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1958
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| Merton Miller from the Nova Special, The Trillion Dollar Bet |
The
Modigliani-Miller Theorems concern decisions about aspects of the accumulated
savings stock. The basic model was formulated in Modigliani's and Miller's
essay, "The Cost of Capital, Corporation Finance" and "The Theory of Investment"
(1958). Two other important essays followed in 1963 and 1966. Using this
basic model, Miller and Modigliani derived two so-called invariance theorems,
now known as the MM theorems. As Peter Bernstein asserts, "You have
only to mention these letters to finance people, and they know what you
mean."
The Model of Portfolio Choice and the Capital Asset Pricing Model focus
on financial investors, while Merton Miller, initially in collaboration
with Franco Modigliani, established a theory for the capital market relationship
between the capital asset structure and dividend policy of production
firms and firms' market value and costs of capital.
The main message of the MM theorems is as follows: a firm’s value
is unrelated to its dividend policy, and policy is an unreliable guide
for stock selection. The MM theorems have become comparative norm for
theoretical and empirical analyses in corporate finance. Merton Miller,
who died in 2001, is the researcher who has dominated these analyses during
the last two decades. He has made a unique contribution to modern theory
of corporate finance.
The
Capital Asset Pricing Model
defines risk as volatility relative to the market and states that a stock's
cost of capital, and the investor's expected return, is proportional to
the stock's risk, relative to the entire stock universe.
In the mid-1960’s, several researchers worked independently of one
another to contribute to the CAPM. William Sharpe's pioneering achievement
in this field was contained in his essay, Capital Asset Prices: A Theory
of Market Equilibrium under Conditions of Risk (1964).
The expected return on an asset is determined by its beta coefficient,
and also measures the similarities between the return on the asset and
the return on the market portfolio. The CAPM shows that risks can be shifted
to the capital market, where they can be bought, sold and evaluated. The
prices of risky assets are adjusted so that portfolio decisions become
consistent, less random, and less hazardous.
The CAPM is the backbone of modern price theory for financial markets.
Widely used in empirical analysis, the model allows an abundance of financial
statistical data to be utilized systematically and efficiently. It is
applied extensively in practical research and has become an important
tool for decision making in different areas. Studies require information
about firms' costs of capital, where the risk premium is an essential
component.
The Capital Asset Pricing Model is routinely used in calculations of capital
costs associated with investment and takeover decisions, estimates of
capital costs for pricing in regulated public utilities, and judicial
inquiries related to court decisions regarding compensation to expropriated
firms whose shares are not listed on the stock market. The CAPM is also
applied to comparative analysis of the success of different investors.
Wells Fargo noted in 1989 "that CAPM has given us all a fertile intellectual
garden to grow in."
William
F. Sharpe was interview by Jason Zweig in the June 2007
issue of Money
Magazine, p. 107 -
Sharpe said, "Some investments do have higher expected
returns than others. Which ones? Well, by and large they're
the ones that will do the worst in bad times."
Paul
Samuelson’s findings can be summarized as follows: Market prices
are the best estimates of value, price changes follow random patterns,
and future stock prices are unpredictable. (Source: Proof That Properly
Anticipated Prices Fluctuate Randomly, Industrial Management Review, Spring
1965)
Paul Samuelson was the first American to win the Nobel Prize in Economics.
His famous textbook, Economics, was published in 1948 and is now
in its 18th edition. He is probably the most famous economist of our time.
Samuelson's wisdom is reflected in his words, "Investing should be
dull, like watching paint dry or grass grow. If you want excitement, take
$800 and go to Las Vegas. It is not easy to get rich in Las Vegas, at
Churchill Downs, or at the local Merrill Lynch office." An impressive
collection of his research from 1937 to 1986 contains 388 articles that
span 4,665 pages.
One of Samuelson's idols was Louis Bachelier, the unappreciated genius
who first wrote about random prices over a century ago. Samuelson discovered
Bachelier’s paper from 1900 in a French library. Like many others,
Samuelson proved, expanded, and refined Bachelier's discovery. In Samuelson's
1965 paper, Proof that Properly Anticipated Prices Fluctuate Randomly,
he describes "shadow prices" or true values of a security. Samuelson
suggests that the best estimate of the true value of a security is the
price that is set in the marketplace every minute of every trading day.
Although these prices may not be the precise true value, no other estimate
is likely to be more accurate than what buyers and sellers agree on in
the marketplace. Of course, there is the opposing view of investment professionals
who believe that there are constant differences between the market price
and the true value of securities, and that those differences can result
in future profits for the skilled money manager. Samuelson insists there
are no easy pickings and no sure gains. Generally speaking, Paul Samuelson
has contributed more than any other contemporary economist to raising
the analytical and methodological level in economic science.
