A Guide to Rational Investing

Hello Less Wrong, I don’t post here much but I’ve been in­volved in the Bay Area Less Wrong com­mu­nity for sev­eral years, where many of you know me from. The fol­low­ing is a white pa­per I wrote ear­lier this year for my firm, RHS Fi­nan­cial, a San Fran­cisco based pri­vate wealth man­age­ment prac­tice. A few months ago I pre­sented it at a South Bay Less Wrong meetup. Since then many of you have en­couraged me to post it here for the rest of the com­mu­nity to see. The origi­nal can be found here, please re­fer to the dis­clo­sures, es­pe­cially if you are the SEC. I have added an af­ter­word here be­neath the cita­tions to ad­dress some crit­i­cisms I have en­coun­tered since writ­ing it. As a com­pany white pa­per in­tended for a gen­eral au­di­ence, please for­give me if the fol­low­ing is a lit­tle too self-pro­mot­ing or spends too much time on grounds already well-tread here, but I think many of you will find it of value. Hope you en­joy!

Ex­ec­u­tive Sum­mary: Cap­i­tal mar­kets have cre­ated enor­mous amounts of wealth for the world and re­ward dis­ci­plined, long-term in­vestors for their con­tri­bu­tion to the pro­duc­tive ca­pac­ity of the econ­omy. Most in­di­vi­d­u­als would do well to in­vest most of their wealth in the cap­i­tal mar­ket as­sets, par­tic­u­larly equities. Most in­vestors, how­ever, con­sis­tently make poor in­vest­ment de­ci­sions as a re­sult of a poor the­o­ret­i­cal un­der­stand­ing of fi­nan­cial mar­kets as well as cog­ni­tive and emo­tional bi­ases, lead­ing to in­fe­rior in­vest­ment re­turns and in­effi­cient al­lo­ca­tion of cap­i­tal. Us­ing an em­piri­cally rigor­ous ap­proach, a ra­tio­nal in­vestor may rea­son­ably ex­pect to ex­ploit in­effi­cien­cies in the mar­ket and earn ex­cess re­turns in so do­ing.

Most peo­ple un­der­stand that they need to save money for their fu­ture, and sur­veys con­sis­tently find a large ma­jor­ity of Amer­i­cans ex­press­ing a de­sire to save and in­vest more than they cur­rently are. Yet the sav­ings rate and per­centage of peo­ple who re­port own­ing stocks has trended down in re­cent years,1 de­spite the in­creas­ing ease with which in­di­vi­d­u­als can par­ti­ci­pate in fi­nan­cial mar­kets, thanks to the spread of dis­count bro­kers and em­ployer 401(k) plans. Part of the rea­son for this is likely the un­re­al­is­ti­cally pes­simistic ex­pec­ta­tions of would-be in­vestors. Ac­cord­ing to a re­cent poll barely one third of Amer­i­cans con­sider equities to be a good way to build wealth over time.2 The ver­dict of his­tory, how­ever, is against the skep­tics.

The Great­est Deal of all Time

Equity own­er­ship is prob­a­bly the eas­iest, most pow­er­ful means of ac­cu­mu­lat­ing wealth over time, and peo­ple reg­u­larly forego mil­lions of dol­lars over the course of their life­times let­ting their wealth sit in cash. Since its in­cep­tion in 1926, the an­nu­al­ized to­tal re­turn on the S&P 500 has been 9.8% as of the end of 2012.3 $1 in­vested back then would be worth $3,533 by the end of the pe­riod. More saliently, a 25 year old in­vestor in­vest­ing $5,000 per year at that rate would have about $2.1 mil­lion upon re­tire­ment at 65.

The strong perfor­mance of stock mar­kets is ro­bust to differ­ent times and places. Though the most ac­cu­rate data on the US stock mar­ket goes back to 1926, fi­nan­cial his­to­ri­ans have gath­ered in­for­ma­tion go­ing back to 1802 and find the av­er­age an­nu­al­ized real re­turn in ear­lier pe­ri­ods is re­mark­ably close to the more re­cent offi­cial records. Look­ing at rol­ling 30 year re­turns be­tween 1802 and 2006, the low­est and high­est an­nu­al­ized real re­turns have been 2.6% and 10.6%, re­spec­tively.4 The United States is not unique in its ex­pe­rience, ei­ther. In a mas­sive study of the six­teen coun­tries that had data on lo­cal stock, bond, and cash re­turns available for ev­ery year of the twen­tieth cen­tury, the stock mar­ket in ev­ery one had sig­nifi­cant, pos­i­tive real re­turns that ex­ceeded those of cash and fixed in­come al­ter­na­tives.5 The his­tor­i­cal re­turns of US stocks only slightly ex­ceed those of the global av­er­age.

The op­por­tu­nity cost of not hold­ing stocks is enor­mous. His­tor­i­cally the in­ter­est earned on cash equiv­a­lent in­vest­ments like sav­ings ac­counts has barely kept up with in­fla­tion—over the same since-1926 pe­riod in­fla­tion has av­er­aged 3.0% while the re­turn on 30-day trea­sury bills (a good proxy for bank sav­ings rates) has been 3.5%.6 That 3.5% rate would only earn an in­vestor $422k over the same $5k/​year sce­nario above. The situ­a­tion to­day is even worse. Most banks are cur­rently pay­ing about 0.05% on sav­ings.

Similarly, in­vest­ment grade bonds, such as those is­sued by the US Trea­sury and highly rated cor­po­ra­tions, though of­ten an im­por­tant com­po­nent of a di­ver­sified port­fo­lio, have offered re­turns only mod­estly bet­ter than cash over the long run. The av­er­age re­turn on 10-year trea­sury bonds has been 5.1%,7 earn­ing an in­vestor $619k over the same 40 year sce­nario. The yield on the 10-year trea­sury is cur­rently about 3%.

Home­own­er­ship has long been a part of the Amer­i­can dream, and many have been taught that build­ing equity in your home is the safest and most pru­dent way to save for the fu­ture. The fact of the mat­ter, how­ever, is that res­i­den­tial hous­ing is more of a con­sump­tion good than an in­vest­ment. Over the last cen­tury the value of houses have barely kept up with in­fla­tion,8 and as the re­cent mort­gage crisis demon­strated, home prices can crash just as any other mar­ket.

In vir­tu­ally ev­ery time and place we look, equities are the best perform­ing as­set available, a fact which is con­sis­tent with the eco­nomic the­ory that risky as­sets must offer a pre­mium to their in­vestors to com­pen­sate them for the ad­di­tional un­cer­tainty they bear. What has puz­zled economists for decades is why the so-called equity risk pre­mium is so large and why so many in­di­vi­d­u­als in­vest so lit­tle in stocks.9

Your Own Worst Enemy

Re­cent in­sights from mul­ti­dis­ci­plinary ap­proaches in cog­ni­tive sci­ence have shed light on the is­sue, demon­strat­ing that in­stead of ra­tio­nally op­ti­miz­ing be­tween var­i­ous trade-offs, hu­man be­ings reg­u­larly rely on heuris­tics—men­tal short­cuts that re­quire lit­tle cog­ni­tive effort—when mak­ing de­ci­sions.10 Th­ese heuris­tics lead to tak­ing bi­ased ap­proaches to prob­lems that de­vi­ate from op­ti­mal de­ci­sion mak­ing in sys­tem­atic and pre­dictable ways. Such bi­ases af­fect fi­nan­cial de­ci­sions in a large num­ber of ways, one of the most profound and per­va­sive be­ing the ten­dency of my­opic loss aver­sion.

