In 1990, William Sharpe won his prize for his contributions to what a generation of business school students have learned to call the Capital Asset Pricing Model (CAPM). In the rarified world of Chartered Financial Analysts, we pronounce it “Cap’em,” like what one gang member might say to another when he wants someone shot.
Like most of what is taught in universities, it was anti-establishment to the extreme and based on theories that sound reasonable in the abstract but don’t fare well in the real world. The CAPM, for example, taught students that all investors have rational expectations. However the parents of those students could testify to the lack of correlation between their children and any sense of rationality at all. They may not talk about it. They may even laugh about it at times. They will go to bat for their kid and threaten to sue the school if it decides to expel a student. But there is very little underlying belief in the concept of a rational college student-consumer. Parents aren’t total idiots.
The CAPM also assumes that investors are solely concerned with level and uncertainty of future wealth. The mere appearance of wealth, in the nightclubs or in later years at high school reunions, is assumed to be unimportant. Risk-free borrowing rates are assumed to be equal, which is true until that first late credit card payment, at which time borrowing rates get very unequal, very quickly. The CAPM assumes perfect information, which isn’t even true after the invention of the internet, and was even less true when Dr. Sharp was dreaming this garbage up. The model assumes no inflation, perfectly efficient markets, and a fixed quantity of assets (whereas in reality the venture capital community exists, primarily it would seem, to create business shells which can be sold into the latest hot stock market sector).
In essence, the completely unrealistic economic theory contrasted wholly and completely with financial reality, which ought to lead one to be suspicious about whatever conclusions are drawn from the high end math incorporated into the study, no matter how elegant the mathematical equations look in the appendix of the study.
Unfortunately, however, the nation’s business schools hopped on the CAPM bandwagon like a day-trader buying into the notion that internet stocks only go up. The study introduced the concept of beta as a measure of stock volatility, but failed to deliver because later studies showed that some low beta stocks may actually offer higher returns to investors, which is exactly opposite of what the CAPM crowd believes. CAPM assumes that the “variance of returns” is an adequate measure of risk, which is a candidate for the biggest lie ever told and deserves an entire chapter or two of its own. The model assumes that given certain and equal return projections, investors will prefer the lower risk strategy but fails to take into account investor fads that drive investors to put money into sexy new products in a pathetic search for excitement. The model assumes no taxes or transactions costs, which in itself is so ludicrous that outside of an election year, not even an economic neophyte would be likely to buy into that hypothesis.
Sharpe’s work stood the investing world on its head. Now the majority of investing models try to encapsulate “risk” into one all-encompassing number, either Beta or a statistic that measures “return variance,” as if the winner of the Super Bowl can be determined by counting the number of first quarter rushing yards throughout the season.
Investors have bought into the notion that markets are “efficient” and that there is no reward for time spent researching one alternative versus another, separating out the boring and profitable from the exciting and overpriced alternatives, as if a flip of the coin has as much chance of picking a winner as does any other method. Ironically, the model which assumes no transaction costs that would limit investors’ ability to shift back and forth between stocks and bonds and other asset classes has decreased investors’ willingness to do that very thing. Investors have come to believe that shifting assets around doesn’t matter, yet it was the assumption that assets would shift around which led to the model’s conclusion that the world is efficient in the first place.
According to the efficient markets hypothesis, no one could have known that we were in a technology bubble in 1999. Outside of Alan Greenspan’s inner sanctum, there was pretty broad agreement among experienced investors that we were in a bubble. You didn’t get a lot of air time on CNBC with such pedestrian observations, but there was no way that the NASDAQ at 5000 was in any sense a “rational” equilibrium. “This time it’s different,” said the market hype, and the efficient market crowd agreed that it must be so. Indexers were among the biggest buyers of tech stocks at the top of the bubble as new names with gargantuan market values were being added to the indexes that index funds emulate. We have the CAPM crowd to thank for much of what happened at the turn of the century, when active management and rational thinking lost favor to the momentum players and the index investors who aided and abetted the thrashing that investors received.
Thanks, Professor Sharpe, for nothing.
Myron Scholes
After Sharpe developed his unrealistic and math-centric view of the world, Dr. Myron Scholes took the formula and put it on steroids. He and Fischer Black left the consulting world to develop the Black-Scholes pricing model, which is still used throughout Wall Street to assign a price to derivative assets for which no real market exists and therefore no actual prices can be found.
