History for Dollars

By DAVID BROOKS

When the going gets tough, the tough take accounting. When the job market worsens, many students figure they can’t indulge in an English or a history major. They have to study something that will lead directly to a job.

So it is almost inevitable that over the next few years, as labor markets struggle, the humanities will continue their long slide. There already has been a nearly 50 percent drop in the portion of liberal arts majors over the past generation, and that trend is bound to accelerate. Once the stars of university life, humanities now play bit roles when prospective students take their college tours. The labs are more glamorous than the libraries.

But allow me to pause for a moment and throw another sandbag on the levee of those trying to resist this tide. Let me stand up for the history, English and art classes, even in the face of today’s economic realities.

Studying the humanities improves your ability to read and write. No matter what you do in life, you will have a huge advantage if you can read a paragraph and discern its meaning (a rarer talent than you might suppose). You will have enormous power if you are the person in the office who can write a clear and concise memo.

Studying the humanities will give you a familiarity with the language of emotion. In an information economy, many people have the ability to produce a technical innovation: a new MP3 player. Very few people have the ability to create a great brand: the iPod. Branding involves the location and arousal of affection, and you can’t do it unless you are conversant in the language of romance.

Studying the humanities will give you a wealth of analogies. People think by comparison — Iraq is either like Vietnam or Bosnia; your boss is like Narcissus or Solon. People who have a wealth of analogies in their minds can think more precisely than those with few analogies. If you go through college without reading Thucydides, Herodotus and Gibbon, you’ll have been cheated out of a great repertoire of comparisons.

Finally, and most importantly, studying the humanities helps you befriend The Big Shaggy.

Let me try to explain. Over the past century or so, people have built various systems to help them understand human behavior: economics, political science, game theory and evolutionary psychology. These systems are useful in many circumstances. But none completely explain behavior because deep down people have passions and drives that don’t lend themselves to systemic modeling. They have yearnings and fears that reside in an inner beast you could call The Big Shaggy.

You can see The Big Shaggy at work when a governor of South Carolina suddenly chucks it all for a love voyage south of the equator, or when a smart, philosophical congressman from Indiana risks everything for an in-office affair.

You can see The Big Shaggy at work when self-destructive overconfidence overtakes oil engineers in the gulf, when go-go enthusiasm intoxicates investment bankers or when bone-chilling distrust grips politics.

Those are the destructive sides of The Big Shaggy. But this tender beast is also responsible for the mysterious but fierce determination that drives Kobe Bryant, the graceful bemusement the Detroit Tigers pitcher Armando Galarraga showed when his perfect game slipped away, the selfless courage soldiers in Afghanistan show when they risk death for buddies or a family they may never see again.

The observant person goes through life asking: Where did that come from? Why did he or she act that way? The answers are hard to come by because the behavior emanates from somewhere deep inside The Big Shaggy.

Technical knowledge stops at the outer edge. If you spend your life riding the links of the Internet, you probably won’t get too far into The Big Shaggy either, because the fast, effortless prose of blogging (and journalism) lacks the heft to get you deep below.

But over the centuries, there have been rare and strange people who possessed the skill of taking the upheavals of thought that emanate from The Big Shaggy and representing them in the form of story, music, myth, painting, liturgy, architecture, sculpture, landscape and speech. These men and women developed languages that help us understand these yearnings and also educate and mold them. They left rich veins of emotional knowledge that are the subjects of the humanities.

It’s probably dangerous to enter exclusively into this realm and risk being caught in a cloister, removed from the market and its accountability. But doesn’t it make sense to spend some time in the company of these languages — learning to feel different emotions, rehearsing different passions, experiencing different sacred rituals and learning to see in different ways?

Few of us are hewers of wood. We navigate social environments. If you’re dumb about The Big Shaggy, you’ll probably get eaten by it.

Revisiting The Capital Asset Pricing Model

by Jonathan Burton

Reprinted with permission from Dow Jones Asset Manager
May/June 1998, pp. 20-28

For pictures and captions, click here

Modern Portfolio Theory was not yet adolescent in 1960 when William F. Sharpe, a 26-year-old researcher at the RAND Corporation, a think tank in Los Angeles, introduced himself to a fellow economist named Harry Markowitz.. Neither of them knew it then, but that casual knock on Markowitz's office door would forever change how investors valued securities.

Sharpe, then a Ph.D. candidate at the University of California, Los Angeles, needed a doctoral dissertation topic. He had read "Portfolio Selection," Markowitz's seminal work on risk and return—first published in 1952 and updated in 1959—that presented a so-called efficient frontier of optimal investment. While advocating a diversified portfolio to reduce risk, Markowitz stopped short of developing a practical means to assess how various holdings operate together, or correlate, though the question had occurred to him.

Sharpe accepted Markowitz's suggestion that he investigate Portfolio Theory as a thesis project. By connecting a portfolio to a single risk factor, he greatly simplified Markowitz's work. Sharpe has committed himself ever since to making finance more accessible to both professionals and individuals.

From this research, Sharpe independently developed a heretical notion of investment risk and reward, a sophisticated reasoning that has become known as the Capital Asset Pricing Model, or the CAPM. The CAPM rattled investment professionals in the 1960s, and its commanding importance still reverberates today. In 1990, Sharpe's role in developing the CAPM was recognized by the Nobel Prize committee. Sharpe shared the Nobel Memorial Prize in Economic Sciences that year with Markowitz and Merton Miller, the University of Chicago economist.