My­opic loss aver­sion refers to the com­bined re­sult of two ob­served reg­u­lar­i­ties in the way peo­ple think: that losses feel bad to a greater ex­tent than equiv­a­lent gains feel good, and that peo­ple rely too heav­ily (an­chor) on re­cent and read­ily available in­for­ma­tion. 11Taken to­gether, it is easy to see how these men­tal er­rors could bias an in­di­vi­d­ual against hold­ing stocks. Though the his­tor­i­cal and ex­pected re­turn on equities greatly ex­ceeds those of bonds and cash, over short time hori­zons they can suffer sig­nifi­cant losses. And while the loss of one’s home equity is gen­er­ally a neb­u­lous ab­strac­tion that may not man­i­fest it­self con­sciously for years, stock mar­ket losses are highly visi­ble, draw­ing at­ten­tion to them­selves in bro­ker­age state­ments and news­pa­per head­lines. Not sur­pris­ingly, then, an all too com­mon pat­tern among in­vestors is to start in­vest­ing at a time when the head­lines are re­plete with sto­ries of the riches be­ing made in mar­kets, only to suffer a pul­lback and quickly sell out at ten, twenty, thirty plus per­cent losses and sit on cash for years un­til the next bull mar­ket is again near its peak in a vi­cious cir­cle of cap­i­tal de­struc­tion. In­deed, in the 20 year pe­riod end­ing 2012, the S&P 500 re­turned 8.2% and in­vest­ment grade bonds re­turned 6.3% an­nu­al­ized. The in­fla­tion rate was 2.5%, and the av­er­age re­tail in­vestor earned an an­nu­al­ized rate of 2.3%.12

Even when in­vestors can over­come their my­opic loss aver­sion and stay in the stock mar­ket for the long haul, in­vest­ment suc­cess is far from as­sured. The meth­ods by which in­vestors choose which stocks or stock man­agers to buy, hold, and sell are also sub­ject to a host of bi­ases which con­sis­tently lead to sub­op­ti­mal in­vest­ing and perfor­mance. Chief among these is over­con­fi­dence, the be­lief that one’s judge­ments and skills are re­li­ably su­pe­rior.

Over­con­fi­dence is en­demic to the hu­man ex­pe­rience. The vast ma­jor­ity of peo­ple think of them­selves as more in­tel­li­gent, at­trac­tive, and com­pe­tent than most of their peers,13 even in the face of proof to the con­trary. 93% of peo­ple con­sider them­selves to be above-av­er­age drivers,14 for ex­am­ple, and that per­centage de­creases only slightly if you ask peo­ple to eval­u­ate their driv­ing skill af­ter be­ing ad­mit­ted to a hos­pi­tal fol­low­ing a traf­fic ac­ci­dent.15 Similarly, most in­vestors are con­fi­dent they can con­sis­tently beat the mar­ket. One sur­vey found 74% of mu­tual fund in­vestors be­lieved the funds they held would “con­sis­tently beat the S&P 500 ev­ery year” in spite of the statis­ti­cal re­al­ity that more than half of US stock funds un­der­perform in a given year and vir­tu­ally none will out­perform it each and ev­ery year. Many in­vestors will even re­port hav­ing beaten the in­dex de­spite hav­ing ver­ifi­ably un­der­performed it by sev­eral per­centage points.16

Over­con­fi­dence leads in­vestors to take out­sized bets on what they know and are fa­mil­iar with. In­vestors around the world com­monly hold 80% or more of their port­fo­lios in in­vest­ments from their own coun­try,17 and one third of 401(k) as­sets are in­vested in par­ti­ci­pants’ own em­ployer’s stock.18 Such con­cen­trated port­fo­lios are demon­stra­bly riskier than a broadly di­ver­sified port­fo­lio, yet in­vestors reg­u­larly eval­u­ate their in­vest­ments as less risky than the gen­eral mar­ket, even if their se­cu­ri­ties had re­cently lost sig­nifi­cantly more than the over­all mar­ket.

If an in­vestor be­lieves him­self to pos­sess su­pe­rior tal­ent in se­lect­ing in­vest­ments, he is likely to trade more as a re­sult in an at­tempt to cap­i­tal­ize on each new op­por­tu­nity that pre­sents it­self. In this en­deavor, the harder in­vestors try, the worse they do. In one ma­jor study, the quin­tile of in­vestors who traded the most over a five year pe­riod earned an av­er­age an­nu­al­ized 7.1 per­centage points less than the quin­tile that traded the least.19

The Folly of Wall Street

Rely­ing on ex­perts does lit­tle to help. Wall Street em­ploys an army of an­a­lysts to fol­low the ev­ery move of all the ma­jor com­pa­nies traded on the mar­ket, pre­dict­ing their earn­ings and their ex­pected perfor­mance rel­a­tive to peers, but on the whole they are about as effec­tive as a strat­egy of throw­ing darts. Bur­ton Malk­iel ex­plains in his book A Ran­dom Walk Down Wall Street how he tracked the one and five year earn­ings fore­casts on com­pa­nies in the S&P 500 from an­a­lysts at 19 Wall Street firms and found that in ag­gre­gate the es­ti­mates had no more pre­dic­tive power than if you had just as­sumed a given com­pany’s earn­ings would grow at the same rate as the long-term av­er­age rate of growth in the econ­omy. This is con­sis­tent with a much broader body of liter­a­ture demon­strat­ing that the pre­dic­tions of statis­ti­cal pre­dic­tion rules—for­mu­las that make pre­dic­tions based on sim­ple statis­ti­cal rules—re­li­ably out­perform those of hu­man ex­perts. Statis­ti­cal pre­dic­tion rules have been used to pre­dict the auc­tion price of bor­deaux bet­ter than ex­pert wine tasters,20 mar­i­tal hap­piness bet­ter than mar­riage coun­selors,21 aca­demic perfor­mance bet­ter than ad­mis­sions officers,22 crim­i­nal re­ci­di­vism bet­ter than crim­i­nol­o­gists,23 and bankruptcy bet­ter than loan officers,24 to name just a few ex­am­ples. This is an in­cred­ible find­ing that’s difficult to over­state. When con­sid­er­ing com­plex is­sues such as these our nat­u­ral in­tu­ition is to trust ex­perts who can care­fully weigh all the rele­vant in­for­ma­tion in de­ter­min­ing the best course of ac­tion. But in re­al­ity ex­perts are sim­ply hu­mans who have had more time to re­in­force their pre­con­ceived no­tions on a par­tic­u­lar topic and are more likely to an­chor their at­ten­tion on items that only in­tro­duce statis­ti­cal noise.

