mark Zuckerberg, market clearing, market fundamentalism, Martin Wolf, means of production, Mexican peso crisis / tequila crisis, Northern Rock, obamacare, offshore financial centre, oil shock, open borders, post-industrial society, precariat, principal–agent problem, profit maximization, profit motive, purchasing power parity, quantitative easing, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, savings glut, Scramble for Africa, shareholder value, Silicon Valley, Simon Kuznets, sovereign wealth fund, spinning jenny, structural adjustment programs, The Great Moderation, The Market for Lemons, The Spirit Level, The Wealth of Nations by Adam Smith, Thorstein Veblen, trade liberalization, transaction costs, transfer pricing, trickle-down economics, Washington Consensus, working-age population, World Values Survey

That is, professional managers may maximize sales rather than profit or may inflate the corporate bureaucracy, as their prestige is positively related to the size of the company they manage (usually measured by sales) and the size of their entourage. This was the kind of practice Gordon Gekko (you’ve met him in Chapter 3) was attacking in Wall Street, when he pointed out the company that he was trying to take over had no less than thirty-three vice presidents, doing God knows what. Many pro-market economists, especially Michael Jensen and Eugene Fama, the 2013 Nobel Economics Prize winner, have suggested that this principal-agent problem can be reduced, if not eliminated, by aligning the interests of the managers more closely to those of the shareholders. They suggested two main approaches. One is making corporate takeover easier (so more Gordon Gekkos, please), so that managers who do not satisfy the shareholders can be easily replaced. The second is paying large parts of managerial salaries in the form of their own companies’ stocks (stock option), so that they are made to look at things more from the shareholder’s point of view.

Information economics explains why asymmetric information – the situation in which one party to a market exchange knows something that the other does not – makes markets malfunction or even cease to exist.7 However, since the 1980s, many Neoclassical economists have also developed theories that go so far as to deny the possibility of market failures, such as the ‘rational expectation’ theory in macroeconomics or the ‘efficient market hypothesis’ in financial economics, basically arguing that people know what they are doing and therefore the government should leave them alone – or, in technical terms, economic agents are rational and therefore market outcomes efficient. At the same time, the government failure argument was advanced, to argue that market failure in itself cannot justify government intervention because governments may fail even more than markets do (more on this in Chapter 11).

The individualist economic model assumes the kind of rationality that no one possesses – Herbert Simon called it ‘Olympian rationality’ or ‘hyper-rationality’. The standard defence is that it does not matter whether a theory’s underlying assumptions are realistic or not, so long as the model predicts events accurately. This kind of defence rings hollow these days, when an economic theory assuming hyper-rationality, known as the Efficient Market Hypothesis (EMH), played a key role in the making of the 2008 global financial crisis by making policy-makers believe that financial markets needed no regulation. The problem is, simply put, that human beings are not very rational – or that they possess only bounded rationality.* The list of non-rational behaviour is endless. We are too easily swayed by instincts and emotion in our decisions – wishful thinking, panic, herd instinct and what not.

 

pages: 576 words: 105,655

Austerity: The History of a Dangerous Idea by Mark Blyth

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accounting loophole / creative accounting, balance sheet recession, bank run, banking crisis, Black Swan, Bretton Woods, capital controls, Carmen Reinhart, Celtic Tiger, central bank independence, centre right, collateralized debt obligation, correlation does not imply causation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, deindustrialization, disintermediation, diversification, en.wikipedia.org, ending welfare as we know it, Eugene Fama: efficient market hypothesis, eurozone crisis, financial repression, fixed income, floating exchange rates, Fractional reserve banking, full employment, German hyperinflation, Gini coefficient, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, interest rate swap, invisible hand, Irish property bubble, Joseph Schumpeter, Kenneth Rogoff, liquidationism / Banker’s doctrine / the Treasury view, Long Term Capital Management, market bubble, market clearing, Martin Wolf, moral hazard, mortgage debt, mortgage tax deduction, Occupy movement, offshore financial centre, paradox of thrift, price stability, quantitative easing, rent-seeking, reserve currency, road to serfdom, savings glut, short selling, structural adjustment programs, The Great Moderation, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, unorthodox policies, value at risk, Washington Consensus

A major reason Keynesianism now became the policy du jour was that governing neoliberal ideas denied that such a crisis was possible in the first place. So when it happened, it was bound to open up room for ideas that said such events were inevitable if you let markets regulate themselves, which is the Keynesian point. It was hard to publicly defend the logic of self-correcting markets when they were so obviously not self-correcting. Indeed, such traditional standard bearers for the neoclassical cause as Eugene Fama, Edward Prescott, and Robert Barro who had previously enjoyed public prominence found themselves confined to the opinion pages of the Wall Street Journal. No one was buying “the price is always right/state bad and market good” story when prices had been shown to be wrong by a few orders of magnitude and the state was bailing out the market. Furthermore, neoclassical policy was entirely focused on avoiding one problem, inflation, and providing one outcome, stable prices.

Agents’ expectations of the future, in new classical language, will be rational, not random, and the price given by the market under such conditions will be the “right” price that corresponds to the true value of the asset in question. Markets are efficient in the aggregate if their individual components are efficient, which they are, by definition. This world was indeed, to echo Dr. Pangloss, the best of all possible worlds. As John Eatwell noted a long time ago, these ideas, formalized as the efficient markets hypothesis (EMH) and the rational expectations hypothesis (RATEX), are just as important politically as they are theoretically, for taken together they hold that free and integrated markets are not merely a good way to organize financial markets, they are the only way. Any other way is pathology. Indeed, you may have noticed in this account that the state, along with the business cycle, booms, slumps, unemployment, and financial regulation, is nowhere to be seen.