Every investment carries two distinct risks, the CAPM explains. One is the risk of being in the market, which Sharpe called systematic risk. This risk, later dubbed "beta," cannot be diversified away. The other—unsystematic risk—is specific to a company's fortunes. Since this uncertainty can be mitigated through appropriate diversification, Sharpe figured that a portfolio's expected return hinges solely on its beta—its relationship to the overall market. The CAPM helps measure portfolio risk and the return an investor can expect for taking that risk.

More than three decades have passed since the CAPM's introduction, and Sharpe has not stood still. A professor of finance at the Stanford University Graduate School of Business since 1970, he has crafted several financial tools that portfolio managers and individuals use routinely to better comprehend investment risk, including returns-based style analysis, which assists investors in determining whether a portfolio manager is sticking to his stated investment objective. The Sharpe ratio evaluates the level of risk a fund accepts vs. the return it delivers.

Sharpe's latest project is characteristically ambitious, combining his desire to educate a mass audience about risk with his longtime love of computers. Technology is democratizing finance, and Sharpe is helping to push this powerful revolution forward. Through Financial Engines, Sharpe and his partners will bring professional investment advice and analysis to individuals over the Internet.

What do you think of the talk that beta is dead?

The CAPM is not dead. Anyone who believes markets are so screwy that expected returns are not related to the risk of having a bad time, which is what beta represents, must have a very harsh view of reality.

"Is beta dead?" is really focused on whether or not individual stocks have higher expected returns if they have higher betas relative to the market. It would be irresponsible to assume that is not true. That doesn't mean we can confirm the data. We don't see expected returns; we see realized returns. We don't see ex-ante measures of beta; we see realized beta. What makes investments interesting and exciting is that you have lots of noise in the data. So it's hard to definitively answer these questions.

Would you approach a study of market risk differently today than you did back in the early 1960s?

It's funny how people tend to misunderstand the CAPM's academic, theoretical and scientific process. The CAPM was a very simple, very strong set of assumptions that got a nice, clean, pretty result. And then almost immediately, we all said, let's bring more complexity into it to try to get closer to the real world. People went on—myself and others—to what I call "extended" capital asset pricing models, in which expected return is a function of beta, taxes, liquidity, dividend yield, and other things people might care about.

Did the CAPM evolve? Of course. Are the results more complicated shall just expected return is a linear function of beta relative to the Standard & Poor's 500-Stock Index? Of course. But the fundamental idea remains that there's no reason to expect reward just for bearing risk. Otherwise, you'd make a lot of money in Las Vegas. If there's reward for risk, it's got to be special. There's got to be some economics behind it or else the world is a very crazy place. I don't think differently about those basic ideas at all.

What about Harry Markowitz's contribution to all of this?

Markowitz came along, and there was light. Markowitz said a portfolio has expected return and risk. Expected return is related to the expected return of the securities, but risk is more complicated. Risk is related to the risks of the individual components as well as the correlations.

That makes risk a complicated feature, and one that human beings have trouble processing. You can put estimates of risk/return correlation into a computer and find efficient portfolios. In this way, you can get more return for a given risk and less risk for a given return, and that's efficiency a la Markowitz.

What stands out in your mind when you think about Markowitz's contribution?

I liked the parsimony, the beauty, of it. I was and am a computer nut. I loved the mathematics. It was simple but elegant. It had all of the aesthetic qualities that a model builder likes. Investment texts in the pre- Markowitz era were simplistic: Don't put all your eggs in one basket, or put them in a basket and watch it closely. There was little quantification.

To this day, people recommend a compartmentalized approach. You have one pot for your college fund, another for your retirement fund, another for your unemployment fund. People's tendencies when they deal with these issues often lead to suboptimal solutions because they don't take covariance into account. Correlation is important. You want to think about how things move together.

Tell us about your relationship with Markowitz.

Harry was my unofficial dissertation advisor. In 1960, he and I were both at the RAND Corporation. My official advisor at the University of California at Los Angeles suggested I work with Harry, but Harry wasn't on the UCLA faculty. I introduced myself to him and said I was a great fan of his work.

With Markowitz's encouragement, you delved into market correlation, streamlining Portfolio Theory with the use of a single-factor model. This became part of your dissertation, published in 1963 as "A Simplified Model of Portfolio Analysis."

I did my dissertation under a strongly simplified assumption that only one factor caused correlation. The result I got was in that setting, prices would adjust until expected returns were higher for securities that had higher betas, where beta was the coefficient with "the factor."

Portfolio Theory focused on the actions of a single investor with an optimal portfolio. You wondered what would happen to risk and return if everyone followed Markowitz and built efficient portfolios.

I said what if everyone was optimizing? They've all got their copies of Markowitz and they're doing what he says. Then some people decide they want to hold more IBM, but there aren't enough shares to satisfy demand. So they put price pressure on IBM and up it goes, at which point they have to change their estimates of risk and return, because now they're paying more for the stock. That process of upward and downward pressure on prices continues until prices reach an equilibrium and everyone collectively wants to hold what's available. At that point, what can you say about the relationship between risk and return? The answer is that expected return is proportionate to beta relative to the market portfolio.

