tag:www.dimensional.com,2008-12-08:/famafrench//1 2009-11-10T01:35:00Z Observations, opinion, research and links from financial economists Eugene Fama and Kenneth French. Movable Type Pro 4.24-en famafrenchhttp://feedburner.google.com tag:www.dimensional.com,2009:/famafrench//1.268 2009-11-09T15:54:09Z 2009-11-10T01:35:00Z

The realized equity premium for U.S. stocks relative to long-term government bonds has been negative for the 5, 10, 15, 20, and 25-year periods ending in 2008 despite substantially greater standard deviation for stocks. How do I use this information...

Fama/French Forum The realized equity premium for U.S. stocks relative to long-term government bonds has been negative for the 5, 10, 15, 20, and 25-year periods ending in 2008 despite substantially greater standard deviation for stocks. How do I use this information to develop a sensible portfolio based on mean-variance optimization? EFF: We have emphasized in previous posts that there is substantial uncertainty about the size of the expected equity premium, that is, the true expected return on stocks less the expected return on riskless bonds. Whatever estimate you use, 5, 10, or even 15 years of recent evidence should not change your estimate much. 20 or 25 years of data are more serious, but then there is another issue.(Read the full entry) ]]> http://www.dimensional.com/famafrench/2009/11/does-your-optimizer-need-a-tune-up.html tag:www.dimensional.com,2009:/famafrench//1.267 2009-11-04T15:49:45Z 2009-11-04T13:34:44Z

Justin Fox ("The Myth of the Rational Market") and many other financial writers claim that much of the blame for the financial meltdown is attributable to a misguided faith in market efficiency that encouraged market participants to accept security...

Fama/French Forum Justin Fox ("The Myth of the Rational Market") and many other financial writers claim that much of the blame for the financial meltdown is attributable to a misguided faith in market efficiency that encouraged market participants to accept security prices as the best estimate of value rather than conduct their own investigation. Is this a fair assessment? If so, how should policymakers respond? EFF: The premise of the Fox book is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH), which posits that market prices reflect all available information. The claim is that the world's investors and their advisors in the financial industry bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. The most recent is the rise and sharp decline in real estate prices which froze financial markets and led to the worst recession since the Great Depression of the 1930s.(Read the full entry) ]]> http://www.dimensional.com/famafrench/2009/11/qa-is-market-efficiency-the-culprit.html tag:www.dimensional.com,2009:/famafrench//1.265 2009-10-02T13:26:34Z 2009-10-02T12:34:18Z

From the American Finance Association's "Masters in Finance" video series, Eugene F. Fama presents a brief history of the efficient market theory. The lecture was recorded at the University of Chicago in October 2008 with an introduction by John Cochrane....

Fama/French Forum
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If a growing percentage of market participants pursued passive investment strategies, at what point would market efficiency break down? Is this a practical concern? EFF/KRF: This is a complicated question that we address at length in "Disagreement, Tastes, and...

Fama/French Forum If a growing percentage of market participants pursued passive investment strategies, at what point would market efficiency break down? Is this a practical concern? EFF/KRF: This is a complicated question that we address at length in "Disagreement, Tastes, and Asset Prices" (Journal of Financial Economics 2007). The answer depends to some extent on who turns passive. If misinformed and uninformed active investors (who make prices less efficient) turn passive, the efficiency of prices improves. If some informed active investors turn passive, prices tend to become less efficient. But the effect can be small if there is sufficient competition among remaining informed active investors. The answer also depends on the costs of uncovering and evaluating relevant knowable information. If the costs are low, then not much active investing is needed to get efficient prices.]]> http://www.dimensional.com/famafrench/2009/09/qa-what-if-everybody-indexed.html tag:www.dimensional.com,2009:/famafrench//1.259 2009-09-15T13:49:26Z 2009-09-15T15:22:42Z

How useful was Monte Carlo-type analysis in preparing for the recent downturn in the economy and stock market? Is there an alternative approach that investors should consider in an effort to address the uncertainty of future returns? EFF: Monte...

Fama/French Forum How useful was Monte Carlo-type analysis in preparing for the recent downturn in the economy and stock market? Is there an alternative approach that investors should consider in an effort to address the uncertainty of future returns? EFF: Monte Carlo analysis is overkill here. All one really needs is good historical perspective on the volatility of volatility. Our white paper, "How Unusual Was the Stock Market of 2008?", is a good start.

