# Does active fund management pay off?



## Brendan Burgess

Marc Westlake had an excellent article in the Sunday Times which is reproduced on his blog [broken link removed]



> Some investment professionals work hard to make their work confusing.  They use jargon that can intimidate and make it difficult for investors  to understand relatively straightforward concepts.
> But investing is actually not that complicated. As Warren Buffet  said; “investing is like dieting”, easy concepts, difficult to apply.
> Investing can be broken down into two major beliefs:
> •    You believe in the ability to pick stocks, or you don’t.
> •    You believe in the ability to time markets, or you don’t.


and 



> Academic studies indicate that investments in the other three quadrants,  on average, do no better than the market after fees, transactions costs  and taxes. Whereas, a low cost, passive buy and hold strategy—those in  the fourth category—have higher returns on average than other types of  strategies.
> There will always be those who will claim to have identified the Tiger  Woods of fund management or have developed some system of market timing  for their clients just as there will always be those clients who believe  that their adviser can push water up hill.


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## Jim2007

Brendan Burgess said:


> Marc Westlake had an excellent article in the Sunday Times which is reproduced on his blog [broken link removed]



Let me start by saying that I do not subscribe to the efficient market hypotheses, I'm a value investor and I have done very well by that!

That aside, I don't believe for a minute that active fund management pays off, but for a different set of reasons than Marc!  The dice is always stacked against the manager of an active fund:

A certain amount of the fund has to be kept in cash to cover withdrawals and so on, so they have to achieve the returns without being fully invested
Investors want instant gratification - if they read an article about some great must have stock the first think they do is check to see if their fund holds it, so managers are often forced to buy at the top of the market in case they loose the client
For the same reason, fund managers often sell entire positions before the quarterly results are announced in case it  is bad news and they don't want to be caught holding and risk loosing the client.  If it turns out OK, they'll buy it back in the afternoon.  All leading to high transaction costs.
There is the management fees and expenses to top it off
With all that baggage it is no surprise that most managers fail to beat or even achieve the benchmark they are being measured against.


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## Brendan Burgess

Neil Osborne has replied to Marc's articel in last Sunday's Times. 

I can't find it on the Covestone Asset Management website (which is the most appallingly designed website).

Brendan


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## Brendan Burgess

I have looked back at Marc's article and I found this bit interesting. 



> We believe that investors are compensated with higher expected returns  for bearing higher investment risk. Research from leading financial  economists has identified two risk factors that the market rewards  investors for bearing –size (meaning smaller companies are more risky  than large companies) and* value meaning that value stocks are more risky  than growth stocks. *The evidence from the last 10 years seems to  support this.



I would have always assumed that value stocks were less risky? 

Brendan


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## Wayne1966

Brendan I agree value stocks are less risky and the evidence shows this. I'm doing a phd at moment on a related topic. I must admit most accepted financial theory is hogwash. Im also an actual investor (small one) so I read the debate between the pair with interest and I have to say that graph Neil showed on Sunday was a knockout blow to the Efficient Market theory. I went onto the covestone website and couldn't find the Sunday times article but I found Thst graph explained on their quarterly newsletters. I'd love to know exactly what goes into it cos I agree with his points. Is there Any more 
value mangers In Ireland does anyone know??  Wayne


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## ClubMan

Wayne1966 said:


> I must admit most "accepted financial theory" is hogwash.


What do you mean by "accepted financial theory" though? And accepted by whom? And as measured how?


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## Wayne1966

Well accepted financial theory is the typical theory that gets thought in colleges and business schools the world over, it dictates how most of the investments in the world are managed, it also influences how policy makers and central bankers look at the world, all this boils down to theories such as Modern Portfolio Theory, CAPM and Efficient Market Hypothesis with their implications such as risk is volatility so high volatile stocks will outperform low volatile stocks etc, Those theories are plainly rotten to the core. Risk is not volatility, how could it be? It is only is if you define it that way. High beta stocks do not outperform low beta stocks over time there are many academic papers on this, the opposite is actually the case. When volatility is high, traditional theories will tell you risk is high but that is not true you get the best risk adjusted long term returns when you buy volatility spikes, similarly when volatility is low you tend to get complacency so risk is present but people ignore it (think 2007). Value investing works particularly well as the studies show and value strategies are actually less risky not more risky. This is what that guy in the paper was saying, though I think what he was saying is that one should use value strategies for the market as a whole and not for individual stocks (as in use it as an asset allocation tool) which is something I need to look into more but makes intuitive sense to me. For a different perspective on risk try Mandelbrot and that annoying guy Taleb or look at way famous value investors like Benjamin Graham and Warren Buffet think about risk. The behavioural schools fill a lot of the gaps that traditional theory leaves yet they still don't teach them in business schools, they just stick with the traditional theories, which are very deficient IMHO.  Wayne