In a paper I finished in 1962 that was published in 1964, I found you didn't have to assume only one factor. That basic result comes through in a much more general setting. There could be five factors, or 20 factors, or as many factors as there are securities. In a Markowitz framework, where people care about the expected return of their portfolios and the risk as measured by standard deviation the results held. That paper was called "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions Of Risk." Eugene Fama called it the Capital Asset Pricing Model. That's where the name came from.

The CAPM was and is a theory of equilibrium. Why should anyone expect to earn more by investing in one security as opposed to another? You need to be compensated for doing badly when times are bad. The security that is going to do badly just when you need money when times are bad is a security you have to hate, and there had better be some redeeming virtue or else who will hold it? That redeeming virtue has to be that in normal times you expect to do better. The key insight of the Capital Asset Pricing Model is that higher expected returns go with the greater risk of doing badly in bad times. Beta is a measure of that. Securities or asset classes with high betas tend to do worse in bad times than those with low betas.

Perhaps you never imagined that the CAPM would become a linchpin of investment theory, but did you believe it was something big?

I did. I didn't know how important it would be, but I figured it was probably more important than anything else I was likely to do. I had presented it at the University of Chicago in January 1962, and it had a good reaction there. They offered me a job. That was a good sign. I submitted the article to The Journal of Finance in 1962. It was rejected. Then I asked for another referee, and the journal changed editors. It was published in 1964. It came out and I figured OK, this is it. I'm waiting. I sat by the phone. The phone didn't ring. Weeks passed and months passed, and I thought, rats, this is almost certainly the best paper I'm ever going to write, and nobody cares. It was kind of disappointing. I just didn't realize how long it took people to read journals, so it was a while before reaction started coming in.

What does the CAPM owe to finance research that came immediately before?

The CAPM comes out of two things: Markowitz, who showed how to create an efficient frontier, and James Tobin, who in a 1958 paper said if you hold risky securities and are able to borrow—buying stocks on margin—or lend—buying risk-free assets— and you do so at the same rate, then the efficient frontier is a single portfolio of risky securities plus borrowing and lending, and that dominates any other combination.

Tobin's Separation Theorem says you can separate the problem into first finding that optimal combination of risky securities and then deciding whether to lend or borrow, depending on your attitude toward risk. It then showed that if there's only one portfolio plus borrowing and lending, it's got to be the market.

Both the CAPM and index funds come from that. You can't beat the average; net of costs, the returns for the average active manager are going to be worse. You don't have to do that efficient frontier stuff. If markets were perfectly efficient, you'd buy the market and then use borrowing and lending to the extent you can. Once you get into different investment horizons, there are many complications. This is a very simple setting. You get a nice, clean result. The basic philosophical results carry through in the more complex settings, although the results aren't quite as simple.

The University of Chicago's Gene Fama and Yale University's Ken French came up with the Three- Factor Model, which states that beta matters less than either market capitalization or book-to-market value. Do Fama and French exaggerate?

All empiricists, myself included when I do empirical work, tend to exaggerate the importance of their particular empirical study. There are different time periods, different markets, different countries. You don't always get the same thing. Fama and French are looking at the question: Using historical manifestations of these ex-ante constructs, can we confirm that expected returns are related to beta and/or related to book-to-price and/or related to size? Given what they did and how they did it—using realized average returns, which are not expected returns—they found a stronger empirical correlation with book-to-price and with size than to their measure of historic beta.

The size effect and the value/growth effect had been written about before, so neither of these phenomena were new What was new was that Fama and French got that very strong result at least for the period they looked at—which, by the way, included the mid-1970s, a very good period for value stocks, which really drove up those results.

Fama and French's results were a product of the time period they examined?

There's a whole industry of turning out papers showing things "wrong" and "partially wrong" with the Fama- French study. I have not been part of that industry. I would only point out that during that period in the United States, value stocks did much better than growth. In the bear market of 1973 and 1974, people thought the world was coming to an end. It didn't come to an end. Surprise. The stocks that had been beaten down came back, and they came back a lot more than some of the growth stocks.

Maybe in an efficient market, small stocks would do better because they're illiquid, and people demand a premium for illiquidity That gets to be less compelling if you start thinking about mutual funds that package a bunch of small stocks and therefore make the illiquid liquid. As people figured that out, they'd put money into those funds, which would drive up the price of small stocks, and there goes the premium. For the value/growth effect, there's the behaviorist story that people overextrapolate. I have quite a bit of sympathy with that. I'm a bit of a fan of behavioral finance—the psychology of markets—so I don't dismiss that argument out of hand.

Since the studies about the size effect were published, small stocks have not done better than large stocks on average. Since the publicity about the value effect, value stocks haven't done as well as before around the world. So there's always the possibility that whatever these things were may have gone away, and that the publication of these studies may have helped them go away. It's too early to tell. It's a short data period. One would not want to infer too much, except that rushing to embrace those strategies has not turned out to be a very good idea, recently, certainly in the United States.

Empiricism is integral to investment theory. Do you discount such methodology?

I wouldn't discount it. I do it, and we all look carefully at the results. But it's been my experience that if you don't like the result of an empirical study, just wait until somebody uses a different period or a different country or a different part of the market. In the data it's hard to find a strong, statistically significant relationship between measured betas and average returns of individual stocks in a given market. On the other hand it's easy to build a model of a perfectly efficient market in which you could have just that trouble in any period. The noise could hide it.