Back in the world of fi­nance, It turns out that to a first ap­prox­i­ma­tion the best es­ti­mate on the re­turn to ex­pect from a given stock is the long-run his­tor­i­cal av­er­age of the stock mar­ket, and the best es­ti­mate of the re­turn to ex­pect from a stock pick­ing mu­tual fund is the long-run his­tor­i­cal av­er­age of the stock mar­ket minus its fees. The ac­tive stock pick­ers who man­age mu­tual funds have on the whole demon­strated lit­tle abil­ity to out­perform the mar­ket. To be sure, at any given time there are plenty of man­agers who have re­cently beaten the mar­ket smartly, and if you look around you will even find a few with records that have been ter­rific over ten years or more. But just as a coin-flip­ping con­test be­tween thou­sands of con­tes­tants would no doubt yield a few who had un­can­nily “called it” a dozen or more times in a row, the num­ber of mar­ket beat­ing mu­tual fund man­agers is no greater than what you should ex­pect as a re­sult of pure luck.25

Ex­pert and am­at­uer in­vestors al­ike un­der­es­ti­mate how com­pet­i­tive the cap­i­tal mar­kets are. News is read­ily available and quickly acted upon, and any fact you know about that you think gives you an edge is prob­a­bly already a value in the cells of thou­sands of spread­sheets of an­a­lysts trad­ing billions of dol­lars. Pro­fes­sor of Fi­nance at Yale and No­bel Lau­re­ate Robert Shiller makes this point in a lec­ture us­ing an ex­am­ple of a hy­po­thet­i­cal drug com­pany that an­nounces it has re­ceived FDA ap­proval to mar­ket a new drug:

Sup­pose you then, the next day, read in The Wall Street Jour­nal about this new an­nounce­ment. Do you think you have any chance of beat­ing the mar­ket by trad­ing on it? I mean, you’re like twenty-four hours late, but I hear peo­ple tell me — I hear, “I read in Busi­ness Week that there was a new an­nounce­ment, so I’m think­ing of buy­ing.” I say, “Well, Busi­ness Week — that in­for­ma­tion is prob­a­bly a week old.” Even other peo­ple will talk about trad­ing on in­for­ma­tion that’s years old, so you kind of think that maybe these peo­ple are naïve. First of all, you’re not a drug com­pany ex­pert or what­ever it is that’s needed. Se­condly, you don’t know the math — you don’t know how to calcu­late pre­sent val­ues, prob­a­bly. Thirdly, you’re a month late. You get the im­pres­sion that a lot of peo­ple shouldn’t be try­ing to beat the mar­ket. You might say, to a first ap­prox­i­ma­tion, the mar­ket has it all right so don’t even try.26

In that last sen­tence Shiller hints at one of the most profound and pow­er­ful ideas in fi­nance: the effi­cient mar­ket hy­poth­e­sis. The core of the effi­cient mar­ket hy­poth­e­sis is that when news that im­pacts the value of a com­pany is re­leased, stock prices will ad­just in­stantly to ac­count for the new in­for­ma­tion and bring it back to equil­ibrium where it’s no longer a “good” or “bad” in­vest­ment but sim­ply a fair one for its risk level. Be­cause news is un­pre­dictable by defi­ni­tion, it is im­pos­si­ble then to re­li­ably out­perform the mar­ket as a whole, and the seem­ingly in­ge­nious in­vestors on the lat­est cover of Forbes or For­tune are sim­ply lucky.

A Noble Lie

In the 50s, 60s, and 70s sev­eral economists who would go on to win No­bel prizes worked out the im­pli­ca­tions of the effi­cient mar­ket hy­poth­e­sis and cre­ated a new in­tel­lec­tual frame­work known as mod­ern port­fo­lio the­ory.27 The up­shot is that cap­i­tal mar­kets re­ward in­vestors for tak­ing risk, and the more risk you take, the higher your re­turn should be (in ex­pec­ta­tion, it might not turn out to be the case, which is why it’s risky). But the mar­ket doesn’t re­ward un­nec­es­sary risk, such as tak­ing out a sec­ond mort­gage to in­vest in your friend’s hot dog stand. It only re­wards sys­tem­atic risk, the risks as­so­ci­ated with be­ing ex­posed to the va­garies of the en­tire econ­omy, such as in­ter­est rates, in­fla­tion, and pro­duc­tivity growth.28 Stock of small com­pa­nies are riskier and have a higher ex­pected re­turn than stocks of large com­pa­nies, which are riskier than cor­po­rate bonds, which are riskier than Trea­sury bonds. But own­ing one small cap stock doesn’t offer a higher ex­pected re­turn than an­other small cap stock, or a port­fo­lio of hun­dreds of small caps for that mat­ter. Own­ing more of a par­tic­u­lar stock merely ex­poses you to the idiosyn­cratic risks that par­tic­u­lar com­pany faces and for which you are not com­pen­sated. Diver­sify­ing as­sets across as many se­cu­ri­ties as pos­si­ble, it is pos­si­ble to re­duce the volatility of your port­fo­lio with­out low­er­ing its ex­pected re­turn.

This ap­proach to in­vest­ing dic­tates that you should de­ter­mine an ac­cept­able level of risk for your port­fo­lio, then buy the largest bas­ket of se­cu­ri­ties pos­si­ble that tar­gets that risk, ideally while pay­ing the least amount pos­si­ble in fees. Aca­demic ac­tivism in fa­vor of this pas­sive ap­proach gained mo­men­tum through the 70s, cul­mi­nat­ing in the launch of the first com­mer­cially available in­dex fund in 1976, offered by The Van­guard Group. The typ­i­cal in­dex fund seeks to repli­cate the over­all mar­ket perfor­mance of a broad class of in­vest­ments such as large US stocks by own­ing all the se­cu­ri­ties in that mar­ket in pro­por­tion to their mar­ket weights. Thus if XYZ stock makes up 2% of the value of the rele­vant as­set class, the in­dex fund will al­lo­cate 2% of its funds to that stock. Be­cause in­dex funds only seek to repli­cate the mar­ket in­stead of beat­ing it, they save costs on re­search and man­age­ment teams and pass the sav­ings along to in­vestors through lower fees.

In­dex funds were origi­nally de­rided and at­tracted lit­tle in­vest­ment, but years of pas­sion­ate ad­vo­cacy by pop­u­lariz­ers such as Jack Bogle and Bur­ton Malk­iel as well as the con­sen­sus of the eco­nomics pro­fes­sion has helped to lift them into the main­stream. In­dex funds now com­mand trillions of dol­lars of as­sets and cover ev­ery seg­ment of the mar­ket in stocks, bonds, and al­ter­na­tive as­sets in the US and abroad. In 2003 Van­guard launched its tar­get re­tire­ment funds, which took the logic of pas­sive in­vest­ing even fur­ther by pro­vid­ing a sin­gle fund that would au­to­mat­i­cally shift from more ag­gres­sive to more con­ser­va­tive in­dex in­vest­ments as its in­vestors ap­proached re­tire­ment. Tar­get re­tire­ment funds have since be­come es­pe­cially pop­u­lar op­tions in 401(k) plans.

The rise of in­dex in­vest­ing has been a boon to in­di­vi­d­ual in­vestors, who have clearly benefited from the lower fees and greater di­ver­sifi­ca­tion they offer. To the ex­tent that in­vestors have bought into the idea of pas­sive in­vest­ing over mar­ket timing and ac­tive se­cu­rity se­lec­tion they have col­lec­tively saved them­selves a for­tune by not giv­ing in to their value-de­stroy­ing bi­ases. For all the good in­dex funds have done though, since their birth in the 70s, the in­tel­lec­tual foun­da­tion upon which they stand, the effi­cient mar­ket hy­poth­e­sis, has been all but dis­proved.

The EMH is now the no­ble lie of the eco­nomics pro­fes­sion; while economists usu­ally teach their stu­dents and the pub­lic that the cap­i­tal mar­kets are effi­cient and un­beat­able, their re­search over the last few decades has shown oth­er­wise. In a tel­ling ex­am­ple, Paul Sa­muel­son, who helped origi­nate the EMH and ad­vo­cated it in his best sel­l­ing text­book, was a large, early in­vestor in Berk­shire Hath­away, War­ren Buffett’s ac­tive in­vest­ment hold­ing com­pany.29 But real peo­ple reg­u­larly ruin their lives through sloppy in­vest­ing, and for them per­haps it is bet­ter just to say that beat­ing the mar­ket can’t be done, so just buy, hold, and for­get about it. We, on the other hand, be­lieve a more nu­anced un­der­stand­ing of the facts can be helpful.

