Risk and Reward Revisited

From the Implications and Conclusion section of this paper, co-written by Nardin Baker and Robert A. Haugen:

"As a result of the mounting body of straightforward evidence produced by us and many serious practitioners, the basic pillar of finance, that greater risk can be expected to produce a greater reward, has fallen. It is now clear to a greater and greater number of researchers and practitioners that inside all of the stock (and even some bond) markets of the world the reward for bearing risk is negative."

Paper: Low Risk Stocks Outperform within All Observable Markets of the World

Well, according to the paper, if the "basic pillar of finance" is not necessarily valid then:

"...its invalidation carries critical implications for the theories underlying investment and corporate finance. In our view, existing textbooks on both subjects are dramatically wrong and need to be rewritten."

Buffett explained this negative correlation between risk and reward very well nearly 30 years ago in The Superinvestors of Graham-and-Doddsville.

I highlighted it in this recent post.

Buffett on Risk and Reward

"I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, 'I have here a six-shooter and I have slipped one cartridge into it. Why don't you just spin it and pull it once? If you survive, I will give you $1 million.' I would decline -- perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice -- now that would be a positive correlation between risk and reward! 

The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is." - Warren Buffett in The Superinvestors of Graham-and-Doddsville

Sometimes risk and reward is positively correlated. Sometimes it is not.

Some act as if they must always be correlated in a positive manner.

Note that, for example, the capital asset pricing model (CAPM) doesn't leave any room for the possibility that risk and reward can be correlated in a negative manner.*

Ra = Rf + β(Rm-Rf)

Ra = Expected Return
Rf = Risk Free Rate
β = Beta of the Security
Rm = Expected Market Return

I think it is fair to say that just because an equation happens to have a greek letter, is elegant in appearance, and is widely taught, it doesn't automatically qualify as some great leap of insight.

"...Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger at UC Santa Barbara back in 2003

Efficient markets and the "descendants" is not just somewhat flawed thinking. It is, to me, worse than useless. Charlie Munger said the following later in the same speech talking about what he calls physics envy:**

"I want economics to pick up the basic ethos of hard science, the full attribution habit, but not the craving for an unattainable precision that comes from physics envy. The sort of precise reliable formula that includes Boltzmann's constant is not going to happen, by and large, in economics." - Charlie Munger at UC Santa Barbara back in 2003

These ideas have -- sometimes quietly and sometimes less so -- influenced real world behavior and system design in far from desirable ways. They continue to do so. The damage done may be subtle but it's real.

Not all flawed ideas deserve to be viewed with contempt (and even a brutal disrespect), but at least some of this stuff just might deserve such treatment.

It's not difficult to show, as Jeremy Grantham points out, that participants do not always behave in the cold, rational manner that the efficient market hypothesis relies upon.***

It's not difficult to show that market prices fluctuate far more than intrinsic business values.

It's not difficult to show that risk and reward are not always positively correlated.

It's not difficult to show that a single greek letter -- in this case β -- cannot possibly be a proxy for risk.

Systems should be designed with these realities in mind. The next generation of business leaders, finance professionals, and economists will be more effective if taught to think about the world the way it is (or, at least, as close as possible to the way it is) instead of an imaginary one built upon certain flawed models and assumptions.

In capital markets, mispricing is the norm and, as we've seen during the past decade and a half or so, sometimes that mispricing goes to extremes.

The paper ends by asking, then attempting to answer, the question "how can it be true that over the course of almost fifty years, millions of unsuspecting students have been trained by thousands of finance professors to believe" in efficient markets?
(Including the many related ideas -- the "descendants" -- that have been spun off from it.)

Well, they say it comes down to the following:

"The answer is that in all but the hardest of sciences, academic research may be influenced by other factors in addition to a pure quest for the truth."

They go on to explain this further. In a nutshell, Baker and Haugen suggest that once ideas like these obtain widespread influence in academia, it is in the interest of those involved to maintain that influence.