The optimal situation involves theory that proceeds from sensible assumptions, is carefully and logically constructed, and is broadly consistent with the data. You want to avoid empirical results that have no basis in theory and blindly say, "It seemed to have worked in the past, so it will work in the future." That's especially true of anything that involves a way to get something for nothing. You're not likely to get something for nothing as long as you've got investors looking to get something for nothing.

Fama and French claim the Three Factor Model is an extension of the CAPM. Would you agree?

To the extent that the Fama-French study is a richer way of measuring the probability of doing badly in bad times, then there's nothing inconsistent with the Capital Asset Pricing Model. But there's a lot of confusion and inconsistency in how some people take the Fama-French results to market and advocate a big value tilt and a big small tilt in your portfolio. If those are just measures of an unrealized but future-looking beta, then you shouldn't have those tilts unless you happen to be one of those people who doesn't care how badly you do when times are bad. We do care when times are bad. Otherwise, there shouldn't be a risk premium for anything.

What about the Arbitrage Pricing Theory, which was originally proposed by Steve Ross at Yale? Is the APT stronger than the CAPM?

Yes and No. The APT assumes that relatively few factors generate correlation, and says the expected return on a security or an asset class ought to be a function of its exposure to those relatively few factors. That's perfectly consistent with the Capital Asset Pricing Model. But the APT stops there and says the expected return you get for exposure to factor three could be anything. The CAPM says no if factor three does badly in bad times, the expected return for exposure to that factor ought to be high. If that factor is a random event that doesn't correlate with whether or not times are bad, then the expected return should be zero.

The APT is stronger in that it makes some very strong assumptions about the return-generating process, and it's weaker because it doesn't tell you very much about the expected return on those factors. The CAPM and its extended versions offer some notion of how people with preferences determine prices in the market. The CAPM tells you more. The CAPM does not require that there be three factors or five factors. There could be a million. Whatever number of factors there may be, the expected return of a security will be related to its exposure to those factors.

Ross has said the APT came from dissatisfaction with the CAPM's assumptions.

You can't actually build a portfolio if you stop at the APT. You've got to figure out the factors and what the returns are for exposure to each factor. Some advocates of the APT have said one should just estimate expected returns empirically. I have argued that's very dangerous because historic average returns can differ monumentally from expected returns. You need a factor model to reduce the dimensions, whether it's a three- factor model or a five-factor model or a 14 asset-class factor model, which is what I tend to use. The APT says if in fact, returns are generated by a factor model, then without making any strong assumptions in addition to the model—which is strong to begin with—you can't assign numeric values to the expected returns associated with the factors. The CAPM goes further, putting some discipline and consistency into the process of assigning those expected returns.

So the great factor debate rages on.

I'd be the last to argue that only one factor drives market correlation. There are not as many factors as some people think, but there's certainly more than one. To measure the state of the debate, look at textbooks. Textbooks still have the Capital Asset Pricing Model because that's a very fundamental economic argument.

You've devoted much of your career to the study and understanding of market risk. Are today's investors focused enough on the downside?

Investment decisions are moving to individuals who are ill-prepared to make them. These are complicated issues. To say, here are 8,000 mutual funds, or even here are 10, do what's right, is not very helpful. The software versions and some of the human versions of the advice that people are getting often seem to ignore risk. They're bookkeeping schemes in which you earn 9% every year like clockwork. You die right on schedule. There's no uncertainty at all. Making a decision as to stocks vs. bonds vs. cash and about how much to save, without even acknowledging uncertainty—let alone trying to estimate it—seems to me the height of folly.

You've acknowledged your fascination with computers. What about your latest venture, Financial Engines, which will be available over the Internet?

We're working to help people understand the downside possibilities of different strategies, as well as the upside. There are two dangers that arise when people are ill-informed. One is that they won't realize what they've done. So when times are bad, they'll be very disappointed.

If you just take somebody's current investments and project return without any notion of risk, you give them a wildly distorted view of what their future might hold. It may be the best point estimate if you've done it carefully, but they have no notion of how good it can get or how bad it can get. So when and if it gets bad, they're not only likely to be desperately disappointed if they're already retired, they're also likely to do the wrong thing if they haven't retired.

In classrooms for decades, we've presented investments as a risk/return tradeoff.. Now, people are being presented investments as a return/return trade-off. There ought to be a law against that. Instead, we can help people understand the range of outcomes associated with different investments and help them find combinations of investments that are optimal.

How will the Internet impact the financial advisory business?

I don't think the Internet is the death knell for financial planning, but it certainly will affect it. There may be a migration to higher-net-worth individuals, or advisors will charge less and service more clients be cause they have better tools. At Financial Engines, we are focusing on investors who don't get any good advice. They get tips from their supervisor or relatives. These people really can't afford a financial advisor. The Internet is going to be potent and powerful for them. But that's not displacing advisors; it's bringing good advice to those who don't have it.

An upper level will always have human financial planners because, as a percentage of their assets, planners aren't very expensive. Even at that level, software is going to be increasingly important. The real issue is what happens in the middle. Almost everyone will get more computer and Internet input. There's going to be more of that and less of human beings in the mix. You can't afford to pay 3% of your money every year for advice, no matter how good it is.