Premium Investing

Shortly af­ter the effi­cient mar­ket hy­poth­e­sis was first put forth re­searchers re­al­ized the idea had se­ri­ous the­o­ret­i­cal short­com­ings.30 Begin­ning as early as 1977 they also found em­piri­cal “anoma­lies,” fac­tors other than sys­tem­atic risk that seemed to pre­dict re­turns.31 Most of the early find­ings fo­cused on val­u­a­tion ra­tios—mea­sures of a firm’s mar­ket price in re­la­tion to an ac­count­ing mea­sure such as book value or earn­ings—and found that “cheap” stocks on av­er­age out­performed “ex­pen­sive” stocks, con­firm­ing the value in­vest­ment philos­o­phy first pro­mul­gated by the leg­endary De­pres­sion-era in­vestor Ben­jamin Gra­ham and pop­u­larized by his most fa­mous stu­dent, War­ren Buffett. In 1992 Eu­gene Fama, one of the fathers of the effi­cient mar­ket hy­poth­e­sis, pub­lished, along with Ken French, a ground­break­ing pa­per demon­strat­ing that the cheap­est decile stocks in the US, as mea­sured by the price to book ra­tio, out­performed the high­est decile stocks by an as­tound­ing 11.9% per year, de­spite there be­ing lit­tle differ­ence in risk be­tween them.32

A year later, re­searchers found con­vinc­ing ev­i­dence of a mo­men­tum anomaly in US stocks: stocks that had the high­est perfor­mance over the last 3-12 months con­tinued to out­perform rel­a­tive to those with the low­est perfor­mance. The effect size was com­pa­rable to that of the value anomaly and again the dis­crep­ancy could not be ex­plained with any con­ven­tional mea­sure of risk.33

Since then, re­searchers have repli­cated the value and mo­men­tum effects across larger and deeper datasets, find­ing com­pa­rably large effect sizes in differ­ent times, re­gions, and as­set classes. In a highly am­bi­tious 2012 pa­per, Clifford As­ness (a former stu­dent of Fama’s) and To­bias Moskow­itz doc­u­mented the sig­nifi­cance of value and mo­men­tum across 18 na­tional equity mar­kets, 10 cur­ren­cies, 10 gov­ern­ment bonds, and 27 com­mod­ity fu­tures.

Though value and mo­men­tum are the most per­va­sive and best doc­u­mented of the mar­ket anoma­lies, many oth­ers have been dis­cov­ered across the cap­i­tal mar­kets. Others in­clude the small-cap pre­mium34 (small com­pany stocks tend to out­perform large com­pany stocks even in ex­cess of what should be ex­pected by their risk), the liquidity pre­mium35 (less fre­quently traded se­cu­ri­ties tend to out­perform more fre­quently traded se­cu­ri­ties), short-term re­ver­sal36 (equities with the low­est one-week to one-month perfor­mance tend to out­perform over short time hori­zons), carry37 (high-yield­ing cur­ren­cies tend to ap­pre­ci­ate against low-yield­ing cur­ren­cies), roll yield38,39 (bonds and fu­tures at steeply nega­tively sloped points along the yield curve tend to out­perform those at flat­ter or pos­i­tively sloped points), prof­ita­bil­ity40 (equities of firms with higher pro­por­tions of prof­its over as­sets or equity tend to out­perform those with lower prof­ita­bil­ity), cal­en­dar effects41 (stocks tend to have stronger re­turns in Jan­uary and weaker re­turns on Mon­days), and cor­po­rate ac­tion pre­mia42 (se­cu­ri­ties of cor­po­ra­tions that will, cur­rently are, or have re­cently en­gaged in merg­ers, ac­qui­si­tions, spin-offs, and other events tend to con­sis­tently un­der or out­perform rel­a­tive to what would be ex­pected by their risk).

Most of these mar­ket anoma­lies ap­pear re­mark­ably ro­bust com­pared to find­ings in other so­cial sci­ences,43 es­pe­cially con­sid­er­ing that they seem to im­ply trillions of dol­lars of easy money is be­ing over­looked in plain sight. In­tel­li­gent ob­servers of­ten ques­tion how such in­effi­cien­cies could pos­si­bly per­sist in the face of such strong in­cen­tives to ex­ploit them un­til they dis­ap­pear. Sev­eral ex­pla­na­tions have been put forth, some of which are con­flict­ing but which all prob­a­bly have some ex­plana­tory power.

The first in­ter­pre­ta­tion of the anoma­lies is to deny that they are ac­tu­ally anoma­lous, but rather are com­pen­sa­tion for risk that isn’t cap­tured by the stan­dard as­set pric­ing mod­els. This is the view of Eu­gene Fama, who first pos­tu­lated that the value pre­mium was com­pen­sa­tion for as­sum­ing risk of fi­nan­cial dis­tress and bankruptcy that was not fully cap­tured by sim­ply mea­sur­ing the stan­dard de­vi­a­tion of a value stock’s re­turns.44 Sub­se­quent re­search, how­ever, dis­proved that the value effect was ex­plained by ex­po­sure to fi­nan­cial dis­tress.45 More so­phis­ti­cated ar­gu­ments point to the fact that the ex­cess re­turns of value, mo­men­tum, and many other pre­miums ex­hibit greater skew­ness, kur­to­sis, or other statis­ti­cal mo­ments than the broad mar­ket: sub­tle statis­ti­cal in­di­ca­tions of greater risk, but the differ­ences hardly seem large enough to jus­tify the large re­turn pre­miums ob­served.46

The only sense in which e.g. value and mo­men­tum stocks seem gen­uinely “riskier” is in ca­reer risk; though the fac­tor pre­miums are sig­nifi­cant and ro­bust in the long term, they are not con­sis­tent or pre­dictable along short time hori­zons. Reap­ing their re­wards re­quires pa­tience, and an an­a­lyst or port­fo­lio man­ager who recom­mends an in­vest­ment for his clients based on these fac­tors may end up wait­ing years be­fore it pays off, typ­i­cally more than enough time to be fired.47 Though any in­vest­ment strat­egy is bound to un­der­perform at times, strate­gies that seek to ex­ploit the fac­tors most pre­dic­tive of ex­cess re­turns are es­pe­cially sus­cep­ti­ble to rep­u­ta­tional haz­ard. Value stocks tend to be from un­pop­u­lar com­pa­nies in bor­ing, slow growth in­dus­tries. Mo­men­tum stocks are of­ten from un­proven com­pa­nies with un­cer­tain prospects or are from fallen an­gels who have only re­cently ex­pe­rienced a turn of luck. Con­versely, stocks that score low on value and mo­men­tum fac­tors are typ­i­cally rep­utable com­pa­nies with pop­u­lar prod­ucts that are grow­ing rapidly and forg­ing new in­dus­try stan­dards in their wake.

