Sunday, November 11, 2012

Interview with Eugene Fama

Always insightful:
I was in Belgium for two years working solo. When I returned, I showed Merton Miller my research produced over that two year period, and he put aside most of it with the comment, “Garbage.” He was right on every count...
[Pensions] should be discounting the liabilities at the expected return implied by the risk of the liabilities, not the expected return on the assets. The liabilities are basically indexed claims—like a TIPS (Treasury Inflation-Protected Security). Therefore, the appropriate discount rate on the high side should be about 2.5%, not the 7% or 8% that the plans are using now...
In Daniel Kahneman’s book Thinking, Fast and Slow, he states that our brains have two sides: One is rational, and one is impulsive and irrational. What behavior can’t be explained by that model?...
Litterman: What’s your view of the purported excess return of low-volatility stocks? Fama: The excess return is really a result of low beta, not low volatility, and this potential source of return has been well known for 50 years. When the first tests of the CAPM were done, the problem always out front was that the market line, or the slope of the premium as a function of beta, was too low relative to what the model predicted. This meant that low-beta stocks had higher returns than predicted and high-beta stocks had lower returns than predicted....
I agree with Fama on almost everything, the exception being the risk premium. Fama seems to think the Security Market Line (SML) is increasing but too flat, rather than downward sloping. The return premium to low volatility equity portfolios is a profound fact and many experts can't see, even though it's there in the data, and the returns of traded low volatility funds. A 'too flat' SML is one thing, a negative one, quite another. One implies tweaks, the other, a paradigm shift. 

2 comments:

Anonymous said...

If you disagree with Fama on the one point you identify, you disagree with Fama on everything.

Jim Oliver said...

In my mind I reconcile your position with Fama's by thinking that investors are paying for volatility just like they pay for lottery ticket or to gamble. That is, the market is efficient (at any level of volatility) but people are willing to pay for a chance to outperform the market. It is the same reason people trade so much. The fact that people trade so much could be seen as evidence Fama is wrong but not if they are paying for a chance to outperform. Also the stock market is entertaining, if you do not believe me watch CNBC.