The Arithmetic of Active Management

William F. Sharpe

Reprinted with permission from The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991. pp. 7-9
Copyright, 1991, Association for Investment Management and Research Charlottesville, VA

"Today's fad is index funds that track the Standard and Poor's 500. True, the average soundly beat most stock funds over the past decade. But is this an eternal truth or a transitory one?"

"In small stocks, especially, you're probably better off with an active manager than buying the market."

"The case for passive management rests only on complex and unrealistic theories of equilibrium in capital markets."

"Any graduate of the ___ Business School should be able to beat an index fund over the course of a market cycle."

Statements such as these are made with alarming frequency by investment professionals¹. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.

If "active" and "passive" management styles are defined in sensible ways, it must be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.

Of course, certain definitions of the key terms are necessary. First a market must be selected -- the stocks in the S&P 500, for example, or a set of "small" stocks. Then each investor who holds securities from the market must be classified as either active or passive.

• A passive investor always holds every security from the market, with each represented in the same manner as in the market. Thus if security X represents 3 per cent of the value of the securities in the market, a passive investor's portfolio will have 3 per cent of its value invested in X. Equivalently, a passive manager will hold the same percentage of the total outstanding amount of each security in the market².

• An active investor is one who is not passive. His or her portfolio will differ from that of the passive managers at some or all times. Because active managers usually act on perceptions of mispricing, and because such misperceptions change relatively frequently, such managers tend to trade fairly frequently -- hence the term "active."

Over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using beginning market values as weights³. Each passive manager will obtain precisely the market return, before costs⁴. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also.

This proves assertion number 1. Note that only simple principles of arithmetic were used in the process. To be sure, we have seriously belabored the obvious, but the ubiquity of statements such as those quoted earlier suggests that such labor is not in vain.

To prove assertion number 2, we need only rely on the fact that the costs of actively managing a given number of dollars will exceed those of passive management. Active managers must pay for more research and must pay more for trading. Security analysis (e.g. the graduates of prestigious business schools) must eat, and so must brokers, traders, specialists and other market-makers.

Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

This proves assertion number 2. Once again, the proof is embarrassingly simple and uses only the most rudimentary notions of simple arithmetic.

Enough (lower) mathematics. Let's turn to the practical issues.

Why do sensible investment professionals continue to make statements that seemingly fly in the face of the simple and obvious relations we have described? How can presented evidence show active managers beating "the market" or "the index" or "passive managers"? Three reasons stand out⁵.

• First, the passive managers in question may not be truly passive (i.e., conform to our definition of the term). Some index fund managers "sample" the market of choice, rather than hold all the securities in market proportions. Some may even charge high enough fees to bring their total costs to equal or exceed those of active managers.

• Second, active managers may not fully represent the "non-passive" component of the market in question. For example, the set of active managers may exclude some active holders of securities within the market (e.g., individual investors). Many empirical analyses consider only "professional" or "institutional" active managers. It is, of course, possible for the average professionally or institutionally actively managed dollar to outperform the average passively managed dollar, after cost. For this to take place, however, the non-institutional, individual investors must be foolish enough to pay the added costs of the institutions' active management via inferior performance. Another example arises when the active managers hold securities from outside the market in question. For example, returns on equity mutual funds with cash holdings are often compared with returns on an all-equity index or index fund. In such comparisons, the funds are generally beaten badly by the index in up markets, but sometimes exceed index performance in down markets. Yet another example arises when the set of active mangers excludes those who have gone out of business during the period in question. Because such managers are likely to have experienced especially poor returns, the resulting "survivorship bias" will tend to produce results that are better than those obtained by the average actively managed dollar.

• Third, and possibly most important in practice, the summary statistics for active managers may not truly represent the performance of the average actively managed dollar. To compute the latter, each manager's return should be weighted by the dollars he or she has under management at the beginning of the period. Some comparisons use a simple average of the performance of all managers (large and small); others use the performance of the median active manager. While the results of this kind of comparison are, in principle, unpredictable, certain empirical regularities persist. Perhaps most important, equity fund managers with smaller amounts of money tend to favor stocks with smaller outstanding values. Thus, de facto, an equally weighted average of active manager returns has a bias toward smaller-capitalization stocks vis-a-vis the market as a whole. As a result, the "average active manager" tends to be beaten badly in periods when small-capitalization stocks underperform large-capitalization stocks, but may exceed the market's performance in periods when small-capitalization stocks do well. In both cases, of course, the average actively managed dollar will underperform the market, net of costs.

To repeat: Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.

This need not be taken as a counsel of despair. It is perfectly possible for some active managers to beat their passive brethren, even after costs. Such managers must, of course, manage a minority share of the actively managed dollars within the market in question. It is also possible for an investor (such as a pension fund) to choose a set of active managers that, collectively, provides a total return better than that of a passive alternative, even after costs. Not all the managers in the set have to beat their passive counterparts, only those managing a majority of the investor's actively managed funds.

An important corollary is the importance of appropriate performance measurement. "Peer group" comparisons are dangerous. Because the capitalization-weighted average performance of active managers will be inferior to that of a passive alternative, the former constitutes a poor measure for decision-making purposes. And because most peer-group averages are not capitalization-weighted, they are subject to additional biases. Moreover, investing equal amounts with many managers is not a practical alternative. Nor, a fortiori, is investing with the "median" manager (whose identity is not even known in advance).