1965
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| Efficient Market Theory - clip from interview with Eugene Fama (also see Library) |
As expected from a
University of Chicago graduate and professor, Eugene F. Fama is another
pillar of modern finance. Building on the ideas of Bachelier,
Cowles, Samuelson, and many others, Fama set out to develop a comprehensive
theory to explain why stock market prices fluctuate randomly. He coined
the famous phrase "Efficient Market."
Fama worked for a stock market newsletter firm while attending undergraduate
school in Boston. One of his duties was to find "buy and sell signals" based
on certain market trends. He experienced firsthand the difficulty in predicting
future market trends. He began to wonder, just as Cowles did before him,
why it was so difficult to translate what appeared to be neatly defined
past trends into sure methods of making money in the stock market. These
ponderings influenced him enough to attend the University of Chicago,
obtain his doctorate, and become a professor teaching classes on the works
of Harry Markowitz. Despite the innovative character of Markowitz's writings
and his association with Chicago, his work was virtually unknown when
Fama first brought it to the attention of the finance department. Fama
later applied his extensive, world famous research to create numerous
index mutual funds at Dimensional Fund Advisors.
In January 1965, the Journal of Business published Fama's entire
70-page Ph.D. thesis, The Behavior of Stock Market Prices, summarized
nine months later by the Financial Analysts Journal and titled "Random
Walks in Stock Market Prices".
Fama suggested that by utilizing the tremendous resources that a major
brokerage firm can muster for researching industry trends, effects of
interest rates, accounting data, and by talking to managers of firms,
consulting economists and politicians, a security analyst should be able
to consistently outperform a randomly selected portfolio of securities
of the same general risk.
Since in any given situation, the analyst has a fifty percent chance of
outperforming the random selection, even if his skills are nonexistent,
Fama's conclusion was that the analysts do not consistently outperform
a market.
These analysts do help keep the market efficient. If all investors held
portfolios of index funds, opportunities would open for active traders
to take advantage of the indexed investors. As more active traders moved
in to exploit these opportunities, the index advantage would be extinguished
and Fama's Efficient Market Theory would once again be evident.
The Efficient Market Theory explains the workings of free and efficient
financial markets. Information about stocks is widely and cheaply available
to all investors. All known and available information is already reflected
in current stock prices. The price of a stock agreed on by a buyer and
a seller is the best estimate, good or bad, of the investment value of
that stock. Stock prices will almost instantaneously change as new unpredictable
information about them appears in the market. All of these factors make
it almost impossible to capture returns in excess of market returns, without
taking greater than market levels of risk.
It is relatively rare to find and profit from a mismatch between a stock's
price and its value, or to identify an undervalued or overvalued stock
through fundamental analysis of stocks. This creates efficient financial
markets where most stock prices accurately reflect their true underlying
investment values. Even when stock prices do not reflect their values,
attempts to establish more accurate values usually cost more than the
profit to be made from successful efforts to do so.
This theory threatens the view that there might be something pinning down
the average price of an asset. Deviations of an asset price from this
value follow a random walk. This annoyed those who claim that they could
anticipate speculative trends in asset prices. They could not beat a market,
because any available information is already incorporated in the price.
Anyone with evidence to the contrary has yet to show a comparably rigorous
analysis of the facts. At the 1968 Institutional Investor conference,
one irate money manager insisted that what he and others did for investors
had to be worth more than just throwing darts at the Wall Street Journal.
The "dart board portfolio" soon became a new benchmark for active
investors, appearing in newspapers, magazines, and in a 1992 20/20
ABC news segment entitled, Who Needs the Experts? In that segment,
a giant wall-sized version of the Wall Street Journal was made
into a dartboard. Reporter John Stossel threw several darts as he described
the firms he randomly hit. The results of that portfolio were compared
to those of the major Wall Street Firm experts. The darts beat 90% of the experts! When ABC requested interviews with several of
these expert firms, not one of them would speak or comment on their humiliating
inability to beat the darts.
The Random Walk Theory of stock market prices was detected as early as
1900 by Louis Bachelier and in later studies by Holbrook Working (1934),
Alfred Cowles (1933, 1937), Clive Granger with Oskar Morgenstern (1963),
and Samuelson (1965). Fama took the theory to new heights with enough
rigorous statistical analysis to shake up Wall Street.
The biggest problem in getting this information out to the public was
that nobody had figured out a way to convert this academic research into
a practical product. The entire investment industry profited from the
active trading of investment portfolios; even the mutual funds were just
very large actively traded portfolios. Today there are index funds incorporating
virtually all the research described in this time line.
1965
Michael Jensen
Putting Active
Management to the Test
Once
again from the University of Chicago, Eugene Fama's graduate student,
Michael
Jensen, published "The Performance of Mutual Funds in the
Period 1945-1965," in the Journal of Finance, 1965. This
was the first study of actively managed mutual funds that documented their
investment professionals' failure to outperform the appropriate market
indexes.
