“A Scientist’s View of Investing”
Hey there! I hope everyone had a wonderful Easter or Passover celebration. I ended up having a ridiculous case of bronchitis; I could hit the really high and low notes in choir, just not the ones in the middle!
In continuing our story from a couple weeks back, we pick up on the science and math of investing. This article appeared in ThinkAdvisor and is written by Michael Fink, PhD, dean and chief academic officer at The American College of Financial Services. The academic research on investing is finally being discussed in larger circles.
Scientists propose theories that are supposed to explain reality. The CAPM (Capital Asset Pricing Model) is a theory which suggests that average returns on financial assets are explained by ‘beta’, or the amount of systematic risk they exhibit compared to the market.
Scientists then test whether beta does in fact explain mutual fund returns. Generally it does, but sometimes it doesn’t. When theories don’t do a great job of explaining reality, then scientists propose new theories.
Maybe there is more to asset returns than just beta? Maybe investors prefer larger to smaller companies? Maybe investors tend to crowd into popular stocks and drive their prices up while leaving unpopular stocks to outperform?
These alternative theories of asset returns are also known as factors. The rise of factor-based investing stems from return anomalies observed by scientists over the years. This is the way science works. When a theory doesn’t do a perfect job of explaining reality, then scientists test new theories that help refine our knowledge of causation.
The original investing factors that, when combined with beta, do a consistent job of explaining fund performance over time are the size of the firm and the price investors are willing to pay for a dollar of profit (otherwise known as value). Investors have enjoyed a higher performance from choosing stocks from small firms with cheap prices.
The so-called Fama/French three-factor model has dominated academic finance for nearly three decades. Scientists found that many of the smartest fund managers were merely the best at identifying these factors before the academics were able to figure them out. Once they controlled for factors, the excess performance of these superstars faded away.
Scientists have since identified additional factors. Today’s winners also tend to outperform in the short run, a phenomenon known as “momentum”. Firms that trade less frequently tend to outperform, known as the liquidity effect. More profitable firms also tend to do better.
Evidence-based investing is about identifying the characteristics of stocks that have outperformed in the past, and building portfolio strategies that overweight stocks that have these particular characteristics.
It isn’t about finding good companies. It’s about finding companies that have the right factors. Instead of inspecting underground cables, a financial economist inspects whether a firm is small, cheap, profitable, or illiquid.
So… the question at this point is: do you think you could figure out how to capture those factors that influence returns… on your own?
**** Next week: Evidenced-based Portfolios
COMING SOON: In addition to a little bit of reading, we’ll begin our new podcasts on various topics. They won’t be long winded… just 10-15 minutes. If there is a topic you’d like to hear about, certainly let us know. We hope you enjoy them.
Looks like a beautiful weekend coming up, so get outside and enjoy!