Con­sider then, two com­pa­nies in the same in­dus­try: Ol’Timer In­dus­tries, which has been around for decades and is con­sis­tently prof­itable but whose product lines are in­creas­ingly con­sid­ered un­cool and out­dated. Re­cent at­tempts to re­vamp the com­pany’s image by the firm’s new CEO have had mod­est suc­cess but con­sumers and in­dus­try ex­perts ex­pect this to be just de­lay­ing fur­ther in­evitable loss of mar­ket share to NuTime.ly, founded eight years ago and post­ing ex­po­nen­tial rev­enue growth and rapid adop­tion by the cov­eted 18-35 year old de­mo­graphic, who typ­i­cally de­scribe its prod­ucts us­ing a wide se­lec­tion of con­tem­po­rary idioms and slang in­di­cat­ing su­pe­rior so­cial sta­tus and func­tion­al­ity. Ol’Timer In­dus­tries’ stock will likely score highly on value on mo­men­tum fac­tors rel­a­tive to NuTime.ly and so have a higher ex­pected re­turn. But con­sider the in­cen­tives of the in­vest­ment pro­fes­sional choos­ing be­tween the two: if he chooses Ol’Timer and it out­performs he may be con­grat­u­lated and re­warded per­haps slightly more than if he had cho­sen NuTime.ly and it out­performs, but if he chooses Ol’Timer and it un­der­performs he is a fool and a laugh­ing­stock who wasted clients’ money on his pet the­ory when “ev­ery­one knew” NuTime.ly was go­ing to win. At least if he chooses NuTime.ly and it un­der­performs it was a fluke that none of his peers saw com­ing, save for a few wingnuts who keep yam­mer­ing about the ar­cane the­o­ries of Gene Fama and Ben­jamin Gra­ham.

For most in­vestors, “it is bet­ter for rep­u­ta­tion to fail con­ven­tion­ally than to suc­ceed un­con­ven­tion­ally” as John May­nard Keynes ob­served in his Gen­eral The­ory. Not that this is at all re­stricted to in­vestors, pro­fes­sional or am­a­teur. In a similar vein, pro­fes­sional soc­cer goal­keep­ers con­tinue to jump left or right on penalty kicks when statis­tics show they’d block more shots stand­ing still.48 But stand­ing in place while the ball soars into the up­per right cor­ner makes the goal­keeper look in­com­pe­tent. The pro­clivity of mid­dle man­agers and bu­reau­crats to de­fault to un­con­tro­ver­sial de­ci­sions formed by group­think is fa­mil­iar enough to be the stuff of pop­u­lar cul­ture; no­body ever got fired for buy­ing IBM, as the say­ing goes. Psy­cholog­i­cal ex­per­i­ments have shown that peo­ple will of­ten af­firm an ob­vi­ously false ob­ser­va­tion about sim­ple facts such as the rel­a­tive lengths of straight lines on a board if oth­ers have af­firmed it be­fore them.49

We find our­selves back to the na­ture of hu­man think­ing and the bi­ases and other cog­ni­tive er­rors that af­flict it. This is what most in­ter­pre­ta­tions of the mar­ket anoma­lies fo­cuses on. Both am­at­uer and pro­fes­sional in­vestors are hu­man be­ings that are apt to make in­vest­ment de­ci­sions not through a me­thod­i­cal ap­pli­ca­tion of mod­ern port­fo­lio the­ory but based rather on sto­ries, anec­dotes, hunches, and ide­olo­gies. Most of the anoma­lies make sense in light of an un­der­stand­ing of some of the most com­mon bi­ases such as an­chor­ing and availa­bil­ity bias, sta­tus quo bias, and herd be­hav­ior.50 Ra­tional in­vestors seek­ing to ex­ploit these in­effi­cien­cies may be able to do so to a limited ex­tent, but if they are us­ing other peo­ples’ money then they are con­strained by the bi­ases of their clients. The more ag­gres­sively they at­tempt to ex­ploit mar­ket in­effi­cien­cies, the more they risk badly un­der­perform­ing the mar­ket long enough to suffer dev­as­tat­ing with­drawals of cap­i­tal.51

It is no sur­prise then, that the most suc­cess­ful in­vestors have found ways to rely on “sticky” cap­i­tal un­likely to slip out of their con­trol at the worst time. War­ren Buffett in­vests the float of his in­surance com­pany hold­ings, which be­haves in ac­tu­ar­i­ally pre­dictable ways; David Swensen man­ages the Yale en­dow­ment fund, which has an ex­plic­itly in­definite time hori­zon and a rules based spend­ing rate; Re­nais­sance Tech­nolo­gies, ar­guably the most suc­cess­ful hedge fund ever, only in­vests its own money; Di­men­sional Fund Ad­vi­sors, one of the only mu­tual fund com­pa­nies that has con­sis­tently earned ex­cess re­turns through fac­tor pre­miums, only sells through in­de­pen­dent fi­nan­cial ad­vi­sors who un­dergo a due dili­gence pro­cess to en­sure they share similar in­vest­ment philoso­phies.

Build­ing a Bet­ter Portfolio

So what is an in­vestor to do? The prospect of del­i­cately craft­ing a port­fo­lio that’s ad­e­quately di­ver­sified while tak­ing ad­van­tage of re­turn pre­miums may seem daunt­ing, and one may be tempted to sim­ply buy a Van­guard tar­get re­tire­ment fund ap­pro­pri­ate for their age and be done with it. Do­ing so is cer­tainly a rea­son­able op­tion. But we be­lieve that with a dis­ci­plined in­vest­ment strat­egy in­formed by the find­ings dis­cussed above su­pe­rior re­sults are pos­si­ble.

The first place to start is an as­sess­ment of your risk tol­er­ance. How far can your port­fo­lio fall be­fore it ad­versely af­fects your qual­ity of life? For in­vestors sav­ing for re­tire­ment with many more years of work ahead of them, the an­swer will likely be “quite a lot.” With ten years or more to work with, your port­fo­lio will likely re­cover from even the most ex­treme bear mar­kets. But peo­ple do not nat­u­rally think in ten-year in­cre­ments, and many must live off their port­fo­lio prin­ci­pal; ac­cept that in the short term your port­fo­lio will some­times be in the red and con­sider what per­centage de­cline over a pe­riod of a few months to a year you are com­fortable en­dur­ing. Over a one year pe­riod the “worst case sce­nario” on di­ver­sified stock port­fo­lios is his­tor­i­cally about a 40% de­cline. For a tra­di­tional “mod­er­ate” port­fo­lio of 60% stocks, 40% bonds it has been about a 25% de­cline.52

With a tar­get on how much risk to ac­cept in your port­fo­lio, mod­ern port­fo­lio the­ory shows us a tech­nique for achiev­ing the most effi­cient trade­off be­tween risk and re­turn pos­si­ble called mean-var­i­ance op­ti­miza­tion. An ad­e­quate treat­ment of MVO is be­yond the scope of this pa­per,53 but es­sen­tially the task is to fore­cast ex­pected re­turns on the ma­jor as­set classes (e.g. US Stocks, In­ter­na­tional Stocks, and In­vest­ment Grade Bonds) then com­pute the weights for each that will achieve the high­est ex­pected re­turn for a given amount of risk. We use an ap­proach to mean var­i­ance op­ti­miza­tion known as the Black-Lit­ter­man model54 and es­ti­mate ex­pected re­turns us­ing a limited num­ber of sim­ple in­puts; for ex­am­ple, the ex­pected re­turn on an in­dex of stocks can be closely ap­prox­i­mated us­ing the cur­rent div­i­dend yield plus the long run growth rate of the econ­omy.55

With op­ti­mal port­fo­lio weights de­ter­mined, next the in­vestor must se­lect the in­vest­ment ve­hi­cles to use to gain ex­po­sure to the var­i­ous as­set classes. Though tra­di­tional in­dex funds are a rea­son­able op­tion, in re­cent years sev­eral “en­hanced in­dex” mu­tual fund and ETFs have been re­leased that provide in­ex­pen­sive, broad ex­po­sure to the hun­dreds or thou­sands of se­cu­ri­ties in a given as­set classes while en­hanc­ing ex­po­sure to one or more of the ma­jor fac­tor pre­miums dis­cussed above such as value, prof­ita­bil­ity, or mo­men­tum. Re­search Affili­ates, for ex­am­ple, li­cences a “fun­da­men­tal in­dex” that has been shown to provide effi­cient ex­po­sure to value and small-cap stocks across many mar­kets.56 Th­ese “RAFI” in­dexes have been li­censed to the as­set man­age­ment firms Charles Sch­wab and Pow­erShares to be made available through mu­tual funds and ETFs to the gen­eral in­vest­ing pub­lic, and have gen­er­ally out­performed their tra­di­tional in­dex fund coun­ter­parts since in­cep­tion.