KRF: Monte Carlo analysis is often worse than overkill because it gives many users a false sense of precision. If used right, it can provide some perspective about the payoff on a long-term investment. Investors who do Monte Carlo simulations, however, often assume returns are drawn from a normal distribution with a constant volatility. In fact, a normal distribution produces far fewer extreme returns than we see in the market. Moreover, it is easy to forget that the inputs for the analysis - the estimated expected returns, variances, and covariances - are almost certainly grossly imprecise.]]> http://www.dimensional.com/famafrench/2009/09/qa-bear-markets-and-monte-carlo-analysis.html tag:www.dimensional.com,2009:/famafrench//1.261 2009-09-09T13:34:03Z 2009-09-29T21:32:41Z

In an interview conducted by Professor Richard Roll, famed University of Chicago economist Eugene F. Fama discusses his life, research, and contributions to the field of finance. Produced by Dimensional in conjunction with the American Finance Association. Directed and edited...

Fama/French Forum
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Richard Thaler observes "Efficient market guys have to be willing to claim that the NASDAQ is efficiently priced at 5,000 and at 1,400. That's a tough sell." Comments? EFF: Stock prices depend on two factors: expected profitability and the...

Fama/French Forum Richard Thaler observes "Efficient market guys have to be willing to claim that the NASDAQ is efficiently priced at 5,000 and at 1,400. That's a tough sell." Comments? EFF: Stock prices depend on two factors: expected profitability and the expected returns investors require to hold stocks. Both can vary dramatically through time. Thus, widely different levels of the market at different times are quite consistent with market efficiency. Indeed, they are required for market efficiency. This might well be a tough sell, but it's Finance 101.

KRF: Dick is referring to the behavior of stock prices during the tech boom and bust of 1995-2001. Gene is certainly right that market efficiency requires prices to adjust to new information about future cashflows and discount rates. (Read the full entry) ]]> http://www.dimensional.com/famafrench/2009/08/qa-nasdaq-at-5000-a-mistake.html tag:www.dimensional.com,2009:/famafrench//1.257 2009-08-27T13:42:44Z 2009-08-27T15:16:56Z

We often hear that the investment world must adjust to a "new normal", reflecting a permanent shift to greater market volatility worldwide. How should investors revise their portfolios in response to these developments? EFF: There has always been lots...

Fama/French Forum We often hear that the investment world must adjust to a "new normal", reflecting a permanent shift to greater market volatility worldwide. How should investors revise their portfolios in response to these developments? EFF: There has always been lots of variation through time in market volatility, and volatility tends to be mean-reverting. (See our white paper, "How Unusual Was the Stock Market of 2008?") If investors can't tolerate periods of high volatility in stocks, this should affect their decisions about stocks, whether or not volatility is currently high.

KRF: It is certainly true that stock market volatility is higher now than it was two or three years ago. At the end of 2006, the VIX, a measure of the annual stock market volatility implied by S&P 500 option prices, was below 12%. (Read the full entry) ]]> http://www.dimensional.com/famafrench/2009/08/qa-is-there-a-new-normal.html tag:www.dimensional.com,2009:/famafrench//1.256 2009-08-25T13:40:14Z 2009-08-25T15:18:01Z

Long-term government bonds outperformed the S&P 500 Index by 0.12% per year for the forty-year period ending March 2009. Does a negative risk premium for stocks vs. bonds over such a long period challenge conventional thinking about risk and...

Fama/French Forum Long-term government bonds outperformed the S&P 500 Index by 0.12% per year for the forty-year period ending March 2009. Does a negative risk premium for stocks vs. bonds over such a long period challenge conventional thinking about risk and return? EFF/KRF: It is important to distinguish between the expected equity premium, which should be positive, and the realized premium, which is the expected premium plus the unexpected premium. Investing in stocks is risky because we do not know what the unexpected premium will be. (Read the full entry) ]]> http://www.dimensional.com/famafrench/2009/08/qa-bonds-for-the-long-run.html tag:www.dimensional.com,2009:/famafrench//1.244 2009-08-20T13:38:23Z 2009-08-20T12:59:10Z

U.S. budget deficits keep expanding and some of our largest trading partners have begun to question the dollar's role as the world's reserve currency. Both trends suggest a dim future for the purchasing power of the U.S. dollar. Does...

