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Weston Wellington Talks Nobel Laureates

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IFA.tv Show 17-Weston Wellington Talks Nobel Laureates

MH: Hi, I am Mark Hebner, President of Index fund Advisors and welcome to IFA.tv! Today I am here with Weston Wellington-Vice President over at Dimensional Fund Advisors…and Weston has been making several appearances at IFA.tv, something we very much appreciate here…and today we wanted to talk about few topics and we are going to first discuss the recent award of the Nobel Prize in economics given to Eugene Fama…and so Weston why don’t you share a few thoughts about this prize and what it might mean to you and to maybe some of folks over at Dimensional…any ideas or thoughts on this?

WW: I’d like to address that from the view point of…my viewpoint as a practitioner in the financial services industry over the last four decades (MH: four decades…) and someone who has made a transition from entering a conventional brokerage firm and conducting the investment advisory process  kind of in the conventional way-you read the newspapers, you listen to all the clever analysts or the analysts who claim to be clever (MH: Sure!),and try to figure out what is going to happen again and that’s what I call the conventional viewpoint…there’s an undercurrent that is basically telling you…to be a successful investor you need to have that inside edge, you need to talk to the really smart people, the people who know these companies inside out…maybe you know some company executives on your own.

The notion is that only by getting that edge-that extra titbit of information ahead of the next guy can you hope to become a successful investor. And while going into all the academic details the real conclusion of a lifetime of effort from Professor Fama-is to show in compelling detail how markets are so competitive and they function so well that you can be a very very successful investor without having to search for the so called inside edge. And in fact the effort you devote to searching for this inside edge-the time, the effort is more often than not-not only going to not help you-it will penalize you with your results.

MH: Right…

WW: Markets, reflect information from all sources so quickly that you can’t expect to reliably gain an edge-now this is a very profound statement in a great scheme of things. It means that markets…securities markets in particular are working well enough that they protect the uninformed investor. That means I can walk on to the floor of the NYSE and buy a 100 stocks at random with no particular knowledge about how these companies work or who their executives are or what the earnings forecast maybe…and expect to do just as well as highly trained stock market analysts.

I think if you explain to somebody from a foreign country for example who had no idea how stock markets work or what capitalism is all about and said this is how our system works…I think their reaction would be…wow! What a terrific invention it is-this market that functions so effectively that I get the same deal that the smartest people do…how do you do that?

MH: It reminds me of John Stossel in that 20-20 show from what…year 1992 or something…where he is throwing darts…and the title was ‘Who needs experts?’ Right?

WW: So the thrust of what work by Gene Fama and others of his ilk was to offer compelling evidence that this is in fact how markets work…not just in the US but all around the world…free and open competitive securities markets…

MH: Sure…

WW: …and every citizen whether you are an investor or not should take comfort and be pleased that at this research that is what we would want to see-as a citizen…we wouldn’t want to see a system where a small group of insiders can consistently take advantage of everybody else.

MH: Sure…so this brings up the second Nobel Prize which was given to Robert Shiller…Professor Shiller at Yale-where he is quite known for his identification of bubbles. So, let’s talk about bubbles…we actually have a book here from our library, from 1720, that actually shows various company executives holding up their bubble…so it’s not that it is something new-this bubble-but in a recent NPR interview-Fama and Shiller were kind of one against each other and kind of debated the topic of bubbles-but why don’t you give you opinion on this subject?

WW: Again…and this is my personal opinion as a financial historian of sorts-not a finance academic…I think most investors have a great deal to profit from both of these viewpoints, even though they are often positioned-Shiller and Fama as somehow polar opposites of this debate.

I think Fama offers compelling evidence that it is very difficult not only for individuals to outfox the market-but even for highly trained professionals to outfox the market and therefore you probably shouldn’t try-you just minimize your cost.

Well, I think Shiller’s insight and his key point for investors is to acknowledge that we are humans and humans aren’t necessarily designed or have not evolved to make complex probability based decisions very effectively! We often make mistakes! And the key insight of research by people like Dr Shiller is-not only do people often make mistakes but they make them repeatedly and you can point out how you have made mistakes but the nature of a true behavioural bias is that you’ll continue to make that mistake even when you have been educated about it and you find it hard to resist the temptation.

So from a practical stand point what Shiller can help investors do-inoculate ourselves into-against our tendencies to attach to much importance for example to recent events-a common behavioural bias, we see stocks if gone up-we think they are gonna keep going up forever-we see stocks that have gone down-we think they are going to keep going down forever-both of those are mistakes that are not supported by any data…professors like Fama can show us! Shiller can show us that nonetheless we often are tempted to make poor decisions based on these behavioural biases and perhaps by having a better understanding of these behavioural biases we have a greater chance of achieving the investment success that is in effect laid out for us by people like Professor Fama. So I think that investors can profit greatly from the insights of both gentlemen.

MH: So we happen to have a copy of Robert Shiller’s book, ‘Irrational Exuberance’ which I guess came out in 1999 or something…what’s the history of this title ‘Irrational Exuberance’?