The formula works great, so long as it isn’t tested in the real world. For example, Scholes threw in with his Nobel Prize co-winner Robert C. Merton and John Meriwether (best known for his adroit skill at playing Liar’s Poker) to form a hedge fund called Long-Term Capital Management. LTCM’s long-term strategy was to leverage up 50 times (so, using borrowed money, a $1 investment was used to collateralize $49 in borrowing to buy $50 in assets) to invest in short-term derivatives trades. So long as money was coming in so nothing needed to be sold, pricing the assets based on the Black-Scholes model worked well for the partners, who claimed a first year annualized return of 40% which made for a big payday to the fund managers.
In 1998, however, a crisis in Asia and Russia resulted in the need to actually sell some of the portfolio assets to satisfy their bankers annoying request that some of the money be paid back. This resulted in a $4.6 billion loss and the fund failed, becoming one of the most prominent examples of a hedge fund blowing itself up. The Federal Reserve finally engineered a bailout in order to avoid a general financial panic, and the hedge fund partners were forced to look for a new gig, although by that time they’d already made so much money off their investors that they didn’t really need to work anymore if they didn’t want to.
The 2008 financial meltdown provided much more evidence that Scholes formula is to investor success what meth is to student achievement. The short-term high it gave traders at bonus time led to a financial addiction that resulted in the long-term destruction of the corporate host, and a lot of collateral social destruction as well.
An early 2008 casualty of mis-priced derivatives was Bear Stearns. A couple of its hedge funds were the first to implode in 2007. The sub-prime issue surfaced early in the year and by Spring it was evident that there was a big problem around the corner – at least, that’s when the fund managers decided to sell down their own holdings in the fund, though publicly they were pretty certain this was just a bump on the long-term road to riches. By July their fund was upside down and the sub-prime market had locked up, which means that everyone wanted their money back; everything was for sale but the buyers were on strike and so prices were plunging even in spite of theoretical values far north of the bid side of the market.
Mark Twain credited Benjamin Disraeli for the observation that there are liars, damn liars, and statistics. What would Twain have said about the econometricians and the Wall Street firms that hired them to design what they called “structured products?” These structured products had no underlying support except for a bunch of untrustworthy math. In the past few years, Wall Street sliced and diced a bunch of disastrous loans on houses to buyers who couldn’t afford them, and watched in amazement as the AAA-ratings failed to protect investors when the underlying loans began defaulting.
These structured products represented ownership of nothing except for a speculative claim and the promise that another speculator will honor it. They represent Wall Street as a casino and the jingle and crash of financial levers and spilled drinks. Believe it or not, there really are good reasons for Wall Street to exist, but ever since Professor Scholes option pricing model came to town, the quality and tone of research and underwriting have gone downhill. He is not solely responsible for the clatter that reverberates throughout today’s capital markets. He is more like a gun manufacturer who hands out handguns on the city streets and then decries the drive-by shootings that ensue.
Joseph Stiglitz and A. Michael Spence
Joseph Stiglitz and Michael Spence have recently been recognized for doing research which pretty much takes to task everything that Arrow, North, Becker, Sharpe and Scholes represent. Whereas the old guard viewed the economy and markets as rational and efficient, Stiglitz and Spence studies show that
- information is not evenly distributed,
- wage opportunities are far from identical,
- companies have difficulty knowing who is working hard and who is hardly working,
- wage changes are sluggish,
- unemployment levels are sticky, and market failures and
- inefficiencies are the rule rather than the exception.
Unfortunately, the professors political prescriptions require a great deal of government intervention to “fix” these problems, but investors should still take note of the fact that these guys just won a Nobel Prize for teaching us to ignore what the first five guys have been telling us for all these years.
Stiglitz wrote about adverse selection in the insurance industry. If the insurance industry prices a risk at an average price, low risk prospects will be forced to overpay while high risk customers can buy the insurance and continue living their high risk lifestyle. Soon enough the low risk prospects (who can) withdraw from the insurance market altogether, choosing to self-insure. The insurance company is left with medium and high risk customers, and higher than average claims, and enormous financial losses. This forces the insurance companies to raise rates to an above-average level, which causes even more prospects to drop out of the pool. Because of what Stiglitz labeled the problem of adverse selection, the price for insurance is higher than it should be, and not everyone chooses to purchase coverage (though all would benefit from coverage at a fair price).
The right “big government” solution would be to require that everyone buy insurance, and perhaps a “public option” as well. But that sort of solution, as you might imagine, has its own set of drawbacks. (Perhaps you’ve heard…)
Stiglitz developed the notion of information asymmetries where one group (the insurance prospects) know more than another group (the insurance providers) about something (their own proclivity for risk taking). Information asymmetries are not efficient, nor optimal, nor rational nor congruent with traditional economic theory. They do, however, have an advantage in that they do help explain the real world better than traditional economic theory.