Tales of Two Small European Countries,” (Giavazzi), 169, 170, 171, 176, 209–210 Canada fiscal adjustment in, 173 Capitalism, Socialism and Democracy, (Schumpeter), 128, 129 Cassel, Gustav, 191 central banks, independence of, 156–158 certificates of deposit (CDs), 234 Chin, Menzie, 11 China, 55 Chowdhury, Anis, 176 Churchill, Winston, 123 and the gold standard, 189 1929 budget speech, 124 Citigroup, 48 Clinton, Bill, 12 Clinton, Hillary, 218 Cochrane, John, 2, 239 Colander, David, 99 collateralized debt obligations, 28, 234 Congressional Research Group, 242 Considine, John, 208 Coolidge, Calvin, 120 Credit Agricole, 87 credit default swaps, 26, 29, 30 Daimler/Mercedes Benz, 132 Darwin’s Dangerous Idea (Dennett), 159 De Grauwe, Paul, 86 debt inflation, 150 default as a way out of financial crises, 183 mortgage, 41, 42, 44, 50 risk, 24 sovereign, 113, 210, 241 See also credit default swaps (CDSs) deflation, 240, 241 demand-side economics, 127 See also supply-side economics Denmark, 207, 209 as a welfare state, 214 austerity in, 17, 169–170, 170–171, 179 expansion, 205, 206, 209 fiscal adjustment in, 173 Dennett, Daniel Darwin’s Dangerous Idea, 159 derivatives, 27–30 credit default swaps, 27–30 special investment vehicles, 29 See also mortgages; real estate Deutsche Bank, 83 devaluation and hyperinflation, 194 as a way out of financial crises, 75, 173, 208, 213 of currency, 76, 77, 147, 169, 171, 188, 191, 197 Diamond, Peter, 243 disintermediation, 23, 49, 232 Dittman, Wilhelm, 195 Dow Jones Industrial Average, 1, 2–3 Duffy, James, 208 Eatwell, John, 42 Economic and Financial Affairs Council of the European Council of Ministers (ECOFIN), 173, 175, 176 economics Adam Smith, 109 Austrian school of, 31, 144 demand-side, 127 Frieburg school of, 135 Germany’s Historical school of, 143 Keynesian, ix, 39, 54 liberal, 99 London School of, 31, 144 macro, 40 neoclassical, 41 neoliberal, 41, 92 public choice, 166 supply-side, 111 zombie, 10, 234 Economics of the Recovery Program, The, (Schumpeter), 128 Economist, The, 69, 166, 216 efficient markets hypothesis, 42 Eichengreen, Barry, 183, 231 Einaudi, Luigi, 165, 167 Eisenhower, Dwight, 243 Englund, Peter, 211 Estonia austerity in, 18, 103, 179, 216–226, 217 fig. 6.1 Eucken, Walter, 135–136 centrally administered economy, 135–136 transaction economy, 135–136 Euro, 74–75, 77 success or failure of, 78–81, 87–93 European banks austerity and, 87 fall of, 84–87 “too big to bail”, 6, 16 European Bond Market, 1 European Central Bank, 54, 55, 84 and austerity, 60, 122 and bailouts, 71–73 and loans to Ireland, 235 and the success of the REBLL states, 216 emergency liquidity assistance program, 4 limitations of, 87–93 long-term refinancing operation, 4, 86 Monthly Bulletin, June 2010, 176 See also Trichet, Jean Claude European Commission, 122 and austerity, 221 and loans to Ireland, 235 and the success of the REBLL states, 216 European Economic Community, 62–64 European Exchange Rate Mechanism, 77 European Union and austerity, 221 and bailouts, 71–73, 208, 221 influence on Europe, 74–75 Eurozone and current economic conditions, 213 current account imbalances, 78 fig. 3.1 ten-year government bond yields, 80 fig. 3.2 exchange-traded funds (ETFs), 234 Fama, Eugene, 55 Fannie Mae, 121 Farrell, Henry, 55 Federal Deposit Insurance Corporation (FDIC), 24 Feldstein, Martin, 55, 78 Ferguson, Niall, 72 Figaro, Le, 201 financial repression, 241 Financial Stability Board, 49 Financial Times, 60 Fisher, Irving, 150 Fitch Ratings, 238 Flandin, Pierre-Étienne, 202 fractional reserve banking, 110 France, 4 and Germany’s nonpayment of Versailles treaty debt, 57 and John Law, 114 and the gold standard, 185, 204 assets of large banks in, 6 austerity in, 17, 126, 178–180 and the global economy in the 1920s and 1930s, 184–189 bond rates in, 6 depression in, 201–202 Eurozone Current Account Imbalances, 78 fig. 3.1 Eurozone Ten-Year Government Bond Yields, 80 fig. 3.2 war debts to the United States, 185 See also Blum, Leon; Flandin, Pierre-Étienne; Laval, Pierre; Poincaré, Raymond Freddie Mac, 121 free option, 29 Freiberg school of economics, 135, 136, 138–139 Frieden, Jeffry, 11 Friedman, Milton, 103, 155, 156, 165, 173 G20 2010 meeting in Toronto, 59–62 Gates, Bill, 7, 8, 13 Gaussian distribution, 33, 34 General Theory (Keynes), 126, 127, 145 Gerber, David, 136 Germany, 2, 16 and repayment war damage in France, 200–201 and the gold standard, 185 and the Treaty of Versailles, 185 as an economic leader, 75–78 austerity in, 17, 25, 57, 59, 101–103, 132–134 and the global economy in the 1920s and 1930s, 178–180, 184–189, 186, 193–197 Bismarkian patriarchal welfare state, 137 Bundesbank, 54, 156, 172, 173 capital drain after World War I, 186 Center Party, 194 Christian Democrats, 137, 139 competition, 137–138 economic ideology of, 56–58, 59–60 entrance into world economy, 134–135 Eurozone Current Account Imbalances, 78 fig. 3.1 Eurozone Ten-Year Government Bond Yields, 80 fig. 3.2 fiscal prudence of, 2, 17, 54 founder’s crisis, 134 German Council of Economic Advisors Report, 169 gold standard and, 196 Historical school of economics, 143 hyperinflation in the 1920s, 56–57, 185, 194, 200, 204 industry in, 132–134 See also BASF, Daimler/Mercedes Benz, Krups, Siemens, ThyssenKrupp ordoliberalism in, 101, 131, 133 origins of, 135–137 order-based policy, 136 National Socialists, 194–195 Nazi period in, 136, 196 Social Democratic Party, 140, 194, 195, 204 social market economy, 139 Stability and Growth Pact, 92, 141 stimulus in, 55–56 See also Freiburg school of economics stop in capital flow from United States in 1929, 190, 194 unemployment in, 196 WTB plan, 195, 196 Giavazzi, Francesco, 179, 205, 206 “Can Severe Fiscal Contractions be Expansionary?

 

pages: 467 words: 154,960

Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael W. Covel

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Albert Einstein, asset allocation, Atul Gawande, backtesting, Bernie Madoff, Black Swan, buy low sell high, capital asset pricing model, Clayton Christensen, commodity trading advisor, correlation coefficient, Daniel Kahneman / Amos Tversky, delayed gratification, deliberate practice, diversification, diversified portfolio, Elliott wave, Emanuel Derman, Eugene Fama: efficient market hypothesis, fiat currency, fixed income, game design, hindsight bias, housing crisis, index fund, Isaac Newton, John Nash: game theory, linear programming, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, mental accounting, Nash equilibrium, new economy, Nick Leeson, Ponzi scheme, prediction markets, random walk, Renaissance Technologies, Richard Feynman, Richard Feynman, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, systematic trading, the scientific method, Thomas L Friedman, too big to fail, transaction costs, upwardly mobile, value at risk, Vanguard fund, volatility arbitrage, William of Occam

26 To understand the LTCM fiasco, we first need to take a quick look at the foundations of modern finance. Merton Miller and his colleague Eugene F. Fama, two scholars at the University of Chicago, launched what became known as the Efficient Market Hypothesis: “The premise of the hypothesis is that stock prices are always right; therefore, no one can divine the market’s future direction, which in turn, must be ‘random.’ For prices to be right, of course, the people who set them must be both rational and well informed.”27 In other words, Miller and Fama believed that perfectly rational people would never pay more or less than any financial instrument was actually worth. A fervent supporter of the Efficient Markets Hypothesis, Myron Scholes was certain that markets could not make mistakes. His associate, Robert Merton, took it a step further with his continuous-time finance theory, which essentially wrapped the finance universe into a supposed tidy ball.28 Chapter 4 • Big Events, Crashes, and Panics 153 Merton’s markets were as smooth as well brewed java, in which prices would flow like cream.

As a result of the book’s success, I soon found myself point person for trend following. With each forecast of trend following doom and gloom, usually in the form of book review, column, or interview, I would “set the record straight.” I’d usually start by addressing the assumption that generates much of the confusion in the first place—the efficient market hypothesis. The hypothesis essentially says that you can’t find an edge to beat the market, and simply sticking with a benchmark or index is the best path to take for profit (believe that still after 2008?). Proponents of the efficient market hypothesis argue that because markets are efficient and prices fully reflect all information, traders who consistently outperform the market do so out of luck, not skill. Of course, in the real world, markets are both efficient and inefficient, some more than others. In the real world, there are traders who do beat the market by a wide margin, and many of them are trend followers.

