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There are hundreds of investment products in the market that claim to outperform. The idea is that certain information is identified that allow us to pick stocks that will do better than average and those that will do worse than average. When you buy the stocks that will do better and short sell the ones that you think will do worse, you have potentially identified a strategy that will ‘beat the market.’

The post Separating investment facts from flukes appeared first on OUPblog.

The star-studded new film “The Big Short” is based on Michael Lewis’s best-selling expose of the 2008 financial crisis. Reviewers are calling it the “ultimate feel-furious movie about Wall Street.” It emphasizes the oddball and maverick character of four mid-level hedge fund managers in order to explain what it would take to ignore the rating agencies’ evaluations and bet against the subprime industry—that is, their own industry.

The post The Big Picture and “The Big Short”: How Virtue helps us explain something as complex as the Financial Crisis appeared first on OUPblog.

t the conclusion of the mid-September meeting of the Federal Open Market Committee (FOMC), the Federal Reserve announced its decision to leave its target interest rate unchanged through the end of this month. Although some pundits had predicted that the Fed might use the occasion of August’s decline in the unemployment rate (to 5.1 percent from 5.3 percent in July), to begin its long-awaited monetary policy tightening, those forecasts left out one crucial fact.

The post Don’t panic: it’s October appeared first on OUPblog.

For investors and asset managers, expected stock returns are the rates of return over a period of time in the future that they require to earn in exchange for holding the stocks today. Expected returns are a central input in their decision process of allocating wealth across stocks, and are essential in determining their welfare. For corporate managers, expected returns on the stocks of their companies, or the costs of equity, are the rates of returns over a period of time in the future that their shareholders require to earn in exchange for injecting equity to their companies today. The costs of equity play a key role in the decision process of corporate managers when deciding which investment projects to take and how to finance the investment. Despite the paramount importance, no consensus exists on how to best estimate expected stock returns. In fact, one of the most important challenges in academic finance is to explain anomalies, empirical patterns of expected stock returns that seem to evade traditional theories.

A manager should optimally keep investing until the investment costs today equal the value of future investment benefits discounted to today’s dollar terms, using her firm’s expected stock return as the discount rate. This economic logic implies that all else equal, stocks of firms with high investment should have lower discount rates than stocks with low investment. Intuitively, low discount rates lead to high discounted values of new projects and high investment. In addition, stocks with high profitability (investment benefits) relative to low investment should have higher discount rates than stocks with low profitability. Intuitively, the high discount rates are necessary to offset the high profitability to induce low discounted values for new projects and low investment.

To implement this idea, we use a standard technique in academic finance that “explains” a stock’s return with the contemporaneous returns on a number of factors. In a highly influential study, Fama and French (1993) specify three factors: the return spread between the overall stock market and the one-month Treasury bill, the return spread between small market cap and big market cap stocks, and the return spread between stocks with high accounting relative to market value of equity and stocks with low accounting relative to market value of equity. Carhart (1997) forms a four-factor model by augmenting the Fama-French model with the return spread between stocks with high prior six to twelve month returns and stocks with low prior six to twelve month returns.

We propose a new four-factor model, dubbed the q-factor model, which includes the market factor, a size factor, an investment factor, and a profitability factor. The market and size (market cap) factors are basically the same as before. The investment factor is the return spread between stocks with low investment and stocks with high investment. The profitability factor is the return spread between stocks with high profitability and stocks with low profitability. The q-factor model captures most of the anomalies that prove challenging for the Fama-French and Carhart models in the data.

Specifically, during the period from January 1972 to December 2012, the investment factor earns an average return of 0.45% per month, and the profitability factor earns 0.58%. The Fama-French and Carhart models cannot capture our factor returns, but the q-factor model can capture the returns on the Fama-French and Carhart factors. More important, the q-factor model outperforms the Fama-French and Carhart models in “explaining” a comprehensive set of 35 significant anomalies in the US stock returns. The average magnitude of the unexplained returns is on average 0.20% per month in the q-factor model, which is lower than 0.55% in the Fama-French model and 0.33% in the Carhart model. The number of unexplained anomalies is 5 in the q-factor model, which is lower than 27 in the Fama-French model and 19 in the Carhart model. The q-factor model’s performance, combined with its economic intuition, suggests that it can serve as a new benchmark for estimating expected stock returns.

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Autumn is high season for American political junkies.

Although the media hype is usually most frenetic during presidential election years, this season’s mid-term elections are generating a great deal of heat, if not much light. By October 13, contestants in 36 gubernatorial races had spent an estimated $379 million on television ads, while hopefuls in the 36 Senate races underway had spent a total of $321 million.

For those addicted to politics, newspapers and magazines have long provided abundant, sometimes even insightful coverage. During the last hundred years, print outlets have been supplemented by radio, then television, then 24/7 cable TV news. And with the growth of the internet, consumers of political news now have access to more analysis than ever.