In any case, it's usually a good idea to never be surprised by how long it takes for widely adopted, credible sounding, but highly flawed thinking to surrender its costly influence.

Adam

Related posts:
-Efficient Markets
-Modern Portfolio Theory, Efficient Markets, and the Flat Earth Revisited
-Buffett on Risk and Reward
-Beta, Risk, & the Inconvenient Real World Special Case
-Howard Marks: The Two Main Risks in the Investment World
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* Some will rightly point out that alpha would pick this up. Well, in my view, all this does is mask the fact that risk and reward are not always positively correlated. As far as I'm concerned that makes alpha really just a fudge factor of the worst kind. A solution that's elegant in appearance, less so in fact. For this reason and others I think alpha, despite its popularity, deserves little attention or, better yet, should be ignored altogether. I'm well aware of how much alpha has become the favored way to express risk-adjusted performance; its broad acceptance in this way need not logically lead one to conclude it's based upon sound thinking or even that, while somewhat flawed, it is at least incidentally useful. Unfortunately, it's not even of incidental utility. It's worse than useless. That probably seems a bit too harsh but I think, in this case, it's appropriately harsh. It succeeds at concealing instead of revealing what's really going on in terms of risk and reward. Sometimes outperformance occurs because additional risk was taken on in a smart way leading to an even greater reward. Other times, outperformance occurs because a very low price was paid so -- as Buffett's example above of the dollar bill bought for 60 cents versus 40 cents makes clear -- less risk is taken for more reward. Alpha doesn't distinguish between the two outcomes even if they couldn't be more different. I guess greek letters have a way of creating an aura of legitimacy that makes something rather dumb seem like it must have merit. It's not the first time this has happened -- where seriously smart people become stubborn proponents of suspect ideas -- and it's likely not going to be the last time. 

If that otherwise intelligent and capable people behave in such ways seems at all surprising, check out Charlie Munger at Harvard-Westlake back in 2010 for more on this subject. Well worth reading. It applies far beyond the world of investing. Psychological factors -- various fallacies/biases/illusions both subconscious and conscious -- lead to cognitive errors that affect even the very brightest (including those who might be quite admirable in other ways). At Harvard-Westlake, Munger provided a very useful explanation why this tends to happen (and often at the major institutions no less). It's how aspects of human nature lead to less than reasonable outcomes. Too often, that's just what happens. I'm sure some will -- consciously or not -- underestimate this stuff. I happen to think that's a mistake. An awareness and understanding of these forces at least has the potential to reduce the quantity and scale one's own cognitive errors. It's worth mentioning that CAPM was expanded upon in the Fama and French three factor model. In the less elaborate CAPM, beta alone was supposed to explain portfolio returns. The expanded model adds company size and value factors (finally!) to the single risk factor of beta. So these two additional factors are an attempt to better explain portfolio returns.

Empiricists surely have the capacity to make useful contributions. No doubt the work that went into developing these models was done by smart individuals, is all very well-intentioned, and not at all simple to do. Those interested in this sort of thing should, of course, study both models as carefully as they feel is necessary. I've unfortunately taken the time to do just that (time I'd like back). To me, as far as the investment decision making process goes, things like equilibrium/asset-pricing models offer not much real world utility (and I'm being generous here). There's just far more effective ways to spend valuable time. Others may come to a more optimistic conclusion. Unfortunately, if not surprisingly, there's not just one multi-factor model. Others exist or are in the works. I suppose even more will likely follow. Ugh.
** At UC Santa Barbara back in 2003, Charlie Munger talked about nine different categories of weaknesses in economics. According to Munger, the following is the third weakness:

"The third weakness that I find in economics is what I call physics envy. And of course, that term has been borrowed from...one of the world's great idiots, Sigmund Freud. But he was very popular in his time, and the concept got a wide vogue."

*** Efficient market hypothesis depends upon the assumption that agents have rational expectations.
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