Over the course of time, port­fo­lio al­lo­ca­tions will drift from their op­ti­mized al­lo­ca­tions as par­tic­u­lar as­set classes in­evitably out­perform rel­a­tive to other ones. Leav­ing this unchecked can lead to a port­fo­lio that is no longer risk-re­turn effi­cient. The in­vestor must pe­ri­od­i­cally re­bal­ance the port­fo­lio by sel­l­ing se­cu­ri­ties that have be­come over­weight and buy­ing oth­ers that are un­der­weight. Re­search sug­gests that by set­ting “tol­er­ance bands” around tar­get as­set al­lo­ca­tions, mon­i­tor­ing the port­fo­lio fre­quently and trad­ing when weights drift out­side tol­er­ance, in­vestors can take fur­ther ad­van­tage of in­ter-as­set-class value and mo­men­tum effects and boost re­turn while re­duc­ing risk.57

Most in­vestors, how­ever, do not re­bal­ance sys­tem­at­i­cally, per­haps in part be­cause it can be psy­cholog­i­cally dis­tress­ing. Re­bal­anc­ing nec­es­sar­ily en­tails reg­u­larly sel­l­ing as­sets that have been perform­ing well in or­der to buy ones that have been lag­gards, ex­actly when your cog­ni­tive bi­ases are most likely to tell you that it’s a bad idea. In­deed, neu­ro­scien­tists have ob­served in lab­o­ra­tory ex­per­i­ments that when in­di­vi­d­u­als con­sider the prospect of buy­ing more of a risky as­set that has lost them money, it ac­ti­vates the mod­ules in the brain as­so­ci­ated with an­ti­ci­pa­tion of phys­i­cal pain and anx­iety.58 Deal­ing with in­vest­ment losses is liter­ally painful for in­vestors.

Many in­vestors may find it helpful to their peace of mind as well as their port­fo­lio to out­source the en­tire pro­cess to a party with less emo­tional at­tach­ment in their port­fo­lio. Real­is­ti­cally, most in­vestors have nei­ther the time nor the mo­ti­va­tion nec­es­sary to at­tain a firm un­der­stand­ing of mod­ern port­fo­lio the­ory, re­search the cap­i­tal mar­ket ex­pec­ta­tions on var­i­ous as­set classes and se­cu­ri­ties, and reg­u­larly mon­i­tor and re­bal­ance their port­fo­lio, all with enough rigor to make it worth the effort com­pared to a sim­ple in­dex­ing strat­egy. By uti­liz­ing the skills of a good fi­nan­cial ad­vi­sor, how­ever, an in­vestor can lev­er­age the ex­per­tise of a pro­fes­sional with the band­width to ex­e­cute these tac­tics in a cost-effi­cient man­ner.

A fi­nan­cial ad­vi­sor should be able to en­gage you as an in­vestor and ac­quire a firm un­der­stand­ing of your goals, needs, and at­ti­tudes to­wards risk, money, and mar­kets. Be­cause he or she will have an en­tire prac­tice over which to effi­ciently ded­i­cate time and re­sources on port­fo­lio re­search, op­ti­miza­tion, and trad­ing, the fi­nan­cial ad­vi­sor should be able to craft a port­fo­lio that’s op­ti­mized for your per­sonal situ­a­tion. Fi­nan­cial ad­vi­sors, as in­sti­tu­tional in­vestors, gen­er­ally have ac­cess to in­sti­tu­tional class funds that re­tail in­vestors do not, in­clud­ing many of those that have demon­strated the great­est ded­i­ca­tion to ex­ploit­ing the fac­tor pre­miums. Notably, DFA and AQR, the two fund fam­i­lies with the great­est aca­demic sup­port, are gen­er­ally only available to in­di­vi­d­ual in­vestors through a fi­nan­cial ad­vi­sor. Should your pro­fes­sion­ally man­aged port­fo­lio provide a bet­ter risk ad­justed re­turn than a com­pa­rable do-it-your­self in­dex fund ap­proach, the FA’s fees have paid for them­selves.

Fur­ther­more, a good fi­nan­cial ad­vi­sor will make sure your in­vest­ments are tax effi­cient and that you are mak­ing the most of tax-preferred ac­counts. Re­searchers have shown that af­ter as­set al­lo­ca­tion, as­set lo­ca­tion, the strate­gic place­ment of in­vest­ments in ac­counts with differ­ent tax treat­ment, is one of the most im­por­tant fac­tors in net port­fo­lio re­turns,59 yet most in­di­vi­d­ual in­vestors largely ig­nore these effects.60 Ad­vi­sor’s fees can gen­er­ally be paid with pre-tax funds as well, fur­ther en­hanc­ing tax effi­ciency.

In­vest with Purpose

There is some­thing of a para­dox in­volved in in­vest­ing. Fi­nance is a highly spe­cial­ized and tech­ni­cal field, but money is a very per­sonal and emo­tional topic. Achiev­ing the joy and fulfill­ment as­so­ci­ated with fi­nan­cial suc­cess re­quires a large mea­sure of emo­tional de­tach­ment and im­per­sonal prag­ma­tism. Far too of­ten peo­ple suffer great loss by con­fus­ing loy­alties and as­pira­tions, fears and re­grets with the effi­cient al­lo­ca­tion of their port­fo­lio as­sets. We as ad­vi­sors hate to see this hap­pen; there is noth­ing to cel­e­brate about the need­less de­struc­tion of cap­i­tal, it is truly a loss for us all. One of the great­est mis­con­cep­tions about fi­nance is that in­vest­ing is just a zero-sum game, that one trader’s gain is an­other’s loss. Noth­ing could be fur­ther from the truth. Economists have shown that one of the great­est pre­dic­tors of a na­tion’s well be­ing is its fi­nan­cial de­vel­op­ment.61 The more liquid and ac­tive our cap­i­tal mar­kets, the greater our so­ciety’s ca­pac­ity for in­no­va­tion and progress. When you in­vest in the stock mar­ket, you are con­tribut­ing your share to the pro­duc­tive ca­pac­ity of our world, your re­turn is your re­ward for helping make it bet­ter, out­perfor­mance is a sign that you have steered cap­i­tal to those with the great­est use for it.

With the right ac­counts and in­vest­ments in place and a pro­cess for man­ag­ing them effec­tively, you the in­vestor are freed to fo­cus on what you are work­ing and in­vest­ing for, and an ad­vi­sor can work with you to help get you there. Whether you want to travel the world, buy the house of your dreams, send your chil­dren to the best col­lege, max­i­mize your philan­thropic giv­ing, or sim­ply re­tire early, an ad­vi­sor can help you de­velop a fi­nan­cial plan to turn the dol­lars and cents of your port­fo­lio into the life you want to live, build­ing more health, wealth, and hap­piness for you, your loved ones, and the world.


