New Facts in Finance, and Portfolio Advice for a Multifactor World
"High returns apparently are earned for holding risks related to recessions and financial distress, as well as for holding the risk of market declines."
The last 15 years have seen a revolution in the way financial economists understand the world, and in turn, their portfolio advice. In New Facts in Finance (NBER Working Paper No. 7169) and Portfolio Advice for a Multifactor World (NBER Working Paper No. 7170) John Cochrane, Director of the NBER Program on Asset Pricing, surveys these developments and summarizes their implications for investors.
Fifteen years ago, economists largely agreed that stock and bond returns were fairly unpredictable over time. This is the famous "random walk" or "coin flip" view of the market. Each day might see good luck or bad luck, but there was no way of telling which in advance. This view, in itself revolutionary, was confirmed in study after study. "Technical" trading rules, newsletters, and other systems were all found to be worthless at predicting day-to-day returns; a good day was just as likely to be followed by upward "momentum" as by downward "profit-taking."
Now we see substantial long-run predictability. Signals such as a high price/earnings ratio, a high yield on long-term bonds relative to short-term bonds, and a high foreign interest rate relative to U.S. interest rates seem to predict subsequent stock, bond, and currency returns. They can't predict day-to-day returns, but they can predict returns more than half the time at horizons of a year or more.
The Capital Asset Pricing Model (CAPM) once reigned supreme as the explanation for why some stocks, funds, or portfolio strategies do better, on average, than others. In this theory, there is one and only one source of risk that earns a reward: namely, movements in the market as a whole. An asset only earns a return higher than a money-market fund if it tends to move up or down with the market, the theory says.
Now we recognize that the average returns of many investment opportunities cannot be explained by their tendency to move with the market. In particular, the CAPM does not explain the average returns of stocks sorted on the basis of market price relative to book value and to overall market value.
Therefore, financial economists now recognize a long-anticipated possibility: that there are multiple sources of risk or "factors" that give rise to high average returns. The multiple sources of risk all suggest a common macroeconomic character. High returns apparently are earned for holding risks related to recessions and financial distress, as well as for holding the risk of market declines.
Similarly, the long-run forecastability seems related to macroeconomics. Few investors want to hold risk in the bottom of a recession, so stock prices are lower than usual. As we come out of the recession, prices rise, so the low prices have signaled a period of unusually high returns. Conversely, stock returns are predictably low in good times. Most investors are feeling wealthy and are willing to hold substantial risks. They drive up prices, and thus drive down the returns we can expect from the stock market in the future.
What should an investor do about these new facts? Cochrane starts by reviewing the traditional advice, that applies when returns are unpredictable over time, and there is only one source of risk that enhances returns across assets. That advice is to split one's wealth between a money-market fund and a passively managed index fund. The split depends on one's tolerance for risk, but does not depend on investment horizon.
The new facts offer a tantalizing chance to escape this boring advice. For example, people who might lose their jobs in a recession should keep away from stocks that do badly in a recession, or even short sell them, even if those stocks provide high average returns. People who are more secure can then buy such stocks, earning the high average returns. Neither group follows the traditional advice, and the buyers serve a socially useful function by providing "recession-insurance" to others. Similarly, people who are hurt by recessions will naturally sell stocks in recessions, despite their attractive returns. This gives others the opportunity to "market-time'': buying stocks when low and selling them later in the boom when high, again providing a kind of insurance. Cochrane surveys these strategies and a number of careful studies that caution on how they should be used.
However, in the end the average investor must hold the market. For everyone who should buy "value" and other high-yield strategies, there must be someone else who, rationally, wants to sell it. If this is not the case, then the unusual returns must disappear, and will do so quickly. This proposition is true both for "rational" and for "behavioral" theories of the stock market. Therefore, one portfolio advice cannot fit all investors. Cochrane advises, then, to take the new portfolio advice and depart from an index fund only if you understand the economic function (like recession insurance) behind the strategy, and if you are "different from average" in knowing the right way to exploit it.
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