You Are A Lab Rat
You Are A Lab Rat
- July 13th, 2010By Jeffery A. Sexton, Managing Member: Arsenal Investment Advisors, LLC
The turmoil in world financial markets the past two years has caused many investors to question the “fairness” of this casino-like situation. Is a CD or 30-day U.S. Treasury bill the only safe investment for Main Street investors to purchase now? Is the game really that rigged in favor of the house? What happened to just buying Pfizer or Merck and holding on for twenty or thirty years until retirement while collecting nice dividends along the way? Unfortunately, you and your investment advisors (and bankers and real estate agents and CPAs and attorneys) are the unwitting victims of a grand academic experiment at the hands of my professors at the University of Chicago and their colleagues at other top business schools. The slick marketing machine of Wall Street with its bottomless budget only made matters worse.
In 1952 Harry Markowitz laid down the foundations of modern portfolio management in his doctoral dissertation at the University of Chicago. He was awarded his PhD despite Milton Friedman’s contention that “this isn’t a dissertation in economics . . . It’s not math, it’s not economics, it’s not even business administration.” Not only was Friedman (who would later win the 1976 Nobel Prize in Economics) a member of his defense committee; he was also Markowitz’ PhD advisor! Markowitz’ controversial idea was that risk and return are the only two properties of any asset with which investors are concerned. Among his insights was the idea that the total risk of a portfolio is not only determined by the risk of the individual investments but also by the correlations between these risks. On the basis of Markowitz’ analysis, it became accepted jargon to speak of an “efficient portfolio,” i.e., “a portfolio that offers the highest expected return for any given degree of risk.” Markowitz continued his work with his Chicago colleague, Merton Miller and their graduate student, William Sharpe. All three shared the 1990 Nobel Prize in Economics for their development of Modern Portfolio Theory (MPT). Another of Markowitz’ and Miller’s illustrious students, Eugene Fama, was this author’s professor at the University of Chicago. Inhis famous 1965 PhD dissertation, Fama extended the concept of an “efficient portfolio” to an “efficient market” where all known information is instantly incorporated into quoted prices thereby rendering attempts to beat the market somewhat futile. He has become known as the “father of efficient markets.” He is the most cited researcher in all of finance and economics.
Many other Chicago academics contributed to the body of work on Modern Portfolio Theory and they, too, won several Nobel Prizes. In the five decades after Markowitz’ seminal PhD, academics at business schools across the country adopted, analyzed, researched, modified and taught MPT to countless students who went on to investment management careers on Wall Street, or real estate, accounting, law, entrepreneurial and—yes—academic careers. The logic behind MPT (higher risk, higher return; lower risk, lower return) is sound but any theory should be put to rigorous testing before declared doctrine. The academics warned that it was not ready for prime time, but Wall Street didn’t care. Investors around the world—individual and institutional—became the lab rats.
The nascent mutual fund industry on Wall Street badly needed something upon which to hang its hat of legitimacy in the late 1950s. MPT coming out of the University of Chicago and its subsequent “acceptance” by other academics was just the ticket. The “story” behind the need for diversified portfolios of mutual funds was set. Without MPT there would be no mutual fund industry as we know it today. There would be no Morningstar with its ubiquitous style box and star ranking system. There would be no legions of stockbrokers at Merrill Lynch, Morgan Stanley, etc.
Wall Street ignored the ONLY goal of academic models—to explain how a perfect world might operate. What if the model is wrong and/or the real world imperfect? After almost sixty years of real world test results that ended with all diversified portfolios crashing together, it seems that MPT is less than perfect. Specifically, it fails to fully account for human emotions (greed, fear) and human psychological biases (overreaction and under-reaction to certain information, holding losers too long). Academics are gleefully sifting through the data and will return to their towers to craft a modified MPT 2.0 while investors only now learn of their role in the failed MPT 1.0 experiment.
So what should you know and do in the meantime? How should you invest your money if diversification across stocks (small cap, large cap, mid cap, international, growth, value), bonds (corporate, government, long-term, short-term), commodities, real estate (REITs, personal residence, raw land, speculative rental property) and cash (T-bills, CDs, money market funds) doesn’t work as advertised?
Well . . . you should know the following:
• Eugene Fama and Kenneth French identified the Small Cap and Value anomalies to MPT in the early 1990s thereby giving rise to the Small Cap and Value mutual fund industries.
