If you ever put money in an index mutual fund, you can thank three economists – Harry Markowitz, William Sharpe, and the late Merton Miller. Such funds are the best-known application of research they did in the 1950s and ‘60’s.
Their work won then the Nobel Prize for economics in the 1990s and changed the way investors and managers think about markets, money management, and securities design. Key concepts in investing and corporate finance that are today accepted as obvious can be traced back to their articles in scholarly journals – everything from the existence of systematic trade-off between risk and return, to the concepts that markets are efficient.
Markovitz, set the ball rolling. In 1952, the University of Chicago economist published a 14-page paper called “Portfolio Selection.” At its heart was what Peter Bernstein, dean of financial economists called “the most famous insight in the history of modern finance” – the idea of diversifying a portfolio of stocks in order to produce the maximum potential returns given the amount of risk an investor is prepared to take on. Of course, the notion of not putting all one’s eggs in the same basket has been a truism for centuries. (It is mentioned in the Talmud and Shakespeare among other places.) Markovitz proved why this is so by explaining the fundamental trade-offs between risk and return between asset concentration and diversification. Money managers around the world still follow his precepts daily.
Markovitz early work sparked a long period of intellectual ferment. In the process, Markovitz, Sharpe and Miller demolished many cherished Wall Street ideas. One example: that it is possible to beat the market consistently by perceptive stock picking. Impossible, they said – because thousands of investors collectively have factored everything that is known about stocks into current prices. These wise men were writing about this in the 1950s and ‘60’s. Today, technology factors put change into stock prices in split seconds, as new information travels at lightening speed on the Internet superhighway, making it even more difficult to outperform the market on a consistent basis.
Sharpe, devised the capital asset pricing model (CAPM) which quantified the idea that investors demand extra returns for taking on more risk. Souped-up versions of CAPM are still widely used in business to guide investment decisions. Miller, developed with Modigliani, the MM Proposition. They showed that any company’s worth depends on its earning power rather than its book value. So, if there is a tax break on interest payments, well-informed companies should favor debt over equity. That insight was a real shocker to a Wall Street steeped in the cult of the equity. It provided the intellectual heft that lead to the surge of the junk bond market. Some cultures (Asian for instance) disfavors carrying debt in personal finance, ignoring the concept that debt is good if it is profitable and earns resources to pay it off. A young couple (not of the super rich) could only save for 25 years to own their first house. The road of life has many detours, and these long-term acquisition plans may never materialize. They would rather get into affordable debt to buy a house and a car. Of course, well-informed business folks of any culture know how to roll the dice between debt and equity for business purposes. However, when it hits your individual wallet, the decision thoughts are cultured or individualized. Today's market meltdown (the past few weeks or so) is mainly due to individuals carrying debt that they can't afford to service. All hope that the Fed will reduce interest rates when it meets on Tuesday, September 18, 2007**. However, that reduction will not bring in a quick miracle as markets take time to tame and react inasmuch as it took time to get into this downturn.
A generation of financial economists is challenging the work of Miller, Sharpe, and Markovitz, often improving on it. However, the three wise men (the Nobel Trio) helped put financial reality into the capital markets.
**The FED funds rate was reduced by one-half percentage point on 9/18/2007. This sent the market roaring up and so did the price of oil go up.
By Christopher Farrell and Adapted by Merrill Cassell
On the other hand, many UN folks think about investing money for a safe return after they have retired, too late brothers and sisters; it is just too late to experiment with the market in the hope of beating it. Folks who work for the UN must realize that their pension fund accumulation (staff-member contribution plus organization’s contribution) is like an accumulated 401K from the private sector. In the case of the private sector staffer, he/she has diversified their portfolio’s from younger days and ideally have moved money into safer financial investments that would give them a stream of income during their golden years and play safe so that they do not outlive their resources. UN staffers must not try to play Russian roulette with their hard-earned lump sums. I personally know of many UN staffers who lost it all, lump sums plus the savings they also had before. It is so easy to buy and sell stocks with the click of the mouse. Unfortunately, many viewed this as a new profession in retirement years to great detriment. Wise counsel is advisable, but at the same time, staffers should be extra careful that vultures out there do not take you for a big ride. Therefore, you can also lose it all with expert advice as well. In my view, load funds are disgusting. If they take 5% upfront as a nonrefundable load, and the market loses say 8% immediately thereafter, then you portfolio is down 13%, and to recover that loss can take a few years.
I have even lost faith in the normal curve and if you do not know much of this statistic, forget-about-it, perhaps you missed nothing. To understand more of this, please look up the black swan theory. And for more in-depth knowledge, please read the book, The Black Swan by Nassim Nicholas Taleb; you may never trust anyone on on Wall Street, thereafter. If you are an astute watcher of stock market news, watch carefully. Folks that make big predictions of the market roar out when the market goes up, but they are in hiding when the market goes down. Furthermore, when the market goes down, many experts speak of the causes of the down turn, a discussion after the fact. So in essence, the stock market is highly improbable and hard to predict. However, people must use common sense - you don't stand in front of a moving train.
Another common error of investing is clingging to stocks and funds most tenaciously despite their mediocre performance as "investments in investor ego.” The solution is the systematic abandonment . Ask yourself this tough question, “If you weren’t already in this investment would you buy the stock. And if the answer is no face the second difficualt question
What are you going to do about it? People get stuck in a mental trap they call sunk costs – money down the drain.” When you are asking whether to invest today, you have to ignore what you’ve already invested. Instead you must ask: Will I get a good return on the money and time I’m going to invest from this time forward, Investing in poor performers or continuing to hold can be throwing good money after bad. Investing is such a long-term program, that one should literally invest in good stock and bond funds that have wide diversification and ideally not look at a computer screen from day-to-day other than reviewing annual performance.
Disclaimer: References to Personal Finance are strictly for "educational purposes" and does not hint or offer any specific financial advice. For financial advice, please seek the advice of a professional if you feel unable to handle your own finances..
This is great stuff. Merrill, You are a very bright fellow. Keep up the excellent work.
Posted by: Don Hall | October 20, 2007 at 04:34 PM