We practice what is now being called “evidence-based investing” (description here for example) – so-called because sound academic research supports it. This month I thought I would review the key findings of some of the seminal papers in the field. I present these in chronological order with a one-sentence summary in bold at the end of each synopsis:
Can Stock Market Forecasters Forecast? (1932) by Alfred Cowles III. He concluded:
Sixteen financial services, in making some 7500 recommendations of individual common stocks for investment during the period from January 1, 1928, to July 1, 1932, compiled an average record that was worse than that of the average common stock by 1.43 per cent annually. Statistical tests of the best individual records failed to demonstrate that they exhibited skill, and indicated that they more probably were results of chance.
Twenty fire insurance companies in making a similar selection of securities during the years 1928 to 1931, inclusive, achieved an average record 1.20 per cent annually worse than that of the general run of stocks. The best of these records, since it is not very much more impressive than the record of the most successful of the sixteen financial services, fails to exhibit definitely the existence of any skill in investment.
William Peter Hamilton, editor of the Wall Street Journal, publishing forecasts of the stock market based on the Dow Theory over a period of 26 years, from 1904 to 1929, inclusive, achieved a result better than what would ordinarily be regarded as a normal investment return, but poorer than the result of a continuous outright investment in representative common stocks for this period. On 90 occasions he announced changes in the outlook for the market. Forty-five of these predictions were successful and 45 unsuccessful.
Twenty-four financial publications engaged in forecasting the stock market during the 42 years from January 1, 1928, to June 1,1932, failed as a group by 4 per cent per annum to achieve a result as good as the average of all purely random performances. A review of the various statistical tests, applied to the records for this period, of these 24 forecasters, indicates that the most successful records are little, if any, better than what might be expected to result from pure chance. There is some evidence, on the other hand, to indicate that the least successful records are worse than what could reasonably be attributed to chance.
In other words, no, forecasters can’t forecast. (Mr. Cowles had a follow-up paper in 1944 as well which concluded much the same thing. See also The Fortune Sellers and The Signal and the Noise.)
Portfolio Selection (1952) by Nobel laureate Harry Markowitz. This landmark paper introduced what became known as Modern Portfolio Theory (MPT). With estimates of the expected returns and variances of investment opportunities, along with expected correlations between them, an optimal portfolio may be constructed that maximizes the expected returns for the risk taken or (identically) minimizes the risk for the expected return. Constructing an optimal portfolio is a mathematical, not creative, exercise.
Challenge to Judgement (1974) by Nobel laureate Paul Samuelson. He concluded, “What is interesting is the empirical fact that it is virtually impossible for academic researchers with access to the published records to identify any member of the subset with flair [the ability to outperform].” Active management doesn’t seem to win.
The Loser’s Game (1975) by Charles Ellis. He concluded, “[E]fforts to beat the market are no longer the most important part of the solution; they are the most important part of the problem.” The way to win (outperform) is not to lose (by incurring high costs).
Common Risk Factors in the Returns on Stocks and Bonds (1993) by Nobel laureate Eugene Fama and Ken French. This paper introduced what became known as the “three-factor model” for stocks (plus two, credit and term, for bonds). There is a return from owning stocks over bonds, plus a premium for smaller companies (earlier identified by Banz in 1980), plus a premium for less expensive (aka value) stocks (earlier identified by Basu in 1977). Despite these earlier papers from Banz and Basu, the 1993 Fama and French paper is much more widely cited. Value (cheaper) and smaller stocks tend to outperform.
The Arithmetic of Active Management (1991) by Nobel laureate William Sharpe. Passive investors own the market portfolio and thus earn the market return. Active investors, in aggregate, must own the market portfolio as well and thus will also earn (gross) the market return, but due to much higher costs will inevitably underperform (as a group) net. Active management can’t win.
Determinants of Portfolio Performance (1995) by Brinson, Hood, and Beebower. In a study of 91 large U.S. pension plans they determined that the strategic allocation to stocks, bonds, and cash was by far the crucial decision. Indeed, the decisions of which individual securities to buy or the decision to deviate tactically from the strategic allocation (presumably with the view that investments were cheap or expensive) removed value! In other words, if these pension plans had just selected an asset allocation, bought index funds to implement it, and rebalanced back to the target periodically, they would have had better performance. Pick an allocation, implement it cheaply, rebalance periodically and otherwise resist the temptation to “do something.”
On Persistence in Mutual Fund Performance (1997) by Mark Carhart. This paper added momentum (previously identified by Jegadeesh and Titmanto in 1993) to the small-cap and value factors previously identified by Fama and French (above) as leading to improved returns. Despite the earlier paper from Jegadeesh and Titmanto, the 1997 Carhart paper is much more widely cited. Investments that have done well (poorly) in the past year tend to continue to do well (poorly).
Despite all of these papers being at least two decades old, most of the industry persists in being “faith-based” instead of “evidence-based” – probably because the management fees are higher for hope! So let me summarize the whole thing:
- The most important thing is to get the allocation to stocks, bonds, and cash right and diversify appropriately.
- Trying to beat the market through timing or security selection generally doesn’t work and costs matter a great deal.
- Notwithstanding the previous point, systematically tilting a portfolio toward smaller companies (small-cap), cheaper companies (value), and investments that have done well recently (momentum) does appear to work (on average over time, of course).