In hindsight, the old-guard Chicago professors were clearly aware of the problem as Nobel Laureate Professor Merton Miller pondered: “Models that they were using, not just Black-Scholes models, but other kinds of models, were based on normal behavior in the markets and when the behavior got wild, no models were able to put up with it.”35 If only the principals at LTCM had remembered Albert Einstein’s quote that elegance was for tailors, part of his observation Chapter 4 • Big Events, Crashes, and Panics 155 about how beautiful formulas could pose problems in the real world. LTCM had the beautiful formulas; they were just not for the real world. Eugene Fama, Scholes’ thesis advisor, had long held deep reservations about his student’s options pricing model: “If the population of price changes is strictly normal [distribution], on the average for any stock…an observation more than five standard deviations from the mean should be observed about once every 7,000 years. In fact, such observations seem to occur about once every three to four years.”36 LTCM lost 44% of its capital, or $1.9 billion, in August 1998 alone.

 

pages: 478 words: 126,416

Other People's Money: Masters of the Universe or Servants of the People? by John Kay

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Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, corporate governance, Credit Default Swap, cross-subsidies, dematerialisation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial innovation, financial intermediation, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Goldman Sachs: Vampire Squid, Growth in a Time of Debt, income inequality, index fund, inflation targeting, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, London Whale, Long Term Capital Management, loose coupling, low cost carrier, M-Pesa, market design, millennium bug, mittelstand, moral hazard, mortgage debt, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, regulatory arbitrage, Renaissance Technologies, rent control, Richard Feynman, risk tolerance, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, Schrödinger's Cat, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, Washington Consensus, We are the 99%, Yom Kippur War

That consequence is critical to an understanding of how financial markets operate today. The models that have been developed in financial economics are wide-ranging, and often technically ingenious. They include the Markowitz model of portfolio allocation (to which Greenspan referred) and the Black–Scholes model (the derivative pricing model to which he alluded). The key components of academic financial theory, however, are the ‘efficient market hypothesis’ (EMH), for which Eugene Fama won the Nobel Prize in 2013, and the Capital Asset Pricing Model (CAPM), for which William Sharpe won the Nobel Prize in 1990. Sharpe shared that prize with Markowitz, and Myron Scholes received a Nobel Prize in 1997, just before the famous blow-up of Long-Term Capital Management, in which Scholes was a partner; Black had died in 1995. All of these financial economists have affiliations to the University of Chicago.

The legendary investor Warren Buffett presented the best summary critique of the efficient market hypothesis: ‘Observing correctly that the market was frequently efficient, they [academics, investment professionals and corporate managers] went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.’27 Or, in Buffett’s case, a $50 billion fortune. EMH is based on an assumption – widely used in economic analysis – that all available profit opportunities, in securities markets and in business, have been taken. In finance and business, most available profit opportunities have been taken. But trading in financial markets, and innovation in business, are directed to the search for profit opportunities that have not been taken. The efficient market hypothesis at once captures an important aspect of reality – the absence of easy profits – and neglects an equally fundamental one: that the search for profits that are not easy is the dynamic of a capitalist system.

The efficient market hypothesis at once captures an important aspect of reality – the absence of easy profits – and neglects an equally fundamental one: that the search for profits that are not easy is the dynamic of a capitalist system. Henry Ford, Walt Disney and Steve Jobs were not attempting to exploit arbitrage opportunities but trying to change the world (as were many less successful entrepreneurs). The wise investor will think twice before rejecting the efficient market hypothesis. Yet the volume of trading we observe in securities markets today would be wholly inexplicable if the hypothesis that all information relevant to security valuation is already in the price were true. There is a logical contradiction at the heart of EMH. If all information were already in the price, what incentive would there be to gather such information in the first place? The capital asset pricing model takes the logic of EMH a stage further.

 

pages: 431 words: 132,416

No One Would Listen: A True Financial Thriller by Harry Markopolos

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backtesting, barriers to entry, Bernie Madoff, call centre, centralized clearinghouse, correlation coefficient, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, family office, fixed income, forensic accounting, high net worth, index card, Long Term Capital Management, Louis Bachelier, offshore financial centre, Ponzi scheme, price mechanism, quantitative trading / quantitative finance, regulatory arbitrage, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, statistical arbitrage, too big to fail, transaction costs

That’s what made him so valuable when we began to analyze Madoff’s numbers. Math came naturally to Neil. Like me, maybe even more than me, he could glance at numbers and draw meaningful conclusions from them. At Bentley College, he played a lot of poker, ran a small bookie operation, and came to believe firmly in the efficient markets hypothesis. Believing that concept was where Neil and I differed most. The efficient markets hypothesis, which was first suggested by French mathematician Louis Bachelier in 1900 and was applied to the modern financial markets by Professor Eugene Fama at the University of Chicago in 1965, claims that if all information is simultaneously and freely available to everyone in the market, no one can have an edge. In this hypothesis having an edge means that for all intents and purposes you have accurate information that your competitors don’t have.

I taught him that ignorance begins where knowledge ends, so to be successful he needed to be a gatherer and a hoarder of information. These were the tools we depended on throughout our investigation. When Neil returned to college in the fall of 1992 to earn credit for his work as an intern, he had to write a paper. This will tell you what you need to know about Neil: The paper he wrote criticized the basic investment strategy we used at Rampart because it violated the efficient markets hypothesis. Three years later, after working in various jobs at several different types of investment companies, Neil returned to Rampart. Initially he was hired to upgrade our accounting system, with the unspoken hope that eventually it might become something more. For several months Neil ran two accounting systems—our legacy system and the new system—in parallel, and reconciled everything to the penny.

The SEC, which is supposedly an independent and nonpolitical agency, was created to regulate the entire securities industry. The goal was to level the playing field, to ensure that anyone who wanted to buy or sell securities had access to the same information as everyone else, that they had all the information they needed to make intelligent decisions. As the SEC explains on its web site, its current mission is to “protect investors, [and] maintain fair, orderly, and efficient markets.” The efficient markets hypothesis, which Neil even now continues to believe in, theorizes—very basically—that as long as all market information is simultaneously and freely available to everyone, no one can have an edge. And that is completely dependent on the ability of the SEC to do its job. Through the years, though, the SEC had gained a completely undeserved reputation as the agency that effectively policed the financial markets, allowing people to believe that their interests were being protected.

 

pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

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algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, mortgage debt, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

The book shows how finance theory can be translated into trading ideas and how trading results can be translated into finance theory. I. EFFICIENTLY INEFFICIENT MARKETS To search for trading strategies that consistently make money over time, we need to understand the markets where securities are traded. The fundamental question concerning financial markets is whether they are efficient, a question that remains hotly debated. For instance, the Nobel Prize in economics in 2013 was awarded jointly to Eugene Fama, the father and defender of efficient markets, Robert Shiller, the father of behavioral economics, and Lars Hansen, who developed tests of market efficiency.2 As seen in Overview Table I, an efficient market, as defined by Fama, is one where market prices reflect all relevant information. In other words, the market price always equals the fundamental value and, as soon as news comes out, prices immediately react to fully reflect the new information.