Fama/French Forum U.S. budget deficits keep expanding and some of our largest trading partners have begun to question the dollar's role as the world's reserve currency. Both trends suggest a dim future for the purchasing power of the U.S. dollar. Does a diversified equity / fixed income strategy represent the soundest way to address this challenge? EFF/KRF: Recent Government actions, both fiscal and monetary have created lots of uncertainty about future inflation. Stocks may compensate for inflation in the long-term, but in the short-term they are not very good. And there is so much other uncertainty in stock returns, stocks are not in any case a good specific inflation hedge. TIPS and short-term bonds are good inflation hedges. If you are concerned about inflation risk, you may want to allocate more to them, probably in the tax-sheltered components of client portfolios. (Read the full entry) ]]> http://www.dimensional.com/famafrench/2009/08/qa-protecting-purchasing-power.html tag:www.dimensional.com,2009:/famafrench//1.243 2009-08-17T13:37:11Z 2009-08-17T13:28:49Z

Stock market analysts often claim that hedge funds represent a significant percentage of trading volume in securities markets. What effect, if any, do hedge funds have on stock and bond prices? EFF/KRF: Good question, but we know of no...

Fama/French Forum Stock market analysts often claim that hedge funds represent a significant percentage of trading volume in securities markets. What effect, if any, do hedge funds have on stock and bond prices? EFF/KRF: Good question, but we know of no evidence on the matter. For example, hedge funds might make markets more efficient or they might reduce the accuracy of financial prices.]]> http://www.dimensional.com/famafrench/2009/08/qa-hedge-funds-and-securities-prices.html tag:www.dimensional.com,2009:/famafrench//1.247 2009-08-11T14:28:09Z 2009-08-11T16:04:41Z

Widely cited as the father of the efficient market hypothesis and one of its strongest advocates, Professor Eugene Fama examines his groundbreaking idea in the context of the 2008 and 2009 markets. He outlines the benefits and limitations of efficient...

Fama/French Forum
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KRF: Professor Robert Lucas of the University of Chicago has an interesting guest article in The Economist, "In defense of the dismal science."...

Fama/French Forum KRF: Professor Robert Lucas of the University of Chicago has an interesting guest article in The Economist, "In defense of the dismal science." ]]> http://www.dimensional.com/famafrench/2009/08/robert-lucas-in-the-economist.html tag:www.dimensional.com,2009:/famafrench//1.242 2009-08-06T13:35:33Z 2009-08-06T13:26:52Z

A buy-and-hold for stocks appears to work well for long periods (such as 1975 - 1999) but then does poorly for extended periods as well, such as the most recent ten years. Isn't it clear that there are "seasons"...

Fama/French Forum A buy-and-hold for stocks appears to work well for long periods (such as 1975 - 1999) but then does poorly for extended periods as well, such as the most recent ten years. Isn't it clear that there are "seasons" for stocks that make the climate favorable or unfavorable for investors? EFF: We always emphasize that ten years is not a long period for stock returns, and ten-year periods with negative market premiums are common. A long period is basically an investment lifetime (35+ years).

KRF: After the fact it is easy to identify periods in which stocks did well and periods in which they did poorly. But if you want to use these "seasons" to build an investment strategy, you have to identify them before they occur - and that is not so easy. The seasons analogy creates the false impression that, like spring, summer, fall, and winter, the favorable and unfavorable periods follow a regular and predictable cycle. Droughts in Australia might be a better analogy. We don't know when the next one will occur and we don't know how long it will last when it does.]]> http://www.dimensional.com/famafrench/2009/08/qa-the-equity-premium-over-long-periods.html tag:www.dimensional.com,2009:/famafrench//1.241 2009-08-04T13:33:01Z 2009-08-04T13:08:38Z

Index funds buy stocks "blind" without regard to company fundamentals. Do their activities contribute to mispricing of securities? EFF: Index funds typically buy cap-weighted portfolios so they do not contribute to mispricing. KRF: We analyze a general version of...

Fama/French Forum Index funds buy stocks "blind" without regard to company fundamentals. Do their activities contribute to mispricing of securities? EFF: Index funds typically buy cap-weighted portfolios so they do not contribute to mispricing.

KRF: We analyze a general version of this question in "Disagreement, Tastes, and Asset Pricing" (Journal of Financial Economics, 2007). Suppose index fund investors hold a passive market portfolio. Then from a pricing perspective they are sitting on the sideline. They are not overweighting or underweighting any securities, so they do not affect (relative) prices. As a result, it is hard to argue that they contribute to mispricing. (Read the full entry) ]]> http://www.dimensional.com/famafrench/2009/08/qa-do-index-funds-contribute-to-mispricing.html