Franco Modigliani (left), Nobel Prize in Economics, 1985 (link)
Merton Miller, Nobel Prize in Economic Sciences, 1990
The Modigliani-Miller Theorems
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
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 firms value is unrelated to its dividend policy, and policy is an unreliable guide for stock selection. The MM theorems have become the 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. Also see Debunking Dividend Myths: Part 1 and Part 2.
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-1960s, 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 interviewed 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, MIT, Nobel Prize in Economics, 1970 (link)
The Random Walk Continues
Farewell to the Eminent Economist - Paul Samuelson (1915-2009)
Samuelsons 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
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 Bacheliers 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.
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 Hypothesis would once again be evident.
The Efficient Market Hypothesis 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.
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 by Gene Fama, Jr.
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 Classic Papers
Michael Jensen (link)
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.
has made significant
contributions to the academic literature. Michael
second out of 19,780 authors, at the Social Science
Electronic Publishing online database, with over 46,000 downloads of his
research papers. A list of other performance measurement articles can be found here.
Jensen also added a risk dimension when comparing mutual fund performance. He adjusted returns of funds using Sharpe's volatility measure, beta. This incorporated the idea that investors who take more risk should receive a higher return. Overperformance or underperformance of an index may be due to exposure to more or less risk than a comparable index. Jensen found that if investors had held a broadly based portfolio of common stocks at the same risk level as the mutual funds, they would have earned fifteen percent more. Only twenty-six out of one hundred fifteen funds outperformed the market over the period of the study.
Jensen's dramatic study opened the eyes of both the mutual fund industry and investors. He pointed out that fund managers have access to extensive research, and that they do their jobs every day with wide ranging contacts and associations in both the business and financial communities. This begs the question: if the experts cannot do better than an index, who can?
Jensen's study did not consider the federal and state taxes on the realized gains generated by the high turnover of these mutual funds. That problem was later studied by Robert Arnott in his paper, "Can Your Alpha Cover Your Taxes?" Alpha refers to a manager's return in excess of a market. When adjusted for all relevant factors, a well defined index of stocks will always outperform the high cost of active manager trading within that index. The only way to get a return that is different from an index is to invest in a portfolio that is different from the index. Since the index is the only source of long-term risk and return data, why would an investor choose anything else?
John McQuown, Wells Fargo Bank (link)
The First Index Fund
John McQuown joined the Wells Fargo Bank Management Science division in 1964. He was recruited by the division's president to implement modern portfolio theories in the bank's trust department. McQuown had learned about these new theories through his acquaintances at the University of Chicago - Fisher, Lorie and Fama. Although McQuown had a degree in Mechanical Engineering, he soon became more interested in applying computer science to the stock market. In revamping the trust department, he called on numerous academic consultants, including Markowitz, Sharpe, Fama, Miller, Lorie, Jensen, Scholes, Black and Treynor.
John McQuown, James Vertin, and William Fouse developed the first commercial product that actually applied the academic theories developed in Chicago.
In 1971, the son of the owner of Samsonite Luggage Corporation completed his graduate studies at the University of Chicago's Department of Finance. When he returned to Denver, he wanted to apply what he had learned to Samsonite's pension fund. His contacts in Chicago put him in touch with Wells Fargo Bank in San Francisco. As a result, Samsonite invested six million dollars of the company's pension fund into the very first index fund. That first institutional fund was not based on the S&P 500, but was comprised of an equal dollar amount of each of the 1,500 stocks on the New York Stock Exchange.
John McQuown, Wells Fargo Bank (link)
Rex Sinquefield (shown below), American National Bank
The Standard and Poor's Composite Index Funds
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.
Burton G. Malkiel (link)
A Random Walk Down Wall Street
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.
On October 13, 2008, Professor Malikiel wrote an article for the Wall Street Journal and stated, "It is very tempting to try to time the market. But neither individuals nor investment professionals can consistently time the market." - Keep Your Money in the Market.
On February 5, 2010, the New York Times reviewed the new book by Burton Malkiel and Charles Ellis. In the article the author states that "Mr. Malkiel, a professor of economics at Princeton University, has long advocated index funds. What’s striking now is his belief that the wealthiest would have fine returns without the volatility and high fees if they simply used indexes to diversify their money across asset classes. “This is still a strategy that is good for people of all income levels,” he said. “If I took all the mutual funds that existed in the early 1970s and asked the question how many really beat the market through 2009, you can count them on the fingers of one hand."