One analytical tool that the politics-following public will not have access to this year is Intrade, an on-line political prediction market. Political prediction markets work very much like financial markets. Investors “buy” a futures contract on a particular candidate; if that candidate wins, the contract pays a set amount (typically $1); if the candidate loses, the contract becomes worthless. The price of candidates’ contracts vary between zero and $1, rising and falling with their political fortunes—and their probability of winning. You can see a graph of Obama and Romney contracts in the months preceding the 2012 election here.

Organized political betting markets have existed in the United States since the early days of the Republic. According to a 2003 paper by Rhode and Strumpf, during the late 19^th and early 20^th centuries wagering on political outcomes was common and market prices of contracts were often published in newspapers along with those of more conventional financial investments. Rhode and Strumpf note that at the Curb Exchange in New York, the total sum placed on political contracts sometimes exceeded trading in stocks and bonds.

Political betting markets became less popular around 1940. Betting on election outcomes no doubt continued to take place, but it was a much less high-profile affair.

Modern political prediction markets emerged with the establishment in 1988 of the Iowa Electronic Markets (IEM), a not-for-profit small-scale exchange run by the College of Business at the University of Iowa. The IEM was created as a teaching and research tool to both better understand how markets interpret real-world events and to study individual trading behavior in a laboratory setting. The IEM usually offers only a few contracts at any one time and investors are allowed to invest a relatively small amount of money. As of mid-October, the Iowa markets—like the polls more generally—were predicting that the Republicans will gain seats in the House and gain control of the Senate.

An important feature of political prediction markets—like financial markets—is that they are efficient at processing information: the prices generated in those markets are a distillation of the collective wisdom of market participants. A desire to harness the market’s ability to process information led to an abortive attempt by the Defense Advanced Research Projects Agency in 2003 to create the Policy Analysis Market, which would allow individuals to bet on the likelihood of political and military events—including assassinations and terrorist attacks–taking place in the Middle East. The idea was that by processing information from a variety disparate sources, monitoring the prices of various contracts would help the defense establishment identify hot-spots before they became hot. The project was hastily cancelled after Congress and the public expressed outrage that the government was planning to provide the means (and motive) to speculate on—and possibly profit from–terrorism.

Another, longer-lived—and for a time, quite popular–prediction market was Intrade.com. This Dublin-based company was established in 1999. At first, it specialized in sports betting, but soon expanded to include an extensive menu of political markets. During recent elections, Intrade operated prediction markets on the presidential election outcome at the national level, the contest for each state’s electoral votes, individual Senate races, as well as a number of other political races in the US and overseas. Thus, Intrade offered a far variety of betting options than the IEM.

Intrade was forced to close last year when the US Commodities Futures Trading Commission (CFTC) filed suit against it for illegally allowing Americans to trade options (by contract, the IEM secured written opinions in 1992 and 1993 from the CFTC that it would not take action against IEM, because of that market’s non-profit, educational nature). The CFTS’s threat to Intrade’s largest customer base very quickly led to a dramatic drop-off in visitors to the site, which subsequently closed. Alternative off-shore betting markets have entered the political markets (e.g., Betfair), but their offerings pale by comparison with those formerly offered by Intrade and are probably too small at present to spur the CFTC to action.

I regret the loss of Intrade, but not because I used their services—I didn’t. Given the federal government’s generally hostile view toward internet gambling, I felt it was prudent to abstain. Plus, having placed a two-pound wager on a Parliamentary election with a bookmaker when I lived in England many years ago convinced me that an inclination to bet with the heart, rather than the head, makes for an unsuccessful gambler.

No, I miss Intrade because it provided a nice summary of many different political campaigns. Sure, there are plenty of on-line tools today that provide a wide array of expert opinion and sophisticated polling data. Still, as an economist, I enjoyed the application of the mechanisms usually associated with financial markets to politics and observing how political news generated fluctuations in those markets. No other single source today does that for as many political races as Intrade did.

Feature image credit: Stock market board, by Katrina.Tuiliao. CC-BY-2.0 via Wikimedia Commons.

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By Louis René Beres

Adam Smith published his Inquiry into the Nature and Causes of the Wealth of Nations in 1776. A revolutionary book, Wealth did not aim to support the interests of any one particular class, but rather the overall well-being of an entire nation. He sought, as every American high-school student learns, “an invisible hand,” whereby “the private interests and passions of men” will lead to “that which is most agreeable to the interest of a whole society.”

Still, this system of “perfect liberty,” as he called it, could never be based upon encouragements of needless consumption. Instead, argued Smith, the laws of the market, driven by competition and a consequent “self-regulation,” actually demanded explicit disdain for any gratuitous or vanity-driven consumption.

What does this all mean for better understanding current economic dislocations and volatility? Above all, it suggests that modern commentators and pundits often speak in blithe disregard for Smith’s true beliefs, ignoring that his primary concern for consumption was always tempered and bounded by a genuine hatred for “conspicuous consumption” (a phrase to be used more pointedly by Thorsten Veblen in a later century).

