Wednesday, June 08, 2011

Bob Haugen's Inconsistency

A glowing piece on Bob Haugen over at MarketWatch:

Before you invest a penny, listen to Bob Haugen.

He’s a former finance professor who’s spent half a lifetime studying the stock market. He’s written a number of books and papers, and is the co-author of remarkable piece of analysis entitled “Case Closed” and available here. Read the analysis .

He looked in excruciating detail at the characteristics of which stocks did best (and worst) over nearly half a century, from 1963 to 2007.

Most of these “styles” are a waste of time. And the idea that you need to take on more “risk” to earn higher returns is a total con.

On the contrary, he says, the stock market has a big secret.

Over many decades, “the stocks with the highest risk produced the lowest returns — and stocks with the lowest risk produced the highest returns.” In other words, he says, “the risk/return ratio was upside down ... the payoff to risk is consistently negative over the 45-year period of this study.”

Like Asness, Frazzini, and Pedersen, and Antti Ilmanen, Bob Haugen believes that there's no risk premium within equities, but there still is a risk premium! This inconsistency is necessary because they can't wean themselves from the utility theory that leads inexorably to the risk premium. That is, as long as utility is an increasing function of wealth, at a decreasing rate, you get a risk premium! So, they basically all have this localized risk loving, but global risk aversion. To paraphrase Benjamin Franklin, such a utility function is 'so convenient a thing since it enables one to find or make a reason for everything one has a mind to do.'

In contrast, I think one should junk the standard argument of the utility, wealth, and replace it with status. Then everything is consistent, and you can explain why happiness does not increase when societies get wealthier (the Easterlin paradox). Risk premiums are to economics what the luminiferous aether was to pre-relativistic physics: omnipresent but unmeasurable.


Anonymous said...

There is absolutely no reason why there can't be a risk premium to owning equities, but no cross-sectional premium to beta.

Eric Falkenstein said...

I don't see how it can't be ad hoc...if you do, please share!

Mercury said...

I agree with the general thesis of the linked-to paper and EF's oft-mentioned assertion that envy is a bigger driver of human behavior than greed (which usually gets all the bad press).

However, sometimes I think envy or what is perceived as envy is misunderstood. For instance, your much loved family home, which holds all sorts of intangible value for you, could eventually become too expensive to carry with rising taxes and other ancillary expenses as the surrounding town gentrifies. Maybe you are richer than you were decades ago but not rich enough to literally stay in the same place you have been forever. When you are forced to sell that special place to some moneyed swell you are understandably bitter. Now you are even richer than before but unable to support many of the "good things in life" you thought you were so wise to cultivate and which perhaps involved thousands of hours of personal handiwork (especially when the new guy tears the place down and throws up a McMansion).

I think this kind of thing happens a lot these days and the personal aftermath can be interpreted as "envious behavior" or "status anxiety" when what is really on display are symptoms of a much more profound personal crisis. People like this feel cheated or wronged and the next thing you know they're voting for central planning.

Eric Falkenstein said...

merc: desirable living plots are 'situational goods', like mates, and status itself. Thus, your more nuanced view just has a different spin. The bottom line is, if you are going to build an edifice, should it be on one based on absolute wealth, x, or x relative to some average level of wealth. I think the latter.

Mercury said...

I see that but a modest home could still become unsustainably expensive because the land underneath it becomes highly (and arbitrarily perhaps from the owner's perspective) coveted by others.

I guess what I'm getting at is: Woe to the man whose personally and emotionally valuable stuff suddenly become status symbols for others with bigger wallets.

Anonymous #5 said...

I feel like a moron because I know I asked you this before and I've simply forgotten what you said, but wouldn't a world in which most investment decisions are made by professional fund managers who need to prove their acumen to the uninformed look very similar to a world driven by envy? In both cases we are going to get a lot of concern with relative benchmarks.

Eric Falkenstein said...

anon#5: yes! Investing relative to a benchmark is the same as having a relative status utility function.

D said...


I've been thinking about the impact of relative benchmarking not on average returns but on covariance of returns. It seems benchmarking should reduce covariance. Have you given any thought to this?