The best way to measure a manager's performance is to compare his or her return with that of a comparable passive alternative. The latter -- often termed a "benchmark" or "normal portfolio" -- should be a feasible alternative identified in advance of the period over which performance is measured. Only when this type of measurement is in place can an active manager (or one who hires active managers) know whether he or she is in the minority of those who have beaten viable passive alternatives.

Footnotes

1. The first two quotations can be found in the September 3, 1990 issue of Forbes.

2. When computing such amounts, "cross-holdings" within the market should be netted out.

3. Events such as mergers, new listings and reinvestment of dividends that take place during the period require more complex calculations but do not affect the basic principles stated here. To keep things simple, we ignore them.

4. We assume here that passive managers purchase their securities before the beginning of the period in question and do not sell them until after the period ends. When passive managers do buy or sell, they may have to trade with active managers, because of the active managers' willingness to provide desired liquidity (at a price).

5. There are others, such as differential treatment of dividend reinvestment, mergers and acquisitions, but they are typically of less importance.

The World Cup will add R38bn to South Africa's economy this year

- more or less the amount spent by South Africa to host the tournament.

Addressing a press conference in Johannesburg on the economic benefits of the tournament, Gordhan said the massive infrastructural improvements undertaken for the world cup would benefit the country for generations to come.

The government has spent R33.7bn on hosting the tournament, including R11.7bn on 10 world cup stadiums, five of which were built from scratch, and R11.2bn to boost the rail network.

A further R1.3bn was spent on securing the event and R1.5bn on telecommunications and new broadcast technology, treasury figures showed.

Those figures do not include spending by host cities and provinces, which bring the overall bill closer to R40bn.

"There's definitely a few billion more. There could be 3 to 5 billion more than the R33bn we've indicated to you," Gordhan conceded.

The minister estimated the world cup had created 130 000 jobs - in the construction of stadiums and other facilities, tourism and feeder industries. He did not say how many were permanent jobs.

Spending by hundreds of thousands of world cup visitors would add 0.4% (R38bn) to GDP this year, he predicted.

Most of the income from the tournament, however, goes to football's ruling body FIFA, which is on course to gross $3.2bn from the world cup.

FIFA says 75% of that goes back into football development.

Many have questioned the judiciousness of South Africa spending so much to host the world cup given the challenge it faces in bringing housing, clean water and electricity to millions of its citizens.

'Soft' benefits

Gordhan said the new infrastructure would act as a magnet for investment as well as improve the lives of citizens.

"Once you build a road, it doesn't disappear the day after the world cup ends," he said. The "soft" benefits were equally important, he added.

The world cup had also forged a sense of unity unseen in the country since the end of apartheid in the 1990s. And South Africa had earned a reputation "as a country that can deliver".

Iraj Abedian, chief executive officer of Pan-African Capital Holdings Ltd, which advises potential investors, said the world cup had buried negativity about South Africa, at home and abroad.

There had been a lot of doubt before the tournament about South Africa's ability to meet deadlines, maintain order and contain crime, he said.

Three weeks into a trouble-free tournament, he said, "those (concerns) have been put to rest". 

Lottery for losers

Playing the lottery is a losing game yet millions of South Africans fritter money away each week, chancing their luck and risking a poorer retirement.

People would be shocked to discover not only the infinitesimal odds of winning the lottery but also just how large a nest egg they could accumulate by investing the money instead.

The chances of winning the lottery are 0,0000072% and the average payout per winner is R2,25-million. The chances of picking five correct balls and one correct bonus ball are only slightly better at 0,000429% with an average payout of R173 130.

If someone plays one ticket per draw from the age of 25 to 60, they are expected on average to lose R57 357 over that period.

If they had saved that money, they would have accumulated R103 507 over the same period.

Not playing will leave you R160 864,36 better off. It’s a no-brainer to save that money and build it up over time. The overwhelming odds are that playing the lottery is going to make you poorer.

In the above analysis it is assumed ticket prices stay stable at R3,50 per draw each Wednesday and Saturday, interest rates are at 10% and historical payouts are a good indication of future payouts.

If someone plays five tickets per draw twice a week between the ages of 25 and 60, they are expected to lose a whopping R286 785,96 over that period.

If they had saved that money, they would have accumulated R517 535,85, making them R804 321,81 richer than a person how had played.
 
People think that R3,50 is a relatively small amount so they aren’t too careful about spending it.

But add it up, and take into consideration the wealth accumulation effects of compounding returns, and it will build up to a very healthy lump sum.

If addition to not playing the lottery people saved the money they normally spend on little things like coffees, take-aways and even cocktails, it would make a life changing difference to their retirement.

• Rob Rainier is Alexander Forbes’ Regional Head of Financial Planning Consulting for the Eastern Cape

This Economic Calendar is developed and provided by FxFisherman.com, a huge forex trading community.

Thinking Economically is a 10-part series produced by the Texas Public Policy Foundation designed to provide a basic economic education for policymakers, the media, and the general public. In this way, the Thinking Economically series highlights the intersection of economics and public policy, and the importance of "thinking economically" when making policy decisions. This project has been made possible with the assistance of Dr. Art Laffer.

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IN HIS book, Your Money and Your Brain, Jason Zweig claims the latest findings in neuroeconomics reveal that much of what we’ve been told about investing is wrong.

“In theory,” he says, “the more we learn about our investments, and the harder we work at understanding them, the more money we will make. In practice, however, these assumptions often turn out to be dead wrong.”