For Adam Smith, it was only proper that the market regulate both the price and quantity of goods according to the final arbiter of public demand, yet, he continued, this market ought never to be manipulated by any avaricious interferers. In fact, Smith plainly excoriated all those who would artificially create or encourage any such contrived demand as mischievously vain meddlers of “mean rapacity.”

Today, of course, where engineered demand and hyper consumption are permanent and allegedly purposeful features of the market, especially here in the United States, we have lost all sight of Smith’s “natural liberty.” As a result, we try, foolishly and interminably, to build our economic recovery and vitality upon sand. Below the surface, we still fail to recognize, lurks a core problem that is not at all economic, fiscal or financial. Rather, as Adam Smith would have understood, it is a starkly psychological and deeply human dilemma.

Wall Street’s persisting fragility is largely a mirror image of Main Street’s insatiable drive toward hyper consumption. This manipulated drive, so utterly execrable to Adam Smith, has already become so overwhelming that many learned economists warn us sternly against saving too much.

If only we could all buy just a little more, they argue, life in America would be better. Retail sales are the authentic barometer of the “good life.”

Collectively, our national economic effort is always oriented, breathlessly, toward buying more. Many of our country’s troubling and troubled economic policies are a more-or-less direct consequence of this sorely misdirected effort. Until we can get an effective reversal of the frenetic public need for more and more things, any “recovery” will remain transient and partial.

Not from the start has contrived demand been a basic driving force of our economy. Obviously, before television and before our newer surrenders to an avalanche of high-tech gadgets, such demand would not have had any such compelling power. Nonetheless, for the foreseeable future, it will take herculean efforts to detach healthy patterns of consumption from a distressingly ceaseless barrage of advertisement.

At the recently-played Super

Edward A. Zelinsky is the Morris and Annie Trachman Professor of Law at the Benjamin N. Cardozo School of Law of Yeshiva University. He is the author of The Origins of the Ownership Society: How The Defined Contribution Paradigm Changed America.  In this article, Zelinsky discusses the federal government’s promotion of common stock investments for 401(k) participants. He suggests that, in light of the Crash of 2008, that promotion constitutes misguided paternalism.

Even as we contemplate the financial carnage of the Crash of 2008, the federal government sends a strong, paternalistic and, ultimately, misguided message to 401(k) participants: Invest your retirement savings in common stocks.

Congress, in the Pension Protection Act of 2006 (PPA), directed the Secretary of Labor to promulgate regulations specifying the “default investments” to which 401(k) funds will be directed if participants fail to make their own investment choices. Under the regulations issued by the Secretary of Labor, a plan fiduciary obtains immunity from liability for a participant’s investment decisions only if the plan’s default investment constitutes a “qualified default investment alternative.” Among other requirements, a qualified default investment alternative must satisfy one of three mandatory patterns: a “life-cycle” pattern under which “a mix of equity and fixed income” investments changes for the individual participant as the participant ages, a “balanced” portfolio under which each participant has the same “mix of equity and fixed income” investments “consistent with a target level of risk appropriate for participants of the plan as a whole,” or a “managed account” under which an investment manager allocates a particular participant’s account to “a mix of equity and fixed income” assets.

When one cuts through the bureaucratic verbiage, a strong message emerges: 401(k) funds, particularly the funds of younger participants, should be invested in common stocks.

At one level, the PPA and the DOL regulations which implement it reflect a plausible investment theory, namely, that common stocks, for the long run, do better than do more conservative investments. The PPA and the DOL regulations also respond, in light of this theory, to two accurate perceptions about the 401(k) world: First, unless participants direct otherwise, 401(k) plans have historically placed participants’ resources into conservative, low-yield investments like money market funds. Second, 401(k) participants often fail to diversify their holdings out of these conservative default investments.

Hence, the PPA and the DOL regulations channel 401(k) funds toward common stocks by effectively requiring that at least part of passive participants’ accounts be invested in such stocks.

Surveying the wreckage of the Crash of 2008, this looks like misguided paternalism. Many investors who buy common stocks in the current bearish environment are likely do well in the long run. But, as they say, past performance is no guarantee of future success. And some, particularly smaller investors, may sincerely and (from today’s perspective) rationally prefer to avoid the volatility associated with common stocks.

There is, as we have just seen, a reason that the extra projected profit associated with common stocks is labeled a “risk premium.” The passive 401(k) participant who leaves his funds in conservative, low-yield investments looks more reasonable today than he did when Congress passed the PPA in the bull market of 2006.

A defender of the PPA and the DOL regulations could retort that they do not require participants to invest in common stocks, but merely send 401(k) funds to equity investments unless the participants direct otherwise. True. But the PPA and the DOL regulations nevertheless reflect a father-knows-best attitude, taking it as the federal government’s responsibility to privilege its preferred approach to investing and enshrining that stock-based approach in the law.

Before the Crash of 2008, such paternalism looked plausible. At an as yet unknown date in the future, such paternalism may look plausible again. Today, it looks misguided.

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