Faces of Laurates

The Academic Advantage

Faces of Laurates

The financial services industry has evolved over the last six decades. What started as essentially a broker or salesman role for getting people access to publicly traded securities has transformed into an academic discipline. We have documented this evolution from its roots with Scottish philosopher Adam Smith, to French mathematician Louis Bachelier, to the establishment of the Center for Research in Security Prices (CRSP) at the University of Chicago in 1960, to all of the academic papers that came thereafter. With a robust dataset, statisticians and researchers were eager to dissect historical stock and bond prices in order to understand the capital markets.

Over six decades of financial research has led to some overwhelming conclusions about the capital markets:

  1. Risk and return are inseparable. We cannot begin to talk about expected returns until we have a firm understanding of risk.
  2. Capital markets are highly efficient. Current prices reflect all known information as well as future expectations from market participants.
  3. Prices most closely follow a “random walk” in which past price movements give market participants no reliable information about future price movements.
  4. People often make sub-optimal decisions when faced with multiple probabilities. In other words, we are not “utility maximizing robots” that traditional economic theory often assumes and often make decisions based on emotion.
  5. Structure determines performance. Asset allocation within a portfolio is the largest determinant of future returns and tactics like market timing or stock picking provide little benefit in the context of future portfolio returns.
  6. There are known dimensions that drive the performance of stock and bond prices in markets around the world. For stocks, this includes the market, size, relative-price, and profitability factors. For bonds, this includes the term and default factors. Constructing diversified portfolios around these dimensions can increase the risk-adjusted returns for investors.
  7. The vast majority of active fund managers fail to outperform their risk-appropriate benchmark on a consistent basis. The number of those who do are similar to what is expected by random chance alone making it hard for investors to decipher skill from luck.
  8. Alternative investments, mainly hedge funds and private equity, have not provided sufficient and consistent risk-adjusted returns to overcome the higher fees they charge their investors.

You can find a list of the peer-reviewed academic papers that provides the basis for the investment philosophy and subsequent strategy that Index Fund Advisors promotes for its clients.

It is important to note that any model or philosophy is a simplification of reality. By definition, all models are incomplete and to a certain extent an inaccurate reflection of reality. But that doesn’t mean that the scientific process and the conclusions we draw from it cannot provide insight into the world we live in. We have laid out an argument, backed by empirical evidence, for why we think investors are best served through buying, holding, and rebalancing a globally diversified portfolio of index funds that properly matches their individual risk capacity.

This should the requirement of anyone who is acting as a fiduciary to their clients let alone providing any sort of advice about personal finances. It needs to be rooted in putting the client’s best interest first and foremost and backed up by research that is peer-reviewed and held to the highest academic standards.

Doing anything less is simply wrong and not keeping up with the evolution of our industry.