WW: Well to the best of my knowledge, as I understand it-it was at it's genesis in a discussion between Dr Shiller and Alan Greenspan I believe that was in 1996 and I believe it was Dr Shiller who mentioned the phrase irrational exuberance as a way of describing in his view the current state of the securities markets and Greenspan made a very brief, a passing reference using the phrase irrational exuberance more as a question than as a statement in a speech he gave some days later and I have read the speech-it is rather long-not particularly exciting speech about the role of central bankers and as I understand the speech did not get a great deal of attention at that time but as people studied it in more detail in subsequent weeks and months they began to attach much greater importance to this notion of irrational exuberance and that was a debate about whether or not Greenspan himself thought whether markets were irrationally overpriced or was he going to take some policy by the Fed to counteract this and this debate will probably never get settled but that to the best of my knowledge is the origin of this particular use of the phrase.

MH: Yeah…so Weston one of the things that we are concerned about here at IFA-as investment advisors is we wanna gather this information from academics and Nobel Laureates and then try and develop an investment strategy around that. So I was very curious what Robert Shiller suggested to investors in his Irrational Exuberance book which was published in 2000-I just checked the date there and so on page 215 I did notice a paragraph that starts out…so what should investors do now? And to summarize what he has over here on the next couple of pages-it was basically two things 1) we should increase our savings rates and 2) we should diversify. And the interesting thing is that probably Eugene Fama would probably fully agree with that… (WW: I suspect he would…) you always want to save as much as you can and we are going to talk about that in the next video-maybe Richest Man in Babylon-but also to diversify is very basic, that goes back to Harry Markowitz-but certainly in any investments that Eugene Fama has been involved with in terms of the design diversification is an elementary principle of those products. Wouldn’t you agree?

WW: It’s an elementary principle but I am not trying to take words out of Dr Shiller’s mouth-but I think the research on behavioural biases offers a lot of evidence that there is a very strong temptation to ignore these lessons about diversification because it seems to look so easy to make terrific amounts of money-if only we concentrated our investments in what appears to be the most attractive sector or handful of companies at the moment.

And so obviously at various points in time we have heated concentration and excitement among some investors at least in fill in the blank…in 2000 it was internet stocks, in the 1950s it was atomic energy stocks, in the late 1960s it was bowling stocks, you can always find at some point in any sort of market mania a concentrated strategy that for a while worked terrifically well and then it didn’t.

And the suggestion here to diversify-it’s one of these best known secrets in the world, it makes so much sense-but it’s so simple that many investors suggest to themselves that well that’s too simple! (MH: It’s too simple!) I can do even better only if I focus on the really good companies.

MH: That’s right…the other component of Fama’s work that led to his Nobel Prize, in fact I think the general category of the prize had to do with asset pricing models and maybe just spend just a moment on that at the end of our segment here…talking about maybe these factors that Fama and French have become quite known for…

WW: Fama and French and the researchers have found that there are differences in stock returns in the US and markets around the world and these differences can be captured by defining them in terms of their company size-large companies versus small companies and for lack of a better word value versus growth-low priced value companies, higher priced growth companies and that if you analyse money managers-any kind of money manager-Dimensional fund or behavioural fund, a conventionally active managed fund, index funds-when you look at them through this prism of how big a helping they have in small versus large, growth versus value-that explains to an overwhelming degree why one fund does better or worse than another.

We think value stocks are selling at the proper prices-we don’t think there is any irrationality going on-there is something riskier about these small value stocks…investors are aware of this risk and they demand a higher expected return to compensate for bearing this risk.  So in some sense if you are watching this you may realize why should I care? In some sense you shouldn’t care, you don’t need to care-as long as you are buying securities that have small value characteristics you would expect that strategy to be similar to another small value strategy and it should outperform the market on a realized or expected return basis because you are bearing extra risk.

This is one of the things that Fama dwells on his viewpoint-this efficient market idea that to say that markets are efficient isn’t enough, you need to have some model that would tell you how do stocks behave if we assume markets are perfectly efficient?

And so he developed some model that says in these efficient markets small stocks have higher expected returns, value stocks have higher expected returns…now he concedes that it doesn’t have to be the case, it could be the case that investors are irrational and that they assign prices that are improper, they are too low to these value stocks in particular but he calls this the joint hypothesis problem-we can almost never be sure which it is? Is it irrationality, is it mispricing, is it proper reward for risk, is it some combination of both…we probably can’t tell!

From my perspective as an industry practitioner I prefer the risk story…for behaviourist reason…just to kind of flip thing around-I think if people are told ahead of time we think this small value strategy will have higher realized returns but it comes at a cost-we don’t know when these higher returns will appear-they are unpredictable…you might get it next year, you might not.

You have to be willing to hold on to it! If I tell you some version of a free lunch story this strategy has higher returns because you are so smart-and you are going to take advantage of all these stupid irrational investors who are selling to you…that maybe will make you feel good but the time when returns aren’t so good you may be tempted to think-maybe I am the stupid one, maybe all the other people have suddenly gotten smart and there is no value premium anymore-I better sell now.

I think you are more likely to be tempted to abandon the strategy when it is not working well…I think there is more likely in my personal opinion to be a temptation to question yourself after the fact-whereas if you were told risk story-I think you are more likely to stick with it.

MH: Yep…by the way we happen to have Eugene’s classic book here…1976 (date)…The Foundations of Finance which actually does a very nice job in laying out his efficient market hypothesis and I believe he has the joint hypothesis problem-I am pretty sure that it’s in here as well.

So very good, I think that pretty much covers the whole discussion of Fama and Shiller and thank you very much for stopping by here at IFA TV.

WW: Thank you Mark