Portfolio Theory
*NEW*
Samuelson’s
dictum and the stock market, by Jeeman Jung and Robert Shiller, Economic
Inquiry, Vol. 43, No. 2, April 2005; also published earlier as National
Bureau of Economic Research Working Paper #9348, November 2002.
Samuelson observed in 1998 that the stock market is “micro efficient” but
“macro inefficient” – that is, you can do better in betting by means of asset
allocation than in picking stocks. This article performs a simple test, based
on the dividend yield’s ability to predict future dividend growth, “that
vividly illustrates that there is some truth to Samuelson’s dictum.” Must
reading for all serious investors.
*NEW*
British
investment overseas 1820-1913: A Modern Portfolio Theory approach, by William
Goetzmann and Andrey Ukhov, Working Paper # 11266, National Bureau of Economic
Research, 1050 Massachusetts Avenue, Cambridge, MA 02138, April 2005.
This paper analyzes British foreign investment in its heyday by applying
mean-variance analysis to the domestic and international investment opportunities
available to British investors. The result is impressive evidence of both higher
returns on foreign assets. Equally important, foreign assets offered significant
benefits from diversification. British investor behavior in going overseas was
clearly rational.
*NEW*
The term
structure of the risk-return trade-off, by John Campbell and Luic Viceira,
Financial Analysts Journal, January/February 2005. This paper
demonstrates that expected excess returns on bonds, on stocks, on real interest
rates, and on risk itself shift over time in predictable ways – shifts that
persist for long periods. The result is a shifting tradeoff of risk and return
among major asset classes. Hence, the “term structure” of this tradeoff.
Commonly used return-forecasting variables, such as dividend yields, interest
rates, and yield spreads have substantial effects on optimal portfolio
allocations, effects that work through the effect of asset return predictability
on the volatility and correlation structure of asset returns across investment
horizons. The findings suggest that asset allocation recommendations based on
short-term risk and return may not be adequate for long-term horizon investors.
*NEW*
The Adaptive
Markets Hypothesis, by Andrew Lo, The Journal of Portfolio Management,
30th Anniversary Issue 2004. The battle between the proponents of
efficient market theory and the proponents of behavioral finance are in an
unending debate over rational decision-making versus fear-and-greed. But these
two perspectives may be opposite sides of the same coin. An adaptive hypothesis
to reconcile the two views applies the principles of evolution – competition,
adaptation, and natural selection – to financial interactions. Much of the
behavioral enthusiasts’ favorite stocks-in-trade, such as loss aversion,
overconfidence, overreaction, and mental accounting - are consistent with an
evolutionary model of individual adaptation to a changing environment via simple
heuristics. This hypothesis yields important concrete implications for portfolio
management.
Fight the
Fed Model, by Cliff Asness, The Journal of Portfolio Management, Fall
2003. Asness mounts a powerful attack on the notion that there is a
systematic relationship between earnings yields and interest rates – despite
the enthusiasm for this construct at the Federal Reserve Board and even though
many markets appear to demonstrate its validity. But the earnings yield is a
real number; the bond yield is a nominal number. Furthermore, the model
ignores differences in risk and variations in such differences. It fails as a
predictor of long-run returns. Over the long run, equity earnings move in
tandem with inflation.
The
efficient market hypothesis and its critics, by Burton Malkiel, Journal of
Economic Perspectives, Winter 2003.
Malkiel, a long-time believer in the theories of the efficient market and
the random walk, vigorously confronts here the evidence against his position
from behavioral finance, momentum investing and popular fundamental ratios.
Malkiel’s response is extensive and comprehensive. Must reading for all
serious investors.