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## ringledman

Wayne1966 said:


> Well accepted financial theory is the typical theory that gets thought in colleges and business schools the world over, it dictates how most of the investments in the world are managed, it also influences how policy makers (the ones who understand finance) look at the world, all this boils down to theories such as Modern Portfolio Theory, CAPM and Efficient Market Hypothesis with their implications such as risk is volatility, high volatile stocks will outperform low volatile stocks etc, Those theories are plainly rotten to the core. Risk is not volatility, how could it be? It is only is if you define it that way. High beta stocks do not outperform low beta stocks over time there are many academic papers on this, the opposite is actually the case. When volatility is high, traditional theories will tell you risk is high but that is not true you get the best risk adjusted long term returns when you buy volatility spikes, similarly when volatility is low you tend to get complacency so risk is present but people ignore it (think 2007). Value investing works particularly well as the studies show and value strategies are actually less risky not more risky. This is what that guy in the paper was saying, though I think what he was saying is that one should use value strategies for the market as a whole and not for individual stocks (as in use it as an asset allocation tool) which is something I need to look into more but makes intuitive sense to me. For a different perspective on risk try Mandelbrot and that annoying guy Taleb or look at way famous value investors like Benjamin Graham and Warren Buffet think about risk. The behavioural schools fill a lot of the gaps that traditional theory leaves yet they still don't teach them in business schools, they just stick with the traditional theories, which are very deficient IMHO. Wayne


 
Fantastic post. 

I would add James Montier to the list of excellent behavioural economists. 

The academic efficient market school ignores any attempt at looking at behaviour in the markets. 

The belief that all investors are rational all of the time and acting with perfect information and hence all price are efficient is falling away as the correct approach. It works some of the time but not always.

Howard Marks in 'The Most Important Thing: Uncommon Sense for the Thoughtful Investor: Uncommon Sense for Thoughtful Investors' sets a truely excellent analysis of when markets are efficient and when they are not. A truely great book.


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## Chris

Wayne1966 said:


> Well accepted financial theory is the typical theory that gets thought in colleges and business schools the world over, it dictates how most of the investments in the world are managed, it also influences how policy makers and central bankers look at the world, all this boils down to theories such as Modern Portfolio Theory, CAPM and Efficient Market Hypothesis with their implications such as risk is volatility so high volatile stocks will outperform low volatile stocks etc, Those theories are plainly rotten to the core. Risk is not volatility, how could it be? It is only is if you define it that way. High beta stocks do not outperform low beta stocks over time there are many academic papers on this, the opposite is actually the case. When volatility is high, traditional theories will tell you risk is high but that is not true you get the best risk adjusted long term returns when you buy volatility spikes, similarly when volatility is low you tend to get complacency so risk is present but people ignore it (think 2007). Value investing works particularly well as the studies show and value strategies are actually less risky not more risky. This is what that guy in the paper was saying, though I think what he was saying is that one should use value strategies for the market as a whole and not for individual stocks (as in use it as an asset allocation tool) which is something I need to look into more but makes intuitive sense to me. For a different perspective on risk try Mandelbrot and that annoying guy Taleb or look at way famous value investors like Benjamin Graham and Warren Buffet think about risk. The behavioural schools fill a lot of the gaps that traditional theory leaves yet they still don't teach them in business schools, they just stick with the traditional theories, which are very deficient IMHO.  Wayne



Great post, I especially agree on the risk comment. What is generally ignored is that level of risk is a totally subjective observation by an individual. My personal portfolio would probably send many mainstream investment advisor gasping, but based on my economic views I have reduced my risk, especially for the long term. I sleep better at night precisely because I do not follow a mainstream approach.



ringledman said:


> Howard Marks in 'The Most Important Thing: Uncommon Sense for the Thoughtful Investor: Uncommon Sense for Thoughtful Investors' sets a truely excellent analysis of when markets are efficient and when they are not. A truely great book.



Thanks for posting, I must look it up.


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## ringledman

Chris said:


> Thanks for posting, I must look it up.