1. “U.S. Stock Own­er­ship Stays at Record Low,” Gal­lup.

2. U.S. In­vestors Not Sold on Stock Mar­ket as Wealth Creator,” Gal­lup.

3. Data pro­vided by Morn­ingstar.

4. Siegel, Stocks for the Long Run, 5-25

5. Dim­son et al, Triumph of the Op­ti­mists.

6. Ibid. 3

7. Ibid

8. Shiller, “Un­der­stand­ing Re­cent Trends in House Prices and Home Own­er­ship.”

9. Mankiw and Zeldes, for ex­am­ple, find that to jus­tify the his­tor­i­cal equity risk pre­mium ob­served, in­vestors would in ag­gre­gate need to be in­differ­ent be­tween a cer­tain pay­off of $51,209 and a 5050 bet pay­ing ei­ther $50,000 or $100,000. Mankiw and Zeldes, “The con­sump­tion of stock­hold­ers and non­stock­hold­ers,” 8.

10. For a highly read­able in­tro­duc­tion to the idea of cog­ni­tive bi­ases, see Daniel Kah­ne­man’s book “Think­ing: Fast and Slow.” Kah­ne­man has been a pi­o­neer in the field and for his work won the 2002 No­bel prize in eco­nomics.

11. Be­nartzi and Thaler, “My­opic Loss Aver­sion and the Equity Premium Puz­zle.”

12. “Guide to the Mar­kets,” J.P. Mor­gan As­set Management

13. See, for ex­am­ple, Kruger and Dun­ning, “Un­skil­led and Unaware of It: How Difficul­ties in Rec­og­niz­ing One’s Own In­com­pe­tence Lead to In­flated Self-Assess­ments” and Zuck­er­man and Jost, “What Makes You Think You’re So Pop­u­lar? Self Eval­u­a­tion Main­te­nance and the Sub­jec­tive Side of the ‘Friend­ship Para­dox’”

14. Sven­son, “Are We All Less Risky and More Skil­lful than Our Fel­low Drivers?”

15. Pre­ston and Har­ris, “Psy­chol­ogy of Drivers in Traf­fic Ac­ci­dents.”

16. Zweig, Your Money and Your Brain. 88-91.

17. French and Poterba, “In­vestor Diver­sifi­ca­tion and In­ter­na­tional Equity Mar­kets.”

18. Ibid. 14. p. 98-99.

19. Bar­ber and Odean, “Trad­ing is Hazardous to Your Wealth: The Com­mon Stock In­vest­ment Perfor­mance of In­di­vi­d­ual In­vestors.”

20. Ashen­felter et al, “Pre­dict­ing the Qual­ity and Prices of Bordeaux Wine.”

21. Thorn­ton, “Toward a Lin­ear Pre­dic­tion of Mar­i­tal Hap­piness.”

22. Swets et al, “Psy­cholog­i­cal Science Can Im­prove Di­ag­nos­tic De­ci­sions.”

23. Car­roll et al, “Eval­u­a­tion, Di­ag­no­sis, and Pre­dic­tion in Pa­role De­ci­sion-Mak­ing.”

24. Stil­lwell et al, “Eval­u­at­ing Credit Ap­pli­ca­tions: A Val­i­da­tion of Mul­ti­at­tribute Utility Weight Elic­i­ta­tion Tech­niques”

25. See Fama and French, “Luck ver­sus Skill in the Cross-Sec­tion of Mu­tual Fund Re­turns.” They do find mod­est ev­i­dence of skill at the right tail end of the dis­tri­bu­tion un­der the cap­i­tal as­set pric­ing model. After con­trol­ling for the value, size, and mo­men­tum fac­tor pre­miums (dis­cussed be­low), how­ever, ev­i­dence of net-of-fee skill is not sig­nifi­cantly differ­ent than zero.

26. Shiller, “Effi­cient Mar­kets vs. Ex­cess Vo­latility.”

27. Pro­fes­sor Goet­z­mann of the Yale School of Man­age­ment has a in­tro­duc­tory hy­per-text text­book on mod­ern port­fo­lio the­ory available on his web­site, “An In­tro­duc­tion to In­vest­ment The­ory.”

28. In the lan­guage of mod­ern port­fo­lio the­ory this risk is known at a se­cu­rity’s beta. Math­e­mat­i­cally it is the co­var­i­ance of the se­cu­rity’s re­turns with the mar­ket’s re­turns, di­vided by the var­i­ance of the mar­ket’s re­turns.

29. Set­ton, “The Berk­shire Bunch.”

30. For ex­am­ple, Gross­man and Stiglitz prove in “On the Im­pos­si­bil­ity of In­for­ma­tion­ally Effi­cient Mar­kets” that mar­ket effi­ciency can­not be an equil­ibrium be­cause with­out ex­cess re­turns there is no in­cen­tive for ar­bi­trageurs to cor­rect mis­pric­ings. More re­cently, Markow­itz, one of fathers of mod­ern port­fo­lio the­ory, showed in “Mar­ket Effi­ciency: A The­o­ret­i­cal Distinc­tion and So What” that if a cou­ple key as­sump­tions of MPT are re­laxed, the mar­ket port­fo­lio is no longer op­ti­mal for most in­vestors.

31. Basu, “In­vest­ment Perfor­mance of Com­mon Stocks in Re­la­tion to their Price-Earn­ings Ra­tios: A Test of the Effi­cient Mar­ket Hy­poth­e­sis.”

32. Fama and French, “The Cross-Sec­tion of Ex­pected Stock Re­turns.”

33. Je­gadeesh and Tit­man, “Re­turns to Buy­ing Win­ners and Sel­ling Losers: Im­pli­ca­tions for Stock Mar­ket Effi­ciency”

34. Ibid. 31.

35. Pas­tor and Stam­baugh, “Liquidity Risk and Ex­pected Stock Re­turns.”

36. Je­gadeesh, “Ev­i­dence of Pre­dictable Be­hav­ior or Se­cu­rity Re­turns.”

37. Froot and Thaler, “Ano­ma­lies: For­eign Ex­change.”

38. Camp­bell and Shiller, “Yield Spreads and In­ter­est Rate Move­ments: A Bird’s Eye View.”

39. Erb and Har­vey, “The Tac­ti­cal and Strate­gic Value of Com­mod­ity Fu­tures.”

40. Novy-Marx, “The Other Side of Value: The Gross Profita­bil­ity Premium.”

41. Thaler, “Sea­sonal Move­ments in Se­cu­rity Prices.”

42. Mitchell and Pul­v­ino, “Char­ac­ter­is­tics of Risk and Re­turn in Risk Ar­bi­trage.”

43. See McLean and Pon­tiff, “Does Aca­demic Re­search De­stroy Stock Re­turn Pre­dictabil­ity?” A meta anal­y­sis of 82 equity re­turn fac­tors was able to repli­cate 72 us­ing out of sam­ple data.

44. Fama and French, “Size and Book-to-Mar­ket Fac­tors in Earn­ings and Re­turns.”

45. Daniel and Tit­man, “Ev­i­dence on the Char­ac­ter­is­tics of Cross Sec­tional Vari­a­tion in Stock Re­turns.”

46. Hwang and Rube­sam, “Is Value Really Riskier than Growth?”

47. Numer­ous in­vestor pro­files have ex­pounded on the difficulty of be­ing a ra­tio­nal in­vestor in an ir­ra­tional mar­ket. In a re­cent ar­ti­cle in In­sti­tu­tional In­vestor, As­ness and Liew give a highly read­able overview of the risk vs. mis­pric­ing de­bate and dis­cuss the prob­lems they en­coun­tered launch­ing a value-ori­ented hedge fund in the mid­dle of the dot-com bub­ble.

