Investment Insight of

Nobel Prize Winners

Michael ZhuangThe Investment ScientistMZ Capital Management

2013 Nobel Prize in Econ

• Eugene Fama– RISK based explanation of the market

• Robert Shiller – BEHAVIOR based explanation of the market

• Lars Peter Hansen– General Method of Moment or GMM– High power mathematical tool to measure the

market

Eugene Fama

• Efficient Market Hypothesis (EMH)– In a competitive capital market participated by

millions of people out to make an extra dime, there will not be any advantageous information left unused.

• Risk factors of the market– There are three factors of risk

Efficient Market Hypothesis (EMH)

• Weak form EMH– Past stock prices have no predictive power of future

stock prices.– Implication: technical analysis useless

• Semi-strong form EMH– All public information has no predictive power of

future stock prices– Implication: watching Jim Cramer waste of time

• Strong from EMH– Private information has no predictive power

More on Strong Form EMH

• There are evidences that Strong Form EMH is rejected

• Insider information: CEO, COO, CFO, 5% Owners, Directors

• Law markers• My experience trading insider information

after Sarbane Oxley Act.

Stock Prices are Predictable …• By company size

Smallest 2 3 4 5 6 7 8 9 Largest0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

17.64%

14.65% 14.64% 14.26%14.88%

13.80%12.84% 12.96%

11.40%10.68%

Annual Returns Relative to Size

Stock Prices are Predictable …• By P/B ratio

Lowest

(Valu

est) 2 3 4 5 6 7 8 9

Highest

(Gro

wthest)

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

20%18%

17% 17%15% 15% 14%

13%12%

8%

Annual Returns Relative to P/B

Contradiction to EMH?

• Isn’t this contradictory to Fama’s own Efficient Market Hypothesis?

• Alas Fama has a risk based explanation– Smaller stocks are riskier than larger stocks,

therefore investors in those stocks are compensated more by the market

– Value (non-growing) stocks are risker than growth stocks, therefore investors in those stocks are compensated more by the market

Fama French Three Factor Model

• Stock expected returns are determined by three risk factors– Beta, or correlation with the broad market.– Size, and– Valuation

Fama French Five Factor Model

• Unified pricing model for stocks and bonds• Stock/Bond expected returns are determined

by five factors– Beta– Size– Valuation– Duration– Credit

Risks That Pay

• Beta risk• Size risk or small cap risk• Value risk• Duration risk• Credit risk

Risks That Don’t Pay

• Idiosyncratic risk, or individual stock risk– Individual stocks risk can be diversified away

costlessly, therefore it’s not compensated by capital market

• Agency risk– Risk that your agent don’t work for your best interest.

Example: Lloyd Blankfein Goldman CEO Congressional Testimony

• Information asymmetric risk– No hedge funds for my clients.

Can Money Managers Pick Stocks

• S&P Active vs Passive Study: No!• Academic research– 25% of money managers outright lost money

picking stocks– 75% of money managers make some money but

not enough to overcome their costs– Only 0.24% of money managers make money

picking stocks, they may not repeat.

Can Analyst Predict Stocks?

• Overwhelming evidences say NO!• Analysts’ “buy” “sell” “upgrade” “downgrade”

calls have very little advantageous information.

• Analysts earning forecasts five years out are negatively correlated to actuals. (La Porta) Thus those companies forecasted to have the strongest growth to have the worst returns.

How I Apply Fama’s Insight

• Construct well-diversified portfolio to seek broad exposure to all five risk factors with a tilt towards small cap and value.

• Shun actively managed funds, use DFA or Vanguard instead.

• Rebalance to maintain risk exposure

Robert Shiller

• “Eugene Fama is like a good friend who believe in a different religion.”

• “The market is not so much driven by risk factors but by animal spirits.”

• Author of two “Irrational Exuberance” books, called the tech bubble and housing bubble.

• Co-creator of Case-Shiller Real Estate Index

Stock Prices Too Volatile

Robert Shiller’s Explanation

• Price volatility shouldn’t be 13x dividend volatitility

• People are basically irrationally• Stock prices are driven by fear and greed;

stock prices are alternating between underpriced and overpriced.

PE10 Can Predict LT Market Ret

How I Apply Shiller’s Insight

• Another Great Depression when stocks drop 85% is nothing to fear

• Not that I can predict it …• But I know how to deal with it after the fact …

Dividend to Rescue

Rebalance Periodically

• Not just as a mean of maintaining risk exposure

• But also can earn additional 50 bps in return a year.

Trading Is Hazardous

Lowest 2 3 4 Highest Index0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

20.00%

17.64%16.93%

16.33%15.22%

12.11%

17.90%

Portfolio Returns vs Turnover (1991-1996)

Investment Do and Don’t

• Do diversify• Do tilt toward small cap and value• Do rebalance• Don’t pick stocks• Don’t pick active fund managers• Don’t time market• Don’t trade frequently