There is much on which I agree with Dan Solin: I agree that index funds, as a way of accessing an asset allocation component within the market, are very efficient and effective, and that it is impossible for everyone to try and beat/time the market, consistently, at any one point in time. Most people, most of the time, are better off with the index and doing nothing!
I also agree that you are best off ignoring the papers and the hype, but I disagree that you should ignore issues relevant to valuation, and this is essentially where we part company.
Dan and Co believe in efficient markets and equilibrium pricing and I do not, and therefore, in particular, I disagree with the main thrust of the article:
“the function of a stock and bond market exchange is to price risks of economic uncertainty so that investors have a future probability distribution of returns with a positive expected return. The prices set by the millions of traders in the market represent their assessment of current and forecasted risks and the cost of capital associated with those risks.”
The statement depends on a general equilibrium assumption, which is necessary to support the randomness and independence (especially the independence) of price movements that drive the probability distribution of future returns/price movements.
In this type of model, a) future information is not known, b) all markets and all economic relationships are in equilibrium (price equates demand and supply), and new information, when it comes, is rapidly incorporated into asset prices. Predicting the future direction of the market is impossible.
It is the nature of the evolution of the relationships that comprise a general equilibrium and the nature and stability of exogenous forces acting on this equilibrium that underlies returns (expansion/contraction of the universe). It is the uncertainty over the future path of equilibrium, that is the size, shape and timing of new information, is not known, that lays the basis for risk and the pricing of returns under uncertainty. All pricing, equilibrium or not will need to factor in the degree to which future returns are exposed to uncertainty.
If we know the historical sensitivities of assets to new information, and the relative price movements of different assets, given this sensitivity, in this universe to new information, we can price return under uncertainty, with provisos:
We have to assume that we know the average expected return, either derived from historical information, or from current market prices, assuming that the market is correctly estimating expected return (efficient markets), and that this return relationship is stable, as are equilibrium relationships.
We have to assume a normal probability distribution of return, otherwise the tail outcomes risk dominating the average. It is the nature of the normal probability distribution, the concentration of most returns close to the mean and narrow tails, that allows you to rely on expected return distributions as a risk management platform.
We have to assume that the expected return and the distribution of returns accurately reflects the true profile of equilibrium over time, because we are only occupying one particular run of the equilibrium. The historical data and market expectations could easily be biased by the size, frequency and direction of historical events.
There are therefore two parts to risk under equilibrium: the sensitivity of an investment’s price movement to new information and the uncertainty over the size, shape and frequency of new information. Under equilibrium pricing there is also the risk that an asset may cease to have value, but this risk is covered by diversification and via other implied dynamics of an equilibrium model – a stable equilibrium reallocates capital, meaning that a diversified allocation will pick up the reallocation of capital.
But, if we are out of equilibrium, then the future path of returns are dependent to lesser or greater extent on the out of equilibrium relationships. And how do we move out of equilibrium? One way is to assume a higher level of certainty than actually exists, extrapolating returns and return friendly environments far further into the future than is safe. Another is to set up asymmetric reward structures (banks, brokers, fund managers) that allows greater risk taking, thereby disrupting efficient pricing of risk in financial markets. In a way, this belief in efficient markets, and general equilibrium risk pricing is what has led us to this point in time.
While there still remains uncertainty over the size, shape and frequency of new information, the sensitivity and relative price movements of assets are now to a far greater extent influenced by out of equilibrium relationships, and the actual risk and return relationships are no longer those represented by a normal probability distribution or implied/historical returns. Under efficient markets with rationale economic agents, it is impossible to reach such a position.
In my opinion markets moved out of the range would could have supported an equilibrium type risk/return distribution of outcomes from about 1996 onwards. It has not been new information that has driven risk and return, but excesses that have skewed economic, financial and market relationships and severely impacted risk/return relationships. I remember value biased investment disciplines, that would have tempered the rise of markets in the 1990s being marginalised and ostracised: the market went for higher returns and assumed greater certainty of those returns, because markets were efficient and the risks of being out of the market, in the short term, were too great for a great many people – these markets were irrational!
To say that prices today are efficiently and effectively pricing the risk of uncertainty is dangerous. This is asking investors to place blind faith on a dogma and a system that has failed investors for close to two decades.
Only in a stable equilibrium where we know the true mean and distribution of uncertainty can the greater risk equal the higher return, and only then, on average, over the full distribution of outcomes, which is a reality which we do not inhabit.
The current price of publicly traded stocks and bonds represents the collective judgment of tens of millions of buyers and sellers….. Their judgment is what places a value (the “price”) on these shares. It takes into account all levels of economic uncertainty. We all know there is a risk that Greece, Italy and Spain may default on their sovereign debt. As that risk level increases, buyers of that debt demand a higher rate of return to compensate them for that risk. When you hear financial pundits discuss economic uncertainty and recommend buying or selling certain assets, you should reject their advice. Whatever facts they are relying on have already been priced into the asset they are recommending you buy or sell. That asset is fairly priced. Trying to find a misplaced asset flies in the face of this basic reality.
If the checks and balances on the rewards and the risks of a financial system are flawed, then we cannot blindly rely on market prices, and if economies and markets and the financial systems that underpin them are out of alignment, then we cannot ignore risks that have influenced the direction of markets to greater extent than new and unknown information.
And of course, the time to have made changes to your asset allocation, to bring your asset allocation into line with your ability and willingness to accept risk, was long ago. But this would have meant acknowledging that markets had not properly priced path dependent risks. It is not the risk of equities that is forcing investors to reassess their allocation to this asset class, but the greed, corruption and shameless blissful ignorance that has led to this point in time.
I find these edicts from MPT’s high priests to be disquieting, and this of course, what I have written, is blasphemy.