Ainslie III of Maverick Capital 108 Chapter 8 Dedicated Short Bias 115 Interview with James Chanos of Kynikos Associates 127 Chapter 9 Quantitative Equity Investing 133 Interview with Cliff Asness of AQR Capital Management 158 Part III Asset Allocation and Macro Strategies 165 Chapter 10 Introduction to Asset Allocation: The Returns to the Major Asset Classes 167 Chapter 11 Global Macro Investing 184 Interview with George Soros of Soros Fund Management 204 Chapter 12 Managed Futures: Trend-Following Investing 208 Interview with David Harding of Winton Capital Management 225 Part IV Arbitrage Strategies 231 Chapter 13 Introduction to Arbitrage Pricing and Trading 233 Chapter 14 Fixed-Income Arbitrage 241 Interview with Nobel Laureate Myron Scholes 262 Chapter 15 Convertible Bond Arbitrage 269 Interview with Ken Griffin of Citadel 286 Chapter 16 Event-Driven Investments 291 Interview with John A. Paulson of Paulson & Co. 313 References 323 Index 331 The Main Themes in Three Simple Tables OVERVIEW TABLE I. EFFICIENTLY INEFFICIENT MARKETS Market Efficiency Investment Implications Efficient Market Hypothesis: Passive investing: The idea that all prices reflect all relevant information at all times. If prices reflect all information, efforts to beat the market are in vain. Investors paying fees for active management can expect to underperform by the amount of the fee. However, if no one tried to beat the market, who would make the market efficient? Inefficient Market: Active investing: The idea that market prices are significantly influenced by investor irrationality and behavioral biases.

Soros has developed a theory of boom/bust cycles and reflexivity, as he describes in the following excerpt from a recent lecture.5 Let me state the two cardinal principles of my conceptual framework as it applies to the financial markets. First, market prices always distort the underlying fundamentals. The degree of distortion may range from the negligible to the significant. This is in direct contradiction to the efficient market hypothesis, which maintains that market prices accurately reflect all the available information. Second, instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the so-called fundamentals they are supposed to reflect. There are various pathways by which the mispricing of financial assets can affect the so-called fundamentals.

 

pages: 483 words: 141,836

Red-Blooded Risk: The Secret History of Wall Street by Aaron Brown, Eric Kim

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Albert Einstein, algorithmic trading, Asian financial crisis, Atul Gawande, backtesting, Basel III, Benoit Mandelbrot, Bernie Madoff, Black Swan, capital asset pricing model, central bank independence, Checklist Manifesto, corporate governance, credit crunch, Credit Default Swap, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, experimental subject, financial innovation, illegal immigration, implied volatility, index fund, Long Term Capital Management, loss aversion, margin call, market clearing, market fundamentalism, market microstructure, money: store of value / unit of account / medium of exchange, moral hazard, natural language processing, open economy, pre–internet, quantitative trading / quantitative finance, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, special drawing rights, statistical arbitrage, stochastic volatility, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve

See Bayesians/Bayesian concepts; Frequency vs. degree of belief Demon of Our Own Design, A, (Bookstaber) Derivatives/derivative money: capital creation and clearinghouses definition derivative money energy sector and exposure from derivatives liquidity and as the new money numeraire and spread trade and as store of value Derivatives Models on Models (Haug) Derman, Emanuel Desrosières, Alain Dexter, Andrew Diogenes Disintermediation Dissertation (Brown) Dorner, Dietrich Drobny, Steven Druckenmiller, Stanley Duffie, Darrell Earle, Timothy Economic Function of Futures Markets, The (Williams) Economics of Risk and Time, The (Gollier) Econophysics Education of a Speculator, The (Niederhoffer) Efficient markets hypothesis (EMH) Efficient markets theory: empirical evidence equilibrium price and father of efficient markets generally market inefficiencies and misrepresentations and myth about Efron, Brad Eichengreen, Barry Einhorn, David Eisenhower, Dwight Emergence of Probability, The (Hacking) EMH. See Efficient markets hypothesis (EMH) Energy industry Engle, Rob Equilibrium eRaider.com Errors/error rates ETFs. See Exchange-traded funds (ETFs) Evans, Dylan Evolution EWMA. See Exponentially weighted moving average (EWMA) Exchange Exchange Artist, The (Kamensky) Exchange-traded funds (ETFs) Exorbitant Privilege (Eichengreen) Expected Returns (Ilmanen) Expected value Exploratory Data Analysis (Tukey) Exploring General Equilibrium (Black) Exponentially weighted moving average (EWMA) Exponentials.

If you look for ideas that worked well in the past, you also lose. There is an infinite number of rules that would have worked in the past, because there is an infinite number of potential rules. You can always find lots that seem to work great—it’s called data mining. Finding ideas that will work in the future requires theory. Efficiency versus Equilibrium A crucial point in interpreting tests of efficient markets theory was described by Eugene Fama, known as the father of efficient markets: “Every test of market efficiency is a joint test of market efficiency and market equilibrium.” In simpler words, you can’t test whether the market is doing what it is supposed to do without first specifying what it is supposed to do. That’s true for testing markets, but not for exploiting markets. Suppose you see something sell at $80 that you think should be worth $100.

The managers might proceed bottom-up and look mostly for investments with better-than-average expected returns rather than investments with the right correlations, and they might have no idea what their portfolio standard deviation or time horizon was, but judging managers on the ratio of return to standard deviation seemed reasonable. A manager in the 1950s might have agreed that MPT was a decent simplified model of portfolio construction, and Markowitz did market it as a product with some limited success. No one thought they were IGT investors, and until Ed Thorp, no one tried to market an IGT product. The next advance in real-world finance was the efficient markets hypothesis (EMH). This held that all securities were priced fairly—that you shouldn’t be able to build two portfolios out of public securities such that one consistently outperforms the other after adjusting for risk. In the IGT world, there’s no clear meaning to fair price. The parallel hypothesis in IGT is that capital is allocated to securities properly. In MPT EMH, if some good news comes out about a security, investors will buy it until its price goes up to the correct new value.

 

pages: 823 words: 220,581

Debunking Economics - Revised, Expanded and Integrated Edition: The Naked Emperor Dethroned? by Steve Keen

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accounting loophole / creative accounting, banking crisis, banks create money, barriers to entry, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, butterfly effect, capital asset pricing model, cellular automata, central bank independence, citizen journalism, clockwork universe, collective bargaining, complexity theory, correlation coefficient, credit crunch, David Ricardo: comparative advantage, debt deflation, diversification, double entry bookkeeping, en.wikipedia.org, Eugene Fama: efficient market hypothesis, experimental subject, Financial Instability Hypothesis, Fractional reserve banking, full employment, Henri Poincaré, housing crisis, Hyman Minsky, income inequality, invisible hand, iterative process, John von Neumann, laissez-faire capitalism, liquidity trap, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market clearing, market microstructure, means of production, minimum wage unemployment, open economy, place-making, Ponzi scheme, profit maximization, quantitative easing, RAND corporation, random walk, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Coase, Schrödinger's Cat, scientific mainstream, seigniorage, six sigma, South Sea Bubble, stochastic process, The Great Moderation, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, total factor productivity, tulip mania, wage slave

These waves can just as easily break – though long after any rational calculation might suggest that they should – when it becomes clear that the wave has carried valuations far past a level which is sustainable by corporate earnings. Addendum: Fama overboard Eugene Fama and his collaborator Kenneth French played a key role in promoting the efficient markets hypothesis, right from Fama’s first major paper while still a PhD student, in which he stated that: ‘For the purposes of most investors the efficient markets model seems a good first (and second) approximation to reality. In short, the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse’ (Fama 1970: 416). Since then, Fama has become almost synonymous with the efficient markets hypothesis – he, rather than Sharpe, is the author referred to as the originator of the hypothesis in most textbooks on finance.