 
Well worth a read, posssibly the best investment book of the past few years IMO.


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## Marc

Brendan,

Thank you for the question about value investing.

So, to address some of the comments made above first.

The Wisdom of Crowds is a book written by James Surowiecki which sets out the simple but powerful idea that under the right circumstances groups can make better decisions than could have been made by any single member of the group. Examples include the odds at a racetrack which almost perfectly predict how likely a horse is to win (this despite the fact that my mother bets on horses based on their name!), Google’s search engine is another example of a process powered by collective wisdom. In a recent BBC TV documentary Professor Marcus du Sautoy asked a group of participants to guess how many jelly beans were in a jar and the average of all the guesses was within 0.1% of the true number. Another good example of the combined wisdom of crowds is the stock market.

However, critics of market efficiency in financial markets claim that much of the blame for the recent financial meltdown is attributable to a misguided faith in market efficiency that encouraged market participants to accept security prices as the best estimate of value rather than conduct their own investigation.
We asked some leading commentators to join the debate and to share their thoughts with us, first the Father of the Efficient Markets Hypothesis Professor Eugene Fama at the University of Chicago.

“The premise is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis, which posits that market prices reflect all available information. The claim is that the world's investors and their advisers bought into this model. Because they ceased to investigate the true value of assets, we have been hit with "bubbles" in asset prices. This premise is fantasy. Most investing is done by active managers who don't believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finance, financial markets, and financial institutions are in disrepute. The popular story is that together, they caused the current recession. I think one can take an entirely different position: financial markets and financial institutions were casualties rather than the cause of the recession.”

I doubt any finance professor believes the efficient market hypothesis is completely and literally true. As Fama has pointed out, “the extreme version of the EMH is surely false.”  The EMH is an abstraction that allows us to construct a framework for rigorous thinking about how capital markets work. Like any model, it must be false to some degree. The relevant question for investors is “How well do relatively simple asset-pricing models explain a very complicated reality?”  Are they perfect? No. But current models do a good job of explaining differences in stock returns as well as money manager results. And researchers such as Fama and his colleague at Dartmouth College, Ken French continue to try and come up with better ways to distinguish high-expected-return securities from low-expected-return securities. If critics can present a superior asset-pricing model, let’s see it so we can subject it to critical review from other financial researchers.

What about the behavioural finance studies which claim that individuals are not rational and are prone to biases in their behaviour?

Fama again; “My academic friends in behavioural finance almost always end up concluding that passive investing is the right choice for almost all investors. In my view, this is an admission that the Efficient Markets Hypothesis provides a good view of the world for almost all practical purposes. “

It is often suggested that investors’ behavioural biases contribute to pricing mistakes which can be exploited by other investors. Many money managers claim to pursue such strategies, but if they were successful in this effort we would see the results in money manager performance studies. We don’t. The results of money managers, including those who claim to apply a “behaviourist” strategy, are well-explained by the same asset-pricing models that critics of market efficiency are so quick to condemn. One of the most prominent economists associated with behavioural finance is Richard Thaler of the Univ. of Chicago. He and Fama don’t agree on much, except when it comes to practical advice for investors. There, his conclusion is essentially indistinguishable from card-carrying market enthusiasts: diversify, keep your costs down, and don’t read your monthly statement. Daniel Kahneman, the Princeton psychology professor who received the Nobel Prize in Economics for his work on behavioural biases, strikes a similar note. Humans often exhibit irrational behaviour, he observes, and, among investors, an example of this irrationality is the persistent delusion that they can outwit the market in the face of overwhelming evidence to the contrary.  

Another attack on modern portfolio theory comes from commentators such as Nassim Nicholas Taleb the author of the "The Black Swan" and a fan of the mathematics of Benoit Mandlebrot who attack the use of Gaussian (normal bell curve) mathematics as the foundation of finance. They argue that the bell curve doesn't reflect reality and is critical of academics who teach modern portfolio theory because it is based on the assumption that returns are normally distributed.

Gene Fama again,  “Half of my 1964 Ph.D. thesis is tests of market efficiency, and the other half is a detailed examination of the distribution of stock returns. Mandelbrot is right. The distribution is fat-tailed relative to the normal distribution. In other words, extreme returns occur much more often than would be expected if returns were normal. For passive investors, none of this matters, beyond being aware that outlier returns are more common than would be expected if return distributions were normal.”

We asked Larry Swedroe author of Quest for Alpha; what about market timing, surely investors should try to avoid buying just before a market crash?