• Small Cap and Value outperform Large Cap and Growth, respectively, over time.
• MPT diversification leaves your investment assets in “dead” zones for extended periods. If you have money invested in international stocks that underperform for a couple of years then your opportunity costs are rising—that money could be invested elsewhere earning a higher return.
• We all have deep psychological biases that cause us to make the wrong decisions with our money such as moving out of international stocks that have underperformed for a couple of years just before they recover. In essence, you are your own worst enemy. Daniel Kahneman won the 2002 Nobel Prize in Economics for his work in this area.
• Momentum is the most important anomaly to MPT because Momentum stocks beat Small Cap and Value. Momentum consistently beats Growth and is negatively correlated (a good thing) to Value.
• There is a specific academic definition of Momentum and it is not what you think.
• Your author conducted earnings momentum research and price momentum research at the University of Chicago under Eugene Fama.
• Dividends are a VERY important part of the total return of a stock portfolio.
• Arsenal Investment Advisors’ Dividend+Growth Fund used the author’s proprietary Price and Earnings Momentum strategy to generate a 33.10% total return versus a –12% return in the Russell 3000 Index from 2001 to 2008. The same portfolio generated an average yield of approximately 5% every year. In other words, on a $1 million portfolio a client received about $50,000 annually in spendable income and still had over $1 million left at the end of a period when the overall market declined 12%.
• The only way to come out ahead (beat the MPT experiment) is to invest in the anomalies— exceptions—to the theory: Small Cap, Value and Momentum with Momentum being the most powerful of the three and the least utilized.
• Arsenal Investment Investors, based in Louisville, is one of only a handful of investment firms in the world focused solely on exploiting the Momentum anomaly. All of the Momentum firms were founded by Chicago alumni because we discovered it and understand it best of all.
• Arsenal shut down the Dividend+Growth Fund strategy in 2009 as companies cut or eliminated dividends thus reducing the pool of potential investments to unacceptable levels. As of Q1 2010, dividends are back (a record number of S&P 500 companies raised or reinstated dividends) and so is the Arsenal Dividend+Growth Fund as of July 1, 2010.
Why are dividends going to be so important? As William H. Gross of PIMCO points out, yields on cash are hovering below 1%. In fact, some investments are yielding almost .01%. At that rate, it would take approximately 6,932 years to double your money. Moreover, the New Normal is likely to be a significantly lower-returning world. Diminished growth, deleveraging and increased government involvement will temper profits and their eventual distributions to investors in the form of dividends and interest. As banks, auto companies and other corporate models become more regulated like utilities, they will return less. So, why not just buy utilities?
Stock prices of utilities are only halfway between their 2007 peaks and 2008 lows—25% off the top, 25% off the bottom. Their growth in earnings should mimic the U.S. economy as they always have, and most importantly they yield 5 to 6%–not .01%! In a low growth environment, a company’s stock should yield more than its less risky debt. Many utilities and quasi-utility telecommunication companies now yield 5 to 6% whereas their 10- and 30-year bonds yield less and at a higher tax rate to you the individual investor!
You needn’t continue to be a lab rat. Look at the coterie of advisors currently around you and consider whether change is needed before retirement or a liquidation event or . . . the next financial crisis. As a Chicago-trained economist, I ask of you the following question in closing: does anyone around you at present truly know how to maximize the marginal efficiency of your investment capital?
To learn more about the author or Arsenal Investment Advisors, LLC, call 502-582-2255 or visit www.arsenal.pro.
Neither the information nor any opinion expressed herein constitutes an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, etc.). This report is not intended to provide personal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person. Investors should seek financial advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed or recommended in this article and should understand that statements regarding future prospects may not be realized. Any decision to purchase or subscribe for securities in any offering must be based solely on existing public information on such security or the information in the prospectus or other offering document issued in connection with such offering, and not on this article. All opinions, projections and estimates constitute the judgment of the author as of the date of the article and are subject to change without notice. Arsenal Investment Advisors, LLC (”AIA”) is under no obligation to update this article and readers should therefore assume that it will not update any fact, circumstance or opinion contained in this article. Neither AIA nor any member, manager, director, officer or employee of AIA accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this article or its contents.