48. Bar-Eli, “Ac­tion Bias Among Elite Soc­cer Goal­keep­ers: The Case of Penalty Kicks. Jour­nal of Eco­nomic Psy­chol­ogy.”

49. Asch, “Opinions and So­cial Pres­sure.”

50. Daniel et al pro­vides one of the most thor­ough the­o­ret­i­cal dis­cus­sions on how cer­tain com­mon cog­ni­tive bi­ases can re­sult in sys­tem­at­i­cally bi­ased se­cu­rity prices in “In­vestor Psy­chol­ogy and Se­cu­rity Mar­ket Un­der- and Over­re­ac­tion.”

51. Sch­leifer and Vishny, “The Limits of Ar­bi­trage.”

52. Data pro­vided by Van­guard.

53. Chap­ter 2 of Goet­z­mann’s “An In­tro­duc­tion to In­vest­ment The­ory” pro­vides an in­tro­duc­tory dis­cus­sion.

54. The Black-Lit­ter­man model al­lows in­vestors to com­bine their es­ti­mates of ex­pected re­turns with equil­ibrium im­plied re­turns in a Bayesian frame­work that largely over­comes the in­put-sen­si­tivity prob­lems as­so­ci­ated with tra­di­tional mean-var­i­ance op­ti­miza­tion. Id­zorek offers a thor­ough in­tro­duc­tion in “A Step-By-Step Guide to the Black-Lit­ter­man Model.”

55. Il­ma­nen’s “Ex­pected Re­turns on Ma­jor As­set Classes” pro­vides a de­tailed ex­pla­na­tion of the the­ory and ev­i­dence of fore­cast­ing ex­pected re­turns.

56. Walk­shausl and Lobe, “Fun­da­men­tal In­dex­ing Around the World.”

57. Bue­tow et al, “The Benefits of Re­bal­anc­ing.”

58. Kuh­nen and Knut­son, “The Neu­ral Ba­sis of Fi­nan­cial Risk Tak­ing.”

59. Dam­mon et al, “Op­ti­mal As­set Lo­ca­tion and Allo­ca­tion with Tax­able and Tax-Deferred In­vest­ing.”

60. Bodie and Crane, “Per­sonal In­vest­ing: Ad­vice, The­ory, and Ev­i­dence from a Sur­vey of TIAA-CREF Par­ti­ci­pants.”

61. Yongseok Shin of the Fed­eral Re­serve pro­vides a brief re­view of the liter­a­ture on this re­search in “Fi­nan­cial Mar­kets: An Eng­ine for Eco­nomic Growth.”

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I wish to thank Romeo Stevens for the feed­back and proofread­ing he pro­vided for early drafts of this pa­per. You should go buy his Mealsquares (just look how happy I look eat­ing them there!)

If the sec­tion on statis­ti­cal pre­dic­tion rules sounded fa­mil­iar it’s prob­a­bly be­cause I stole all the ex­am­ples from this Less Wrong ar­ti­cle by luke­prog about them. After you’re done giv­ing this ar­ti­cle karma you should go give that one some more.

After I made my South Bay meetup pre­sen­ta­tion Peter McCluskey wrote on the Bay Area LW mailing list that “Your pa­per’s re­port of ‘a mas­sive study of the six­teen coun­tries that had data on lo­cal stock, bond, and cash re­turns available for ev­ery year of the twen­tieth cen­tury’ could be con­sid­ered a study of sur­vivor­ship bias, in that it uses crite­ria which ex­clude coun­tries where stocks lost 100% at some point (Rus­sia, Poland, China, Hun­gary).” This is a good point and is worth ad­dress­ing, which some re­searchers have done in re­cent years. Dim­son, Marsh, and Staunton (2006) find that the sur­viv­ing mar­kets of the 20th cen­tury I cite in my pa­per dom­i­nated the global mar­ket cap­i­tal­iza­tion in 1900 and the effect of na­tional stock-mar­ket im­plo­sions was mostly neg­ligible on wor­ld­wide av­er­ages. Peter did go on to say that “I don’t know of bet­ter ad­vice for the av­er­age per­son than to in­vest in equities, and I have most of my wealth in equities...” so I think we’re mostly on the same page at least in terms of prac­ti­cal ad­vice.

In a con­ver­sa­tion with Alyssa Vance she similarly ex­pressed skep­ti­cism that the equity risk pre­mium has been sig­nifi­cantly greater than zero due to the fact that at some point in the 20th cen­tury most ma­jor economies ex­pe­rienced dou­ble-digit in­fla­tion and very high marginal rates of tax­a­tion on cap­i­tal in­come. It is true that taxes and in­fla­tion sig­nifi­cantly dilute an in­vestor’s re­turn, and one would be fool­ish to ig­nore their effects. But while they may re­duce the ab­solute at­trac­tive­ness of equities, the effects of taxes and in­fla­tion ac­tu­ally make stocks look more at­trac­tive rel­a­tive to the al­ter­na­tives of bonds and cash in­vest­ments. In the US and most ju­ris­dic­tions, the div­i­dends and cap­i­tal gains earned on stocks are taxed at prefer­en­tial rates rel­a­tive to the in­ter­est earned on fixed in­come in­vest­ments, which is typ­i­cally taxed as or­di­nary in­come. Fur­ther­more, the ma­jor­ity of in­di­vi­d­ual in­vestors hold a large frac­tion of their in­vest­ments in tax-sheltered ac­counts (such as 401(k)s and IRAs in the US).

At my South Bay meetup pre­sen­ta­tion, Pa­trick LaVic­toire (among oth­ers) ex­pressed in­cre­dulity at my claim that re­tail in­vestors have on av­er­age badly un­der­performed rele­vant bench­marks and that by im­pli­ca­tion in­sti­tu­tional in­vestors have out­performed. The source I cite in my pa­per is gated but there is plenty of re­search on ac­tual in­vestor perfor­mance. Morn­ingstar reg­u­larly pub­lishes info on how in­vestors rou­tinely un­der­perform the mu­tual funds they in­vest in by buy­ing into and sel­l­ing out of them at the wrong times. Find­ing data on in­sti­tu­tional in­vestors is a lit­tle trick­ier but Busse, Goyal, and Wa­hal (2010) find that in­sti­tu­tional in­vestors man­ag­ing e.g. pen­sions, foun­da­tions, and en­dow­ments on av­er­age out­perform the broad US equity mar­ket in the US equity sleeve of their port­fo­lios. (the lan­guage of that pa­per sounds much more pes­simistic, with “alphas are statis­ti­cally in­dis­t­in­guish­able from zero” in the ab­stract. The key is that they are con­trol­ling for the size, value, and mo­men­tum effects dis­cussed in my pa­per. In other words, once we ac­count for the fact that in­sti­tu­tional in­vestors are tak­ing ad­van­tage of the fac­tor pre­miums that have been shown to most con­sis­tently out­perform a sim­ple in­dex strat­egy, they aren’t pro­vid­ing any ex­tra value. This ties in with the idea of “shrink­ing alpha” or “smart beta” that is cur­rently en vogue in my in­dus­try.)

I’m happy to ad­dress fur­ther ques­tions and crit­i­cisms in the com­ments.