“Clearly expected returns are based on current valuations, and have nothing to do with historical returns since prices move independently in a random walk. Yes, it is true that high valuations mean low expected returns and vice versa, but that doesn’t mean you can time the market! All high valuations mean is that the Equity Risk Premium is relatively Low, not that it is non-existent.”

But this doesn’t mean that equity returns are more predictable even over the long term. Ask any Japanese investor for last twenty years. All we can say is that current valuations lead us to have a certain expectation of a mean return around a wide potential dispersion of returns.”

We regularly read that investors should follow some form of value strategy. Well here is a newsflash. We are value investors and all our portfolios include an allocation to the value premium. Where we differ from some value investors is that we say that “value” is not a pricing mistake by the market allowing investors to profit from some “unloved” security but rather a risk factor – or compensation for risk. Value stocks are more risky than growth stocks and have a higher expected return as compensation for this additional risk.  Legendary investor and Warren Buffet’s mentor, Ben Graham suggested that investors should seek a “margin of safety” when selecting stocks and today many still cite Graham’s 1934 classic Security Analysis. However, just before his death in an interview with Charles Ellis Graham said;” I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors.”

The key to any market timing strategy is that stock returns are predictable based on observation of various fundamental variables such as P/E, dividend yield, etc.  To a degree, academic research supports this assertion: there is some degree of return predictability. The practical question for investors, however, is whether the “signal” from these variables is strong enough relative to the “noise” in the data to develop a useful timing strategy. The evidence here is not compelling. It’s easy to find patterns or variables that have worked in the past. It’s hard to find strategies that continue to work after they are discovered. Many papers have explored this topic, for example A Comprehensive Look at The Empirical Performance of Equity Premium Prediction by Ivo Welch and Amit Goyal which surveys a wide range of variables which allegedly offer useful timing signals. The paper concludes that the evidence of success is weak: “These models would not have helped an investor with access only to available information to profitably time the market.”

The bad news is that, unfortunately, it remains just as difficult to predict where different asset classes will go from here; of course this will not stop many industry experts from trying. In the words of renowned economist, JK Galbraith, "We have two classes of forecasters; those who don’t know and those who don’t know they don’t know."

So, what recommendations do we have for investors when uncertainty is great and emotions are running high?

A final word from Warren Buffett “Most investors ... will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”  It seems that following the wisdom of crowds rather than an investment guru is the practical recommendation for most investors.

By Marc Westlake CFP®,TEP, Grad Dip, Dip PFS, QFA
CERTIFIED FINANCIAL PLANNER TM AND REGISTERED TRUST & ESTATE PRACTITIONER
www.globalwealth.ie


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## Brendan Burgess

Hi Marc

There is a lot there to digest. 

*I agree that active fund management does not pay off*
All the statistics support this.  Very few people can pick winners or losers. Warren Buffett is extraordinary because he is so rare. 

However I would make two points 

*Volatility is not risk*
Wayne makes a point which I have made before.


> Risk is not volatility, how could it be? It is only is if you define it that way.



It's very difficult to measure risk. In fact, I don't think you can. But people like measuring things, and they can measure volatility. 

*Value shares are not  more risky than growth shares*


> we say that “value” is not a pricing mistake by the market allowing  investors to profit from some “unloved” security but rather a risk  factor – or compensation for risk.



This seems like a circular argument to me. 

The EMH says that the share price reflects the risk. 
The price of value stocks are lower than growth stocks
Therefore value stocks are more risky.

I would suggest that value stocks are less risky than growth stocks and therefore the EMH is wrong in this regard. 

The dot.com stocks were extraordinarily risky. I remember at the time being laughed at for my holdings in CRH and DCC which were growing at "only" 10% a year.  The holders of the dot.com shares did not accept that they were taking risks.


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## Marc

Brendan,

One of the original counters to the Fama French research (Journal of Finance 1992) into the value effect was that it looked like an arbitrage opportunity. If you go long the value stocks and short the growth stocks you should end up with a portfolio with no variance.

Well, it turns out that isn't true. The variance of the difference is essentially the High Book to market low book to market risk factor and the variance of that is on the order of that of the market. Both ends of the portfolio include everything you can buy in those asset classes so you are diversifying and the variance doesn't go away. There is therefore something about the covariance in the returns that you just can't get rid off - which is the sign of a true risk factor. Like the Equity Risk Premium that says that stocks are more risky than T