19711973
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John McQuown
at Wells Fargo and Rex Sinquefield at American National Bank in Chicago
both established the first Standard and Poor's Composite Index Funds in
1973. Both of these funds were established for institutional clients;
individual investors were excluded. Wells Fargo started with $5 million
from their own pension fund, while Illinois Bell put in $5 million of
their pension funds at American National Bank.
In 1981, Rex Sinquefield became chairman of Dimensional Fund Advisors
(DFA), and McQuown joined its Board of Directors. DFA further developed
index-based investment strategies and currently has $136 billion under
management. Wells Fargo sold its indexing operation to Barclay's Bank
of London, and it now operates as Barclay's Global Investors. It is one
of the world's largest money managers with over $1.4 trillion under management.
1973
Burton G. Malkiel
A Random
Walk Down Wall Street
Also
in 1973, Burton G. Malkiel published his book, A Random Walk Down Wall
Street, which clearly lays out several of the principles of the academic
research described above. He presents these theories to the private investor,
even making a plea to any institution to sponsor an index fund. "Fund
spokesmen are quick to point out you can't buy the market averages. It's
time the public can." Two years later on December 31, 1975, Vanguard
created the First Index Investment Trust, and Burton Malkiel joined the
Vanguard Board of Directors in 1977. John Bogle has referred to him as
a spiritual leader of the crusade.
1975
John
Clifton Bogle graduated from Princeton (not Chicago!) in 1951, where his
senior thesis was titled: "Mutual Funds can make no claims to superiority
over the Market Averages." Bogle claims his inspiration came from
three sources, all of which confirmed his 1951 research: Paul Samuelson's
1974 paper, "Challenge to Judgment", Charles Ellis' 1975 study,
"The Loser's Game," and Al Ehrbar's 1975 Fortune magazine
article on indexing. Bogle founded The Vanguard Group in 1974; it is now
the third largest Mutual Fund Company in the world.
Vanguard has 140 mutual funds and assets totaling $1.1 trillion. When Bogle started the First Index Investment Trust on December 31, 1975, it was labeled "Bogle's Folly" and regarded as un-American, because it sought to achieve the averages rather than insisting that Americans had to play to win. This first Index Mutual Fund offered to individual investors was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999, an astonishing growth rate of fifty percent per year. Bogle predicted in January 1992 that it would very likely surpass the Magellan Fund before 2001, which it did in 2000. "But in the financial markets it is always wise to expect the unexpected" (Bogle speech 1998).
1981
David
G. Booth, Co-Chairman Dimensional Fund Advisors
A New Frontier of Investing
David Booth graduated from the University of Chicago in 1971, naturally
exposed to minds such as Eugene Fama, Merton Miller, and Kenneth French.
In the years before starting his own company, Booth came to believe that
people were missing out on some of the importance of the market efficiency
story.
Twenty-five
years of scientific research convinced Booth that academic study gave
investors an advantage, providing information about products that are
underserved, or those that were not already on the market. Understanding
the vital relationship between risk and return was also facilitated by
this scientific approach.
In 1981,
Booth made room in his two-bedroom apartment for a Quotron machine. Determined
to explore new frontiers of investing, he founded Dimensional Fund Advisors.
DFA is significant because it was one of the first to impart the idea
of equilibrium and the concept that the scientific method proves the direct
relationship between risk and return. The proof of this is in DFA's continued
success, even during the 1980's when small cap stocks were at their worst.
As of March, 2007, the firm manages $136 billion in assets.
1990  |
1992
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In June 1992, Eugene
Fama and Kenneth French of the University of Chicago published Size and
Book-to-Market Equity: Returns and Economic Fundamentals. Their research
improved on William Sharpe's single factor asset-pricing model (CAPM). By
identifying market, size, and value factors in returns, they developed the
three-factor asset pricing model. It is an invaluable tool for asset allocation
and portfolio analysis. This revolutionized the way we construct and analyze
portfolios by identifying independent sources of risk and return. They introduced
the first concentrated, empirical value strategies. This research led to
similar findings internationally, and they updated their studies in 1998
to include data from as far back as 1929.
2.5 |
Summary |
The tumultuous stock
markets with their many new instruments and novel approaches to investing
are a dramatic contrast from the quiet academic libraries where the academics
created their revolution. Considering the extent of the academics’
research, we know that it deserves to be considered a superior source
of information for making decisions concerning investment portfolios.
Random and efficient markets have been one of the underlying themes throughout
this step. Under these conditions, a mix of index funds must be the best
and most logical conclusion for investors.
Now that you have learned a little about the individuals and institutions that contributed to our current knowledge of Modern Portfolio Theory, you are ready to move on to Step 3 to confirm why stock picking just doesn't work.
2.6 |
Review
Questions |
Please answer the following questions correctly before you move on to the next Step in your 12-Step Program.
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1. Who first proposed in the year 1900 that the markets in which stocks are traded are basically random in nature?
2. Modern Portfolio Theory is not so modern because Harry Markowitz first introduced one of the basic tenets in:
3. The three factors of Fama and French's three-factor model are:
