How to exploit the biggest glitch in investing
Brian Durrant Mar 08, 2013
Stocks are hitting all-time highs and everyone seems to want to join the party. So now is a good time for a bit of perspective. Brian Durrant of The Fleet Street Letter is a fan of low-risk stocks, the type that often get left behind when the market gets excitable.
Picture the scene: it’s the mid-'90s, and everyone is making money. In an opulent block of offices in Connecticut, there’s a room full of bulky computers humming away. Highly skilled economists have loaded them with reams of instructions based on elegant mathematical models.
The machines execute trades in the blink of an eye, amassing huge profits. And they help the hedge fund, Long-Term Capital Management, earn their clients a 40% annual return. That’s after fees. The men who designed the theories behind all this went on to win Nobel prizes.
Do you know how this ends? Even if you’re not familiar with LTCM’s story, you can probably guess. After all, we have plenty of recent experience of complicated mathematical models triggering devastation. In 1998, LTCM haemorrhaged $4.6bn. The esteemed economists behind the fund saw their models torn to shreds by the market.
It seems to take a horrible disaster before dodgy theories face proper scrutiny from investors. More recently, it was the 2008 crisis that saw a wave of attacks on the 'efficient market hypothesis'.
This theory formed the basis of risk management models used in the run-up to the crisis. Its failure led former Federal Reserve chairman Paul Volcker to observe that it was “clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations and market efficiencies”.
But why should you care? Well, if you’re a contrarian value investor like me, then taking advantage of the failings of efficient market theories is your bread and butter. The evidence shows that investing in boring, unloved stocks outperforms returns from investing in the latest growth fad. And that the defects of efficiency theories mean common-sense investors can reap huge rewards in the long run.
There are deep-seated behavioural reasons why low-risk contrarian stocks prevail, which I’ll get onto in a second. But the 'efficient market hypothesis' says it can’t be done.
Today, I want to put this theory to bed, and show you how it has created one persistent glitch that can give you a huge advantage. But first, what exactly is this theory?
The 'efficient market hypothesis', which underpins a body of investment theory, suggests that, because the market prices of tradable assets react automatically to new pieces of information, it is very difficult, if not impossible, for investors to outperform the stock market through diligent stock selection.
But if you look under the bonnet of the theory, the assumptions behind the hypothesis reside in a different world of no transactions costs, no taxes and all investors sharing the same time horizon.
At the same time, market liquidity is always assumed to be abundant, so investors can take positions in any size either long or short and, what’s more, they can borrow money at the risk-free rate.
Why I love boring stocks
Not only are the assumptions wholly unrealistic, the facts do not fit the theory. Research by Robert Haugen and Nardin Baker shows that between 1990 and 2011 in 21 developed countries, the least volatile (most boring) decile of stocks generated annualised returns of 8.75%.
Meanwhile, over the same time frame, the most volatile decile lost 8.8% per year. In the liquid world of US equities where the 'efficient market hypothesis' would probably be the most applicable, the results show an even larger disparity between boring and sexy stocks.
The least volatile 10% of US equities delivered annualised returns of 12% over the same period, while the most volatile 10% of stocks sustained annual losses of 7%. The exercise was replicated for emerging markets in the 2001-2011 period and produced similar results.
It could be argued that these studies, particularly of emerging markets, are based on too short a time frame. So let’s look at an older study going back to 1968.
Malcolm Baker, Brendan Bradley and Jeffrey Wurgler of Harvard Business School undertook a review of the US equity market from January 1968 to December 2008. If an investor adopted the strategy of buying the one fifth of US shares with the lowest volatility in the previous five years, the plan would have turned $1 in January 1968 into $59.55 by December 2008. Now consider the investor that bought into the top 20% of stocks in terms of their volatility on a five-year basis; the $1 would be worth just 58c over the 40-year investment horizon.
Malcolm Baker describes the tendency for low-risk stocks to outperform the market as “perhaps the greatest anomaly in finance”.
