Models And Mavens

"In Pursuit of the Perfect Portfolio

By Andrew W. Lo and Stephen R. Foerster

(Princeton, 400 pages, $29.95)

Financial markets are unpredictable, prone to fads, bubbles and crashes. This frustrates academics who would prefer that the stock market obey Newtonian laws.

Andrew Lo and Stephen Foerster have written an intellectual history of modern finance theory, built around interviews with influential academics and thoughtful practitioners. Their book documents the quest for the perfect portfolio, and shows how far from a science investing remains.

The most important -- and well-known -- theory to emerge from academic finance is Nobel Prize winner Eugene Fama's efficient-markets hypothesis, which holds that the actual price of a security is the best estimate of its intrinsic value.

Mr. Fama argues that the last half-century of scholarship has been focused on challenging his thesis. "Look guys, you have to grow up. You can't just be complaining about market efficiency all your life," he says of other economists. "You have to come up with something that we can test and reject." Mr. Fama doesn't think any studies have passed that bar.

The greatest proof of the rigor of Mr. Fama's theory lies in the success of low-fee passive index funds, the brainchild of the great John Bogle, the late founder of Vanguard. Bogle argued that, as a group, active investment managers must fall short of the market return by the amount of costs they incur. The best strategy for investors, therefore, is to assume efficient-markets theory holds and embrace low-cost, passive all-stock-market investing.

The data have borne out Bogle's insights. Charles Ellis, founder of investment consulting firm Greenwich Associates and a great advocate of passive index funds, notes that "over 10 years, 83 percent of active funds in the U.S. fail to match their chosen benchmarks; 40 percent stumble so badly that they are terminated before the 10-year period is completed." Insofar as equity investing is concerned, Mr. Ellis's findings seem to vindicate Mr. Fama's big idea and Bogle's big innovation.

Most of the thinkers interviewed in this book argue in favor of low-cost passive equity index funds as the foundation of the perfect portfolio. Yet that's where agreement ends, the eat-your-vegetables portion of the book stops, and the fun and controversy begin.

The book glowingly profiles Bill Sharpe, one of the originators of the capital asset pricing model (CAPM), which argues that there is a linear relationship between a stock's expected return and its riskiness, as measured by how much it varies relative to the market. Messrs. Lo and Foerster say the idea has stood the test of time. Yet Mr. Fama chimes in to claim that "the central prediction of the CAPM just has never worked. The relation between average return and beta has always been too flat."

Despite this repudiation by the most brilliant thinker in the field, the CAPM still earns a chapter in this book and a prominent place in most business-school curricula. Professors, it seems, never want to let a bad model go to waste. Academia's resistance to abandoning models is nowhere better evidenced than in the famous collapse of Long-Term Capital Management, a hedge fund run by several of the most brilliant finance academics. Reflecting on its blowup, the distinguished professor and co-founder of LTCM Robert Merton said that "errors were made and unforeseeable things happened . . . But the crisis was not precipitated by an error in the models." In other words, it's the market's fault, not the model's.

Financial bubbles are a particularly thorny problem for finance theorists. It's hard to explain how the price of Dogecoin or AMC or Pets.com is efficient in any sense of the word -- even if it's also difficult to short them when they seem overvalued! Mr. Fama argues against the existence of bubbles, claiming that if we can only identify them in hindsight they must have been rational at the time.

Robert Shiller, who won the Nobel Prize the same year as Mr. Fama, and is famous for calling both the internet and the housing bubbles, argues that this is academic fundamentalism, a refusal to let common sense get in the way of a beautiful model. "Crazy dictators in history -- are they rational? They look crazy to me. But, you know it's an act," says Mr. Shiller. "There are bubbles." Mr. Shiller argues that his cyclically adjusted price-to-earnings ratio (CAPE) is a good method for identifying financial bubbles. Notably, Mr. Shiller's CAPE currently indicates that the U.S. market is near all-time highs on valuations, and suggests shifting money to cheaper international markets.

Mr. Shiller's most famous idea is that markets are more volatile than efficient-markets theory allows. This excess-volatility problem poses a challenge for investors, who have to navigate wild and seemingly nonsensical fluctuations. The options pioneer Myron Scholes argues that investors should be razor-focused on this volatility problem. He warns of downside "tail risks" and argues that investors should try to reduce the peak-to-trough drawdowns in their portfolio value and seek to capture the "tail gains" that result when markets swing back. Mr. Scholes advocates for a much more active investing style than anyone else in the book. He recommends reacting to the market information contained in options prices, and using asset allocation to avoid big drawdowns and capitalize in times of crisis. Above all else, he advises, focus on terminal wealth and compounding.

Andrew Lo, the lead author of this book, is known for his adaptive-markets hypothesis, which says that people respond to the unique experiences of their lives, that different experiences and different preferences lead individuals to adapt. There is, then, no perfect portfolio, because it would depend on the preferences and experiences of individuals. Not even the world's most famous academics, who have all looked at the same data and read the same papers, come to the same conclusions. Perhaps that is the greatest challenge to the brilliant academic theories presented in this book: that markets are human, and human action rarely accords with simple linear models or mathematical equations. "The Perfect Portfolio" highlights these great debates, providing fascinating insights into the people behind the ideas and raising important questions about the power and limitations of a scientific approach to investing." [1]

1. Models And Mavens
Rasmussen, Daniel. Wall Street Journal, Eastern edition; New York, N.Y. [New York, N.Y]. 05 Jan 2022: A.13.