The Index Funds Gospel According to Burton Malkiel. guardian.co.uk
A Case for Capitalism (link)
In his book, The Road to Serfdom, Austrian economist Friedrich von Hayek (1899 to 1992) made the case for free market capitalism as a superior economic model to communism or socialism. He and his mentor Ludwig von Mises were influential figures in the Austrian school of political economy. He postulated that centralized planning by a government is not democratic and that market economies are the result of spontaneous order, resulting in a more efficient allocation of social resources
than any other system could achieve. Building on the work of Adam Smith, Mises, and others, Hayek argued that in socialist or communist societies, an individual or a small group of people unreliably determines the distribution of resources. The crux of Hayek's theory is succinctly summarized in an article he published in 1945, “The Use of Knowledge in Society” in which he puts forth the concept that prices in a free market, such as the New York Stock Exchange, are set by information that is available to market participants and serve as a means of communication between buyers and sellers. Hayek describes the price system as a “marvel” because, in his own words:
“I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind.”
Joseph Chi and Jed Fogdall of Dimensional Fund Advisors beautifully explained it by noting that there are two types of information: (1) general knowledge widely available to all market participants and (2) specific knowledge of the particular circumstances of time and place, including the preferences and needs of each investor, which vary by investor. The price system aggregates both types of information, including the knowledge about the specific circumstances of all market participants, into one single statistic—the price—so that investors have the knowledge necessary to make decisions for themselves. Because both types of knowledge can move prices, market participants compete with one another to be the first to bring information not yet reflected in prices to the market and profit from it, but no participant has the full set of information because each participant has some specific knowledge not generally available to others. That competition and interaction among market participants makes market prices reflect information about fundamental values and expectations, with no single participant able to interact with the market in isolation, up to the point at which the marginal benefit of acting on information that is not reflected in prices (that is, the profits to be made) is at best equal to the marginal cost of gathering that information and acting on it.
Hayek was awarded the Nobel Memorial Prize in Economics in 1974 and the Presidential Medal of Freedom in 1991 by President George H.W. Bush.
John Bogle, Chairman, The Vanguard Group (link)
The First Index Mutual Fund for the Private Investor
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).
David G. Booth, Co-Chairman Dimensional Fund Advisors (link)
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.
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). DFA is significant because it was one of the first companies to impart the idea of equilibrium and the concept that a scientific method can show the direct relationship between risk and return. DFA has continued to succeed, even during the 1980's when small cap stocks were at their worst. In January 2009, DFA completed construction of its new, state of the art, world headquarters in Austin, Texas. As of September 30, 2011, the firm manages $195.3 billion in assets. On November 6, 2008, the University of Chicago Graduate School of Business announced a $300 million dollar gift from David Booth. This is the largest donation in the University's history and the largest gift to any business school in the world. The school was renamed the University of Chicago Booth School of Business. The Chicago Booth School of Business made the announcement on this page.
Nov 6, 08 Update
William F. Sharpe (left), Nobel Prize in Economic Sciences, 1990 (link)
Merton H. Miller, Nobel Prize in Economic Sciences, 1990
Harry M. Markowitz, Nobel Prize in Economic Sciences, 1990
Nobel Prize Site
The Science Of Investing Is Recognized
On October 16, 1990, the Alfred Nobel Memorial Prize in Economic Sciences
acknowledged the role of science in investing and awarded the prize to Harry
M. Markowitz of the City University of New York, William F. Sharpe of Stanford
University and Merton H. Miller of the University of Chicago for their pioneering
work in the field of financial economics. The science of investing, which
began with Alfred Cowles back in 1933, was formally recognized that year.
This occasion marked a milestone, since it formally recognized the continuing
revolution in investment theory and practice that was sparked nearly forty
years ago. All equally deserving, William Sharpe was rewarded for the Capital
Asset Pricing Model, beta and relative risk; Harry Markowitz for the theory
of portfolio selection; and Merton Miller for work on the effect of a firm's
capital structure and dividend policy on market price.
Eugene Fama, University of Chicago (link)
Kenneth French (shown below), University of Chicago (currently MIT)
The Three-Factor Asset Pricing Model
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.
Kenneth French speaks on tech ticker:
Try to Time the Market, Either
Why Investors Shouldn't Own Commodities
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.
1. Who first proposed in the year 1900 that stock market prices are random?
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:
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