While some fudging has been allowed to make membership possible in the first place, when an economic crisis eventually strikes, Europe’s governments may be compelled to impose austerity upon economies which will be in desperate need of a stimulus (ibid.: 212–13). The Efficient Markets Hypothesis encouraging debt-financed speculation [According to the Efficient Markets Hypothesis] The trading profile of the stock market should therefore be like that of an almost extinct volcano. Instead, even back in the 1960s when this [Sharpe] paper was written, the stock market behaved like a very active volcano. It has become even more so since, and in 1987 it did a reasonable, though short-lived, impression of Krakatau. In 2000, we saw 25 percent movements in a week. October 2000 lived up to the justified reputation of that month during bull markets; heaven only knows how severe the volatility will be when the bubble finally bursts (ibid.: 232). What can I say? By promulgating the efficient markets hypothesis, which is predicated on each investor having the foresight of Nostradamus, economic theory has encouraged the world to play a dangerous game of stock market speculation.

Partly for this reason, his thesis was received poorly by the economics profession, and his insights were swamped by the rapid adoption of Hicks’s IS-LM analysis after the publication of Keynes’s General Theory.9 After the Great Depression, economists continued to cite his pre-Crash work on finance, while his debt-deflation theory was largely ignored.10 As a result, the antipathy he saw between the formal concept of equilibrium and the actual performance of asset markets was also ignored. Equilibrium once again became the defining feature of the economic analysis of finance. This process reached its zenith with the development of what is known as the ‘efficient markets hypothesis.’ The efficient markets hypothesis Non-economists often surmise that the term ‘efficient’ refers to the speed at which operations take place on the stock market, and/or the cost per transaction. Since the former has risen and the latter fallen dramatically with computers, the proposition that the stock market is efficient appears sensible. Market efficiency is often alleged to mean that ‘investors are assumed to make efficient use of all available information,’ which also seems quite reasonable.

 

pages: 475 words: 155,554

The Default Line: The Inside Story of People, Banks and Entire Nations on the Edge by Faisal Islam

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Asian financial crisis, asset-backed security, balance sheet recession, bank run, banking crisis, Basel III, Ben Bernanke: helicopter money, Berlin Wall, Big bang: deregulation of the City of London, British Empire, capital controls, carbon footprint, Celtic Tiger, central bank independence, centre right, collapse of Lehman Brothers, credit crunch, Credit Default Swap, crony capitalism, dark matter, deindustrialization, Deng Xiaoping, disintermediation, energy security, Eugene Fama: efficient market hypothesis, eurozone crisis, financial deregulation, financial innovation, financial repression, floating exchange rates, forensic accounting, forward guidance, full employment, ghettoisation, global rebalancing, global reserve currency, hiring and firing, inflation targeting, Irish property bubble, Just-in-time delivery, labour market flexibility, London Whale, Long Term Capital Management, margin call, market clearing, megacity, Mikhail Gorbachev, mini-job, mittelstand, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, North Sea oil, Northern Rock, offshore financial centre, open economy, paradox of thrift, pension reform, price mechanism, price stability, profit motive, quantitative easing, quantitative trading / quantitative finance, race to the bottom, regulatory arbitrage, reserve currency, reshoring, rising living standards, Ronald Reagan, savings glut, shareholder value, sovereign wealth fund, The Chicago School, the payments system, too big to fail, trade route, transaction costs, two tier labour market, unorthodox policies, uranium enrichment, urban planning, value at risk, working-age population

‘Milton Friedman was right about some things, wrong about others, but maybe we should all apologise for not grasping the fragile nature of the banking system.’ Would Friedman be turning in his grave? Lucas pointed out that he would have backed a more tightly regulated banking system with ‘100 per cent reserves’. He defended the ‘efficient markets hypothesis’, the intellectual basis of pre-crisis financialisation, as ‘a law of nature’, but conceded his colleague Eugene Fama might have been wrong in naming it ‘efficient’. So there was a sliver of self-doubt. Three years on, and Elkhart was back on its feet. Un-employment had fallen from 20 to 8 per cent. Jewellers who in 2009 had been tempting residents to pawn their gold teeth were now back to selling engagement rings. The RV factories were again churning out their behemoths of the road, and some of them were employing as many workers as they had pre-crisis.

The Rock was offering returns above Libor (the inter-bank lending rate), at a time when the interest rate on US credit cards was below Libor. Amazingly, in November 2006, on behalf of the mortgage-seekers of Britain, the Northern Rock roadshow reached Africa. Scarce African liquidity, which could have funded local infrastructure, was instead diverted into Northern Rock to fund instant negative-equity mortgages at the very top of the UK housing bubble. For half a century the ‘efficient markets hypothesis’ conquered all in financial thinking. Of the many refutations of the hypothesis since the crisis, this African investment in Northern Rock stands out as one of the most egregious examples. Northern Rock did not itself slice up all the risk into CDOs. The Rock’s methods were relatively simple. It did, however, pioneer relentless attempts to reduce the capital set aside to underpin their offshored mortgages.

 

pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

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Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, New Journalism, oil shock, p-value, passive investing, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond

Vayanos–Woolley (2010) show that delegated asset management can cause momentum patterns. As investors (principals) try to learn about a manager’s (agent’s) skill from his past performance and effectively chase returns, the resulting fund flows push prices away from fair values, inducing short-term momentum and long-term reversal patterns. 5.3 DETOUR: A BRIEF SURVEY OF THE EFFICIENT MARKETS HYPOTHESIS Before turning to behavioral finance, it is appropriate to briefly survey the efficient markets hypothesis (EMH). The classic statement from Fama (1970) is that markets are informationally efficient if “prices reflect all available information”. The EMH is also closely tied to the assumption of investor rationality. The main practical implication of the EMH is investors’ inability to consistently beat the market. Why? Competition among many profit-seeking agents eliminates any easy pickings.

Index AAA/AA/A-rated bonds absolute valuation academic investors active investing active risk puzzle (Litterman) active strategies adaptive markets hypothesis (Lo) advisors, CTAs agriculture alpha—beta barbell alpha—beta separation alphas CAPM currency carry hedge funds long horizon investors portable alpha alternative assets assets list commodities hedge funds liquidity momentum strategies PE funds premia real estate risk factors alternative betas AM see arithmetic mean ambiguity aversion Amihud, Yakov announcement days arbitrage behavioral finance CRP front-end trading equity value strategies term structure models Argentina arithmetic mean (AM) art investing asset classes 1990—2009 alternative assets “bad times” performance currency carry derivatives foreign exchange forward-looking indicators growth sensitivities historical returns inflation long history momentum strategies performance 1990—2009 profitable strategies risk factors style diversification traditional trend following understanding returns value strategies volatility selling world wealth assets 1968—2007 asset richening AUM Berk—Green management model cyclical variation empirical “horse races” ERPC feedback loops forward-looking measures growth illiquidity liquidity long-horizon investors market relations multiple asset classes prices/pricing privately held real assets risky assets seasonal regularities survey-based returns tactical forecasting tail risks time-varying illiquidity premia volatility see also asset classes assets under management (AUM) asymmetric information asymmetric returns asymmetric risk at-the-money (ATM) options seasonal regularities tail risks volatility selling attention bias AUM see assets under management BAB see betting against beta backfill bias backwardation “bad times” carry strategies catastrophes crashes crises inflation rare disasters bank credibility Bank of England Barcap Index BBB-rated bonds behavioral finance applications arbitrage biases cross-sectional trading heuristics historical aspects macro-inefficiencies micro-inefficiencies momentum over/underreaction preferences prospect theory psychology rational learning reversal effects speculative bubbles value stocks BEI see break-even inflation benchmarks, view-based expected returns Berk—Green asset management model Bernstein, Peter betas alpha—beta barbell BAB currency carry equity hedge funds long-horizon investors risk time-varying betting against beta (BAB) biases attention behavioral finance confirmation conservatism currency carry downgrading extrapolation forward rate hedge funds heuristic simplifications high equity premium hindsight historical returns learning limits memory momentum overconfidence overfitting overoptimism reporting representativeness reversal tendencies self-attribution self-deception survey data terminology volatility selling binary timing model Black—Litterman optimizers Black—Scholes (BS) option-pricing formula Black—Scholes—Merton (BSM) world blind men and elephant poem (Saxe) bond risk premium (BRP) approximate identities bond yield business cycles covariance risk cyclical factors decomposed-year Treasury yield drivers ex ante measures historical returns inflation interpreting BRP IRP macro-finance models nominal bonds realized/excess return safe haven premium supply—demand survey-based returns tactical forecasting targets terminology theories YC bonds AAA/AA/A-rated balanced portfolios BBB-rated credit spreads ERPB government historical records HY bonds IG bonds inflation-linked long-term nominal non-government relative valuation stock—bond correlation top-rated yields see also bond risk premium; corporate bonds booms break-even inflation (BEI) Bretton Woods system BRIC countries BRP see bond risk premium BSM see Black—Scholes—Merton bubbles absolute valuation memory bias money illusion real estate Shiller’s four elements speculative Buffet, Warren building block approach business cycles asset returns economic regime analysis ex ante indicators realized returns buybacks B-S see Black—Scholes option-pricing formula C-P BRP see Cochrane—Piazzesi BRP forward rate curve calls seasonal regularities tail risks volatility selling Campbell, John Campbell—Cochrane habit formation model Capital Asset Pricing Model (CAPM) alphas carry strategies Consumption CAPM covariance with “bad times” disagreement models ERP Intertemporal CAPM liquidity-adjusted market frictions market price equation multiple risk factors risk factors risk-adjusted returns risk-based models skewness stock—bond correlation supply—demand volatility Capital Ideas (Bernstein) capitalism capitalization (cap) rate CAPM see Capital Asset Pricing Model carry strategies 1990—2009 active investing asset classes business cycles credit carry currency ERP financing rates foreign exchange forward-looking indicators forward-looking measures generic proxy role historical returns long-horizon investors non-zero yield spreads real asset investing roll Sharpe ratios 2008 slide tactical forecasting cash, ERPC cash flow catastrophes see also “bad times” CAY see consumption/wealth ratio CCW see covered call writing CDOs see collateralized debt obligations CDSs see credit default swaps central banks Chen three-factor stock returns model China Citi (Il—)Liquidity indices Cochrane—Piazzesi BRP (C-P BRP) forward rate curve see also Campbell—Cochrane collateral return collateralized debt obligations (CDOs) comfortable approaches commodities characteristics equity value strategies excess returns expected returns expected risk premia futures historical returns inflation momentum return decomposition returns 1984—2009 supply—demand seasonals term structure trading advisors value indicators commodity momentum performance rational stories simple strategies trend following tweaks when it works well why it works see also momentum strategies commodity trading advisors (CTAs) composite ranking cross-asset selection models compound returns conditioners confirmation bias conservatism constant expected returns constant relative risk aversion (CRRA) Consumption CAPM consumption/wealth ratio (CAY) contemporaneous correlation contrarian strategies blunders feedback loops forward indication approach see also reversal convenience yield corporate bonds credit spreads CRP forward-looking indicators front-end trading IG bonds liquidity sample-specific valuation tactical forecasting correlation asset returns correlation premium correlation risk default correlations equities implied risk factors tail risks costs control currency carry enhancing returns taxes trading costs country-specific vulnerability indices covariance with “bad times” covariance risk risk factors covered call writing (CCW) crashes markets see also “bad times” credit default swaps (CDSs) credit-pricing models credit risk credit risk premium (CRP) analytical models attractive opportunities business cycles credit default swaps credit spreads decomposing credit spread default correlations emerging markets debt front-end trading historical excess returns IG bonds low ex post premia mortgage-backed securities non-government debt portfolio risk reduced-form credit-pricing models reward—risk single-name risk swap—Treasury spreads tactical forecasting terminology theory credit spreads AAA/AA/A-rated bonds BBB-rated bonds business cycles CRP cyclical effects decomposition empirical “horse races” forward-looking indicators high-yield bonds rolling yield top-rated bonds volatility yield-level dependence credit and tactical forecasting creditworthiness crises 2007—2008 crisis currency carry liquidity money markets see also “bad times” cross-asset selection forecasting models cross-sectional market relations cross-sectional trading CRP see credit risk premium CRRA see constant relative risk aversion CTAs see commodity trading advisors currency base of returns carry empirical “horse races” equity value strategies inflation see also foreign exchange currency carry baseline variants combining carry conditioners costs diversification emerging markets ex ante opportunity financial crashes foreign exchange historical returns hyperinflation indicators interpreting evidence maturities pairwise carry trading portfolio construction ranking models regime indicators seasonals selection biases strategy improvements “timing” the strategy trading horizons unwind episodes why strategies work cyclical effects credit spreads growth seasonal regularities see also business cycles D/P see dividend yield data mining see also overfitting; selection bias data sources of time series data series construction day-of-the-week effect DDM see dividend discount model debt supercycle default correlations, CDOs default rates, HY bonds deflation delta hedging demand see supply—demand demographics derivatives Dimson, Elroy direct hedge funds disagreement models discount rates discounted cash flows discretionary managers disinflation disposition effect distress diversification currency carry drawdown control long-horizon investors return risk factors style diversification return (DR) dividend discount model (DDM) equities ERP forward-looking indicators growth rate debates dividend growth dividend yield (D/P) DJCS HF index dollars base of returns cost averaging currency carry foreign exchange downgrading bias downside beta DR see diversification return drawdown control duration risk duration timing dynamic strategies equity value strategies portfolio construction risk factors E/P see earnings/price ratio earnings E/P ratio EPS equity returns forecasts growth rates yield see also earnings/price ratio earnings-per-share (EPS) earnings/price (E/P) ratio absolute valuation drivers forward-looking indicators measures choices relative valuation value measures economic growth see also growth efficiency behavioral finance macro-inefficiencies market inefficiency micro-inefficiencies efficient markets hypothesis (EMH) elephant and blind men poem (Saxe) EMBI indices emerging markets carry strategies currency carry debt equity returns future trends growth EMH see efficient markets hypothesis empirical multi-factor finance models endogenous return and risk feedback loops market timing research endowments energy sector commodity momentum trend following volatility selling enhancing returns costs horizon investors risk management skill EPS see earnings per share equilibrium accounting equilibrium model equities 1990—2009 business cycles carry strategies correlation premium empirical “horse races” forward-looking indicators inflation long history momentum sample-specific valuation tactical forecasting ten-year rolling averages value strategies see also stock . . .

It is mainly this last experience that has inspired this book. OK, that was too mildly put. I confess: I have been obsessed with expected returns. The passion for the topic arose in as different places as the Bank of Finland in Helsinki and the UofC campus in Hyde Park. I earned my finance doctorate at the University of Chicago Business School (now the Booth School of Business) in the early 1990s, with Professors Eugene Fama and Kenneth French as my dissertation chairmen. In many minds this background puts me squarely in the efficient markets’ camp. However, we Chicago finance students were not taught a dogma. Instead, we were given a lifelong desire to learn more about financial markets with the emphasis on an empirical approach: let ideas compete freely and let data be the judge. The EMH paradigm gave a very useful framework for understanding and analyzing markets, but few of us became EMH purists.

 

pages: 363 words: 28,546

Portfolio Design: A Modern Approach to Asset Allocation by R. Marston

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asset allocation, Bretton Woods, capital asset pricing model, capital controls, carried interest, commodity trading advisor, correlation coefficient, diversification, diversified portfolio, equity premium, Eugene Fama: efficient market hypothesis, family office, financial innovation, fixed income, German hyperinflation, high net worth, hiring and firing, housing crisis, income per capita, index fund, inventory management, Long Term Capital Management, mortgage debt, passive investing, purchasing power parity, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, Silicon Valley, superstar cities, transaction costs, Vanguard fund

This chapter will investigate whether value stocks do offer a premium over growth stocks. For the past two decades, many investment advisors have divided their U.S. stock allocations along the value-growth dimension. Since portfolios are also typically divided by size, many of these same advisors divide portfolios into four quadrants called style boxes: large-cap value and growth and small-cap value and growth. Two influential papers by Eugene Fama and Kenneth French present evidence that book-to-market and size explain a large portion of the cross-section variation of stocks, so it makes sense to divide portfolios along these two dimensions.1 We will examine the chief characteristics of value and growth indexes, beginning with a description of large-cap value and growth stocks. I DESCRIPTION OF THE RUSSELL 1000 INDEXES Value and growth stocks will be compared using the Russell indexes which were developed in the 1980s with most indexes beginning in 1979.

Karlin, 2008, “Defaults and Returns in the HighYield Bond Market: the Year 2007 in Review and Outlook”, New York University Salomon Center. Arnott, Robert D., and Peter L. Bernstein, 2002. “What Risk Premium Is ‘Normal’?”, Financial Analyst Journal (March-April). Banz, Rolf W., 1981, “The Relation between Return and Market Value of Common Stocks, ”Journal of Financial Economics (March), pp. 3–18. Basu, Sanjoy, 1977, “Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis,” Journal of Finance (June), pp. 663–682. Bernstein Wealth Management Research, 2006, Hedge Funds: Too Much of a Good Thing?, Bernstein Global Wealth Management (June). Black, Fischer, and Robert Litterman, 1992, “Global Portfolio Optimization,” Financial Analysts Journal (September-October), pp. 28–43. Bodnar, Gordon, Bernard Dumas, and Richard Marston, 2004, “Cross-Border Valuation: The International Cost of Equity Capital,” in Hubert Gatignon and John Kimberly, eds., Globalizing: Drivers, Consequences and Implications, INSEADWharton Alliance.

 

pages: 524 words: 143,993

The Shifts and the Shocks: What We've Learned--And Have Still to Learn--From the Financial Crisis by Martin Wolf

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air freight, anti-communist, Asian financial crisis, asset allocation, asset-backed security, balance sheet recession, bank run, banking crisis, banks create money, Basel III, Ben Bernanke: helicopter money, Berlin Wall, Black Swan, bonus culture, Bretton Woods, call centre, capital asset pricing model, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, debt deflation, deglobalization, Deng Xiaoping, diversification, double entry bookkeeping, en.wikipedia.org, Erik Brynjolfsson, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial innovation, financial repression, floating exchange rates, forward guidance, Fractional reserve banking, full employment, global rebalancing, global reserve currency, Growth in a Time of Debt, Hyman Minsky, income inequality, inflation targeting, invisible hand, Joseph Schumpeter, Kenneth Rogoff, labour market flexibility, labour mobility, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, margin call, market bubble, market clearing, market fragmentation, Martin Wolf, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, new economy, North Sea oil, Northern Rock, open economy, paradox of thrift, price stability, private sector deleveraging, purchasing power parity, pushing on a string, quantitative easing, Real Time Gross Settlement, regulatory arbitrage, reserve currency, Richard Feynman, Richard Feynman, risk-adjusted returns, risk/return, road to serfdom, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, Second Machine Age, secular stagnation, shareholder value, short selling, sovereign wealth fund, special drawing rights, The Chicago School, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, too big to fail, Tyler Cowen: Great Stagnation, very high income, winner-take-all economy

The logic is impeccable. Moreover, the passage of time and the experience of a long period of financial stability had robbed the Western world of the terror of financial instability born in the 1930s. At the same time, economics provided theories justifying the proposition that free markets would allocate resources optimally. We saw the rise, for example, of the efficient market hypothesis associated with Chicago University’s Nobel laureate Eugene Fama and of belief in shareholder value maximization associated with Harvard University’s Michael Jensen. Beyond these intellectual arguments in favour of financial liberalization there were also practical arguments against regulation. Over time, it was found increasingly difficult to make the regulations that existed stick, as financial actors increasingly found ways around them.

 

pages: 741 words: 179,454

Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

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affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Fall of the Berlin Wall, financial independence, financial innovation, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, Kevin Kelly, labour market flexibility, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, merger arbitrage, Mikhail Gorbachev, Milgram experiment, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Naomi Klein, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, pets.com, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Feynman, Richard Thaler, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond

Bachelier’s thesis received a mention honorable, below the très honorable needed to gain a place in the academic world. Random movements in prices, devoid of any trend or cycle, were a depressing prospect for economists. Maurice Kendall, a British statistician, described it as the work of “the Demon of Chance,” randomly drawing a number from a distribution of possible price changes, which, when added to today’s price, determined the next price. While working for a stock market newsletter, Eugene Fama noticed patterns in stock prices that would appear and disappear rapidly. In his doctoral dissertation, he laid out the argument that stock prices were random, reflecting all available information relevant to its value. Prices followed a random walk and market participants could not systematically profit from market inefficiencies. The EMH does not require market price to be always accurate. Investors force the price to fluctuate randomly around its real value.

The physicist Paul Dirac observed that: “In physics, we try to tell people in such a way that they understand something that nobody knew before. In the case of poetry, it’s the exact opposite.”6 Economics, as practiced at Chicago, with its mix of dogma, political fundamentalism, and mathematics, was neither poetry nor physics. Theories—rational expectations, real business cycle theory, portfolio theory, efficient market hypothesis, capital structure theory, capital asset pricing models, option pricing, agency theory—rolled off the academic production line. Many economists received recognition in the form of the Nobel prize in Economics (technically the “Severige Riksbank [Swedish Central Bank] Prize in Economic Sciences in Memory of Alfred Nobel” founded in 1968). Some historians assert that every recent economics Nobel prize winner was either from the University of Chicago, was at Chicago at the time of doing their prize-winning work, had at some time visited the city or had simply inhaled the campus air—especially bottled and sent to them.

Michael Jensen, a graduate student at Chicago, used a measure developed by Sharpe called the information ratio to compare actual returns earned by investment managers adjusting for the risk taken. Jensen found that few funds outperformed the broad market. On average, investors buying all the stocks in the market would earn higher returns with lower risk. Fund managers with high returns simply took higher risk rather than possessing supernatural skill. Demon of Chance The efficient market hypothesis (EMH) stated that the stock prices followed a random walk, a formal mathematical statement of a trajectory consisting of successive random steps. Pioneers Jules Regnault (in the nineteenth century) and Louis Bachelier (early twentieth century) had discovered that short-term price changes were random—a coin toss could predict up or down moves. Bachelier’s Sorbonne thesis established that the probability of a given change in price was consistent with the Gaussian or bell-shaped normal distribution, well-known in statistical theory.

 

pages: 670 words: 194,502

The Intelligent Investor (Collins Business Essentials) by Benjamin Graham, Jason Zweig

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accounting loophole / creative accounting, air freight, Andrei Shleifer, asset allocation, buy low sell high, capital asset pricing model, corporate governance, Daniel Kahneman / Amos Tversky, diversified portfolio, Eugene Fama: efficient market hypothesis, hiring and firing, index fund, Isaac Newton, Long Term Capital Management, market bubble, merger arbitrage, new economy, passive investing, price stability, Ralph Waldo Emerson, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, sharing economy, short selling, Silicon Valley, South Sea Bubble, Steve Jobs, the market place, transaction costs, tulip mania, VA Linux, Vanguard fund, Y2K, Yogi Berra

Incredibly, investors fell for it hook, line, and sinker. Daddy Knows Best became such gospel that, by 1999, only 3.7% of the companies that first sold their stock to the public that year paid a dividend—down from an average of 72.1% of all IPOs in the 1960s.9 Just look at how the percentage of companies paying dividends (shown in the dark area) has withered away: FIGURE 19-1 Who Pays Dividends? Source: Eugene Fama and Kenneth French, “Disappearing Dividends,” Journal of Financial Economics, April 2001. But Daddy Knows Best was nothing but bunk. While some companies put their cash to good use, many more fell into two other categories: those that simply wasted it, and those that piled it up far faster than they could possibly spend it. In the first group, Priceline.com wrote off $67 million in losses in 2000 after launching goofy ventures into groceries and gasoline, while Amazon.com destroyed at least $233 million of its shareholders’ wealth by “investing” in dot-bombs like Webvan and Ashford.com.10 And the two biggest losses so far on record—JDS Uniphase’s $56 billion in 2001 and AOL Time Warner’s $99 billion in 2002—occurred after companies chose not to pay dividends but to merge with other firms at a time when their shares were obscenely overvalued.11 In the second group, consider that by late 2001, Oracle Corp. had piled up $5 billion in cash.

., dual-purpose funds due diligence Dundee, Angelo Durand, David e*Trade “earning power,” earnings: and advice; average; and bargains; on capital funds; “consensus” about; debt and profits on capital (1950–69); and dividends; and expectations for investors; hiding true; and history and forecasting of stock market; inflation and; and margin of safety; and market fluctuations; owner; and per-share earnings; and performance (1871–1970); and portfolio policy for aggressive investors; and portfolio policy for defensive investors; real; and repurchase plans; and security analysis; and speculation; and stock selection for aggressive investors; and stock selection for defensive investors. See also “earning power”; per-share earnings; price/earnings ratio; specific company or type of security earnings-covered test Eastman Kodak Co. EDGAR database Edison Electric Light Co. Edward VII (king of Great Britain), “efficient markets hypothesis” (EMH) Electric Autolite Co. Electronic Data Systems electronics industry Elias, David Ellis, Charles ELTRA Corp. EMC Corp. emerging-market nations Emerson, Ralph Waldo Emerson Electric Co. Emery Air Freight Emhart Corp. employee-purchase plans employees: stock options for. See also managers/management endowment funds “enhancing shareholder value,” Enron Corp. enterprising investors.

Although the sector is much more diversified today, Graham’s caveats about financial soundness apply more than ever. * Only a few major rail stocks now remain, including Burlington Northern, CSX, Norfolk Southern, and Union Pacific. The advice in this section is at least as relevant to airline stocks today—with their massive current losses and a half-century of almost incessantly poor results—as it was to railroads in Graham’s day. * Graham is summarizing the “efficient markets hypothesis,” or EMH, an academic theory claiming that the price of each stock incorporates all publicly available information about the company. With millions of investors scouring the market every day, it is unlikely that severe mispricings can persist for long. An old joke has two finance professors walking along the sidewalk; when one spots a $20 bill and bends over to pick it up, the other grabs his arm and says, “Don’t bother.

 

pages: 1,336 words: 415,037

The Snowball: Warren Buffett and the Business of Life by Alice Schroeder

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affirmative action, Albert Einstein, anti-communist, Ayatollah Khomeini, barriers to entry, Bonfire of the Vanities, Brownian motion, capital asset pricing model, card file, centralized clearinghouse, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, Donald Trump, Eugene Fama: efficient market hypothesis, global village, Golden Gate Park, Haight Ashbury, haute cuisine, Honoré de Balzac, If something cannot go on forever, it will stop, In Cold Blood by Truman Capote, index fund, indoor plumbing, interest rate swap, invisible hand, Isaac Newton, Jeff Bezos, joint-stock company, joint-stock limited liability company, Long Term Capital Management, Louis Bachelier, margin call, market bubble, Marshall McLuhan, medical malpractice, merger arbitrage, Mikhail Gorbachev, moral hazard, NetJets, new economy, New Journalism, North Sea oil, paper trading, passive investing, pets.com, Plutocrats, plutocrats, Ponzi scheme, Ralph Nader, random walk, Ronald Reagan, Scientific racism, shareholder value, short selling, side project, Silicon Valley, Steve Ballmer, Steve Jobs, supply-chain management, telemarketer, The Predators' Ball, The Wealth of Nations by Adam Smith, Thomas Malthus, too big to fail, transcontinental railway, Upton Sinclair, War on Poverty, Works Progress Administration, Y2K, zero-coupon bond

These academics had started by positing the reasonable but not necessarily obvious truth that if a whole lot of people were trying to be better than average, they would become the average. Paul Samuelson, an MIT economist, revived and circulated the 1900 work of Louis Bachelier, who observed that the market is made up of speculators who cohere into a whole that operates according to a “random walk.”38 A professor from the University of Chicago, Eugene Fama, took Bachelier’s work and tested it empirically in the modern-day market, which he described as “efficient.” The scrabbling efforts of legions of investors to beat the market made those very efforts futile, he said. Yet an army of professionals had sprung up who charged everything from modest fees to the soon-to-be-legendary hedge-fund cut of “two-and-twenty”(two percent of assets and twenty percent of returns) for the privilege of managing an investor’s money and trying to predict the future behavior of stocks.

Charles Ellis, a consultant to professional money managers, blew the whistle on the market’s pickpockets in 1975 in “Winning the Loser’s Game,” an article that showed that professional money managers failed to beat the market ninety percent of the time.39 Ellis’s work also had disheartening implications for individual investors and the readers of books and attendees of seminars like “Invest Your Way to Millions.” He said the best way to make money in the market was to simply buy an index of the market itself without paying the high fees that the toll-takers charged. Over the long term, the market tended to outperform bonds, so investors would receive the payback from the entire economy’s growth. So far, so good. The professors who had discovered this efficient-market hypothesis (EMH) kept hacking away at their computers over the years, however, to turn these ideas into an even tighter version, one that had the purity and rigor of physics and mathematics, one to which there could be no exceptions. They concluded that nobody could beat the average, that the market was so efficient that the price of a stock at any time must reflect every piece of public information about a company.

It was what he did with the information the Wall Street Journal gave him, however, that made him a superior investor. If a monkey got the Wall Street Journal in its driveway every night just before midnight, the monkey still could not match Buffett’s investing record by throwing darts. Buffett made sport of the controversy by playing with a Wall Street Journal dartboard in his office. The efficient-market hypothesis invalidated him, however. Furthermore, it invalidated Ben Graham. That would not do. He and Munger saw these academics as holders of witch doctorates.42 Their theory peddled bafflemath, teaching a whole generation of students something disprovable. They offended Buffett’s reverence for rational thinking and for the profession of teaching. Columbia held a seminar in 1984 to celebrate the fiftieth anniversary of Security Analysis.