In the stock market, adverse selection means that new, hard to value companies where insiders know more than public shareholders are inefficiently priced. Poor quality companies have an incentive to issue shares because average share prices overvalue them, while more profitable companies are undervalued in the public markets. Gradually, as more and more poor quality companies go to the public markets, eventually the public markets become dominated by these “lemons.” When the average investor finally discovers this, the average share prices fall toward the fair value for lemons.
Can you spell “internet bubble?”
In addition to his work on information asymmetry, Professor Spence also furthered research in the area of signaling theory, such as when corporations take expensive actions, like paying dividends in spite of the disadvantageous tax treatment, in order to signal to shareholders with (less) asymmetrical information characteristics how high profitability is at the firm level. In the wake of the sub-prime mess, but before things got so bad that they no longer had a say in the matter, some banks were faced with the diliemma of not being able to afford to pay the dividends that shareholders were accustomed to receiving, but at the same time they couldn’t afford to cut dividends because such a move might get them completely kicked out of the capital markets, and the companies were truly capital starved and would fail if they couldn’t retain access to new funding.
Annuity products are classic examples of “signaling theory” where the insurance company selling the contract offers high first year interest rate “signals,” but in reality clients lock into product for many years and may receive substandard returns during subsequent policy years. Outside the rarified world of econometrics, we call these tactics “bait and switch.” If the stars are in alignment and every step of the fraud has been well documented, we prosecute those guilty of sending illicit signals. That doesn’t happen nearly often enough, however, so mostly we reward such expert signal providers with big profits and a high share price.
Make no mistake, the Ivy League MBA is itself a “signal” of future productivity. The companies who hire these MBA’s don’t really care if they’ve learned anything in class or not. What is most valuable is the fact that these future employees made it through the admissions office filter and the fact that they’ll spend the next two years hanging around other fast-track folks who also made the cut. If you ever wondered why a typical 2007 Harvard MBA had a starting salary and bonus of $141,250 and the local State College MBA is negotiating a foreclosure proceeding, it’s not because of what they learned in the classroom. It’s because of whom they shared the classroom with (please pardon my dangling preposition). To put it in Web2.0 terms, it’s all about the quality of the network.
The network itself has one primary mission. For better or for worse, in whatever way they can, the network is focused on separating you from your money. Some firms hire these MBA’s to go after your “wallet share.” They want to nickel and dime you for every money transaction you make. Others go for the big score – magically transforming your life’s retirement savings into a hedge fund strategy that, if it works, will add to your nestegg and make them incredibly, gloriously, fabulously wealthy. If it doesn’t work and decimates your retirement portfolio, which we might call performance asymmetry, then it’s just off to another job for them, and you’ll have to go back to work as well.
Can you say, “do you want fries with that?”
Caveat Emptor (Buyer Beware)
The strategies we use and the positions we advocate add up to one big wake-up call that your advisor and your daughter’s Professor will call heresy. We’re just asking hard questions and taking action based on the answers we’ve received.
Why is it that many of the most famous “efficient markets” random walk theorists have switched to the “active management” side? Is it just because the pay is better, or is it because they’ve realized that the “collective thinking” of the market is sometimes crazy, often foolish, and rarely profitable? Other than John Bogle, whom I love as a kindred frugal soul, why don’t we find any indexers in the money manager Hall of Fame? Indeed, why are big institutional managers moving away from indexing strategies toward active management (via hedge funds) approaches. They may combine an indexing core with a hedge fund “satellite,” but at the end of the day the total portfolio when you combine the neutral-weighted core with the long and short positions in the hedge fund is a traditional actively managed total portfolio. The only thing that has really changed is how the managers are compensated.
For all the work that has been done in the economic arena, investors are left with the sickening feeling that they’ve come full circle and paid full fare for the roller coaster ride. First, markets were efficient. Now they’re not, again. Give back the prize, guys, we’re no further ahead than we were 50 years ago.
Investors, throw away the textbook. It isn’t going to help you know how to invest your money. If nothing else, tossing the text shortens your summer reading list significantly, which might leave a spot on the list for a good murder mystery.
The good news is that with a little homework, almost anyone can design an investment management approach that takes the best of Wall Street (it’s hard to find, but it’s there) and combines it with a little technology and a pinch of professional advice to enable you to invest wisely for your future.
Before you can do that, however, there are a few myths which we need to unlearn.
Next post: There is a reward for doing your homework
To read "A Prize For the Most Useless - Part I" string, click here
To start at the beginning of the Investment Heresies eMag, click here
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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