Zweig sites several examples:

Theory: You have clear and consistent financial goals.

Reality: You’re not sure what your goals are. Last time you thought you knew, you had to change them.

Theory: You carefully calculate the odds of success and failure.

Reality: That stock your cousin recommended was “a sure thing” until it went to zero.

Theory: You know how much risk you’re comfortable with.

Reality: While the market was going up, you thought you had a high tolerance for risk.

When it went down, you realised you didn’t.

Theory: You efficiently process all the available information.

Reality: You can’t be bothered to read the fine print in the financial statements (who does?)

Theory: the smarter you are the more money you’ll make.

Reality: In 1720, Sir Isaac Newton was wiped out in a stock market crash, blazing a trail of financial failure that geniuses have been following ever since.

Theory: the more closely you follow your investments, the more money you’ll make.

Reality: Those who keep a close watch on their stocks often earn lower returns than those who don’t. “Like dieters lurching from Pritikin to Atkins to South Beach and ending up at least as heavy as they started,” says Zweig, “investors are their own worst enemies …”

Theory: the more work you put into investing, the more money you’ll make.

Reality: Professionals, on average, don’t outperform amateurs.

- Everyone knows they should buy low and sell high — yet often buy high and sell low.

- Everyone knows that beating the market is nearly impossible — but just about everyone thinks they can do it.

- Everyone knows that it’s impossible to predict what the market is about to do — but still hang on to every word from the pundits on TV.

- Everyone knows that chasing hot stocks is a sure way to get burnt — yet they flock back to the flame every year.

But, as Zweig says: “None of that makes us irrational. It simply makes us human. Emotional circuits deep in our brains make us instinctively crave whatever feels likely to be rewarding — and shun whatever seems liable to be risky. To counteract these impulses … we have only a thin veneer of relatively modern analytical circuits that are no match for the blunt emotional power of the most ancient part of our brain.”

Which is why knowing what to do often turns out so different from what we actually do.

5 Lies About Index Funds

Image via Wikipedia

 

Financial incentives encourage advisors to talk trash about indexing.

The truth about index investing must be told over and over again because lies are constantly being told around it. Many of those telling lies are financial advisors whose income depends on their client’s use of high-cost active management strategies.  They view simple, low-cost passive strategies through index funds as bad for their business.

I started out about 22 years ago as an investment professional monitoring and evaluating active managers. As a result of this experience, by the mid-1990s, I became an avid believer in what John Bogle, Charley Ellis, Burton Malkeil and many others had been saying for a long time. The fees in active funds are too high, the talent too scarce, and competition too intense for active managers to outperform indexing in the long-term. Ellis cleverly described the entire process as a loser’s game.

My upcoming book, The Power of Passive Investing, provides summaries of exhaustive academic studies covering the active versus passive debate going back many decades. Every study in the book ends with the same conclusion; while a handful of active managers beat their benchmarks due to skill, it wasn’t by much, and most didn’t sustain that benchmark-beating performance for long. In addition, it’s not possible to determine luck from skill or to pick skilled managers in advance. To make matters worse for investors, the success rate for a portfolio of funds drops precipitously as more active funds are added to the portfolio.

With the evidence overwhelmingly in favor of passive investing for the long-term, why won’t more advisors admit these facts and shift their focus to advising clients on the benefits of index investing rather than making believe they’re market gurus or trying to pick those who are? One reason – there’s a lot more money to be made by keeping the lie alive. The fees and commissions earned through active investing are considerably higher than what should be earned by telling the truth about passive investing and charging a fair fee for this advice. Even those advisors who have switched can’t bring it upon themselves to lower their own fee. See my recent article on High-Fee Passive Advisor Hypocrisy.

Brokers in particularly are deeply set against index fund investing because they believe it’s very bad for their revenue stream. Their efforts to sell costly actively-managed mutual funds have generated a lot of trash talk about low-cost index funds. The following is a list of 5 common lies spun by advisors who are dead-set against indexing.

1. Active US stock funds beat the market over the past decade.  Less than 50 percent of surviving US stock funds beat the S&P 500 since 2000, and this number would be much lower if closed and merged funds were included. But that’s not the problem with this argument. The primarily large cap S&P 500 is not a good benchmark for many actively managed US equity funds because they have a small cap or mid cap focus. Using appropriate size benchmarks brings the percentage of winning funds down considerably.
2. Index funds will always achieve below average returns. Index funds will achieve returns that are much closer to the market averages than the active funds your advisor is pushing, and that’s what matters. On average, mutual funds underperform by the fees they charge. Index funds have much lower fees than active funds. This makes low-cost index fund investing an above average portfolio strategy. 
3. Indexing doesn’t work in inefficient markets such as small cap or international. You can count on every active fund advocate to use poorly constructed or inappropriate indexes to make the argument that active returns are better than they are. For example, the Russell 2000 is a common benchmark for US small cap stocks, but it has known annual reconstruction flaws that reduce its annual return by up to 2 percent. The MSCI EAFE is a common international equity benchmark, but it doesn’t include popular emerging markets stocks or Canadian stocks. Proper benchmarking makes active management far less attractive.
4. Active managers perform better in bear markets. The evidence surrounding this often heard statement is inconclusive. The data does show that active funds tend to hold more cash in a bear market due to greater fund redemptions, and this can create the impression of lower risk, but there’s no evidence supporting the idea that active funds have lower volatility or that fund managers have market timing skill.
5. Warren Buffett has beaten the market and this proves indexing doesn’t work. Wrong. This only proves that Warren Buffett, chairman of Berkshire Hathaway (Ticker: BRK), has the Midas touch. It doesn’t prove that the advisor you’re using has Buffett-like talent. Your portfolio may beat the market due to luck, but let’s not be naive and call advisor luck as skill. Even Buffett repeatedly recommends that individual investors buy index funds that charge minimal fees. As an aside, I find it ironic that most advisors who use the Buffett argument typically don’t own BRK in their client’s portfolios.