In the world of the 'efficient market hypothesis' this anomaly would not persist as smarter investors would pick up on this buying opportunity. However, there are strong behavioural reasons why investors shun boring stocks and overpay for both long shots and complete certainty. Human beings are not totally rational, so anomalies like this persist.
We know that the worst result for bookmakers on Grand National day is for the favourite to win. This is because bookmakers make their money under-pricing long shots. Horses that should be priced at 100/1 may be priced at 60/1 and the punters don’t really mind because 60/1 is still a big win.
Despite the fact that long shots are mispriced, they are still popular with the punters. For them, the hope of potentially winning a huge jackpot is infinitely preferable to putting out a large wager on an odds-on favourite, fearing that it won’t win. Hope and fear are common behavioural traits that keep bookmakers in business.
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This is why bookies stay in business
The studies by Baker, Bradley and Wurgler show that investing in high volatility stocks has delivered extremely poor returns. But they remain popular. One reason is hindsight bias. Here’s how it works.
A punter can vividly recall the time and place when he jumped for joy on seeing a horse he backed at 50/1 crossing the finishing line first. But he has a tendency to overlook the number of times his long shots have fallen at the first fence. If the punter kept a record of each of his bets, the losses accumulated from investing in long shots would most likely have swamped the occasional memorable win. This is why bookmakers stay in business.
The same applies to investors who piled into dotcom stocks towards the end of the 1990s. Each start-up promised a road to riches, but the vast majority were doomed to failure. Investing in dotcom companies has parallels with buying a lottery ticket. People are drawn to low probability, high payoff gambles. And even if there is an early success, the natural reaction is not to cash in your chips and walk away but to invest in an overconfident manner.
After a few successes with dotcom stocks, stock pickers had a tendency to exaggerate their ability to see the future, and put too much store in their ability to spot the next big thing. These traits naturally lead investors to underrate the virtues of safer, duller shares.
I think the smartest thing to do it to invest in low beta stocks. Beta is the measure of the volatility of a stock relative to the market. If a share has a beta of 0.8, for example, this means that if the underlying market rises by 10%, this stock will have a tendency to rise by 8%.
By the same token were the benchmark to fall by 10%, we would expect the stock to fall by 8%. So essentially, the lower the beta the less volatile the stock is relative to the market. A share with a beta of one would tend to track the underlying index very closely. A stock with a beta of say 1.5 would be considered quite volatile. A 10% rise in the benchmark would be accompanied by a 15% rise in the stock and vice versa.
Studies show that, in the long run, the lowest beta stocks seriously outperform the highest beta stocks. So you would think professional investors would be immune to this bias towards riskier stocks. But they’re not. Think about it. Fund managers are trying to outperform the benchmark. And to do that they need more volatile stock, which will outpace a rally. So they have a strong incentive to avoid low beta stocks.
Investors pay too much for certainty
Right now, investors are overpaying for high-risk equities. And at the same time they’re overpaying for certainty by accepting negative real yields on sovereign bonds. And a guaranteed real capital loss on index-linked bonds. If that’s the case it makes sense that there must be bargains for investors elsewhere.
The 'efficient market hypothesis' is a flawed way at looking at the investment world. The perfect world of rational investors does not exist. We have to accept that investors are emotive individuals who react to choices in a non-rational way.
Long-term studies show that investing in equities at the low end of the risk spectrum is much more rewarding than investing in the most volatile stocks. Moreover, this anomaly has persisted over time because investors are not totally rational and because many fund managers have a tendency to hug the benchmark. Warren Buffett has also argued against 'efficient market hypothesis' (EMH), saying the preponderance of value investors among the world’s best money managers rebuts the claim of EMH proponents that luck is the reason some investors appear more successful than others.
Still, investing in low volatility stocks takes strength of character and patience. Low beta stocks tend to be dull, unexciting and somewhat old-fashioned. In terms of daily share price movement they provide little excitement. Also, investing in the low-beta sector can often be lonely at times like this, when the rest of the equity market is partying with the latest fad.
Well, loneliness is a price worth paying. I mean, why have your money in stocks at all? It’s to grow your wealth without taking on too much risk. If it’s thrills you’re after, you can bet on the horses.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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