Indexing works because active investing can’t work. The fees are too high, the opportunities too few, and the talent too scarce. Ignore the lies told by those people who earn a fat living selling the dream of market beating returns. You’ll earn more money over your lifetime by creating and maintaining a low-cost, low-tax, low-turnover portfolio of index funds.

5 Lies About Index Funds

Image via Wikipedia

 

Financial incentives encourage advisors to talk trash about indexing.

The truth about index investing must be told over and over again because lies are constantly being told around it. Many of those telling lies are financial advisors whose income depends on their client’s use of high-cost active management strategies.  They view simple, low-cost passive strategies through index funds as bad for their business.

I started out about 22 years ago as an investment professional monitoring and evaluating active managers. As a result of this experience, by the mid-1990s, I became an avid believer in what John Bogle, Charley Ellis, Burton Malkeil and many others had been saying for a long time. The fees in active funds are too high, the talent too scarce, and competition too intense for active managers to outperform indexing in the long-term. Ellis cleverly described the entire process as a loser’s game.

My upcoming book, The Power of Passive Investing, provides summaries of exhaustive academic studies covering the active versus passive debate going back many decades. Every study in the book ends with the same conclusion; while a handful of active managers beat their benchmarks due to skill, it wasn’t by much, and most didn’t sustain that benchmark-beating performance for long. In addition, it’s not possible to determine luck from skill or to pick skilled managers in advance. To make matters worse for investors, the success rate for a portfolio of funds drops precipitously as more active funds are added to the portfolio.

With the evidence overwhelmingly in favor of passive investing for the long-term, why won’t more advisors admit these facts and shift their focus to advising clients on the benefits of index investing rather than making believe they’re market gurus or trying to pick those who are? One reason – there’s a lot more money to be made by keeping the lie alive. The fees and commissions earned through active investing are considerably higher than what should be earned by telling the truth about passive investing and charging a fair fee for this advice. Even those advisors who have switched can’t bring it upon themselves to lower their own fee. See my recent article on High-Fee Passive Advisor Hypocrisy.

Brokers in particularly are deeply set against index fund investing because they believe it’s very bad for their revenue stream. Their efforts to sell costly actively-managed mutual funds have generated a lot of trash talk about low-cost index funds. The following is a list of 5 common lies spun by advisors who are dead-set against indexing.

1. Active US stock funds beat the market over the past decade.  Less than 50 percent of surviving US stock funds beat the S&P 500 since 2000, and this number would be much lower if closed and merged funds were included. But that’s not the problem with this argument. The primarily large cap S&P 500 is not a good benchmark for many actively managed US equity funds because they have a small cap or mid cap focus. Using appropriate size benchmarks brings the percentage of winning funds down considerably.
2. Index funds will always achieve below average returns. Index funds will achieve returns that are much closer to the market averages than the active funds your advisor is pushing, and that’s what matters. On average, mutual funds underperform by the fees they charge. Index funds have much lower fees than active funds. This makes low-cost index fund investing an above average portfolio strategy. 
3. Indexing doesn’t work in inefficient markets such as small cap or international. You can count on every active fund advocate to use poorly constructed or inappropriate indexes to make the argument that active returns are better than they are. For example, the Russell 2000 is a common benchmark for US small cap stocks, but it has known annual reconstruction flaws that reduce its annual return by up to 2 percent. The MSCI EAFE is a common international equity benchmark, but it doesn’t include popular emerging markets stocks or Canadian stocks. Proper benchmarking makes active management far less attractive.
4. Active managers perform better in bear markets. The evidence surrounding this often heard statement is inconclusive. The data does show that active funds tend to hold more cash in a bear market due to greater fund redemptions, and this can create the impression of lower risk, but there’s no evidence supporting the idea that active funds have lower volatility or that fund managers have market timing skill.
5. Warren Buffett has beaten the market and this proves indexing doesn’t work. Wrong. This only proves that Warren Buffett, chairman of Berkshire Hathaway (Ticker: BRK), has the Midas touch. It doesn’t prove that the advisor you’re using has Buffett-like talent. Your portfolio may beat the market due to luck, but let’s not be naive and call advisor luck as skill. Even Buffett repeatedly recommends that individual investors buy index funds that charge minimal fees. As an aside, I find it ironic that most advisors who use the Buffett argument typically don’t own BRK in their client’s portfolios.

Indexing works because active investing can’t work. The fees are too high, the opportunities too few, and the talent too scarce. Ignore the lies told by those people who earn a fat living selling the dream of market beating returns. You’ll earn more money over your lifetime by creating and maintaining a low-cost, low-tax, low-turnover portfolio of index funds.

Charges and fees cutting 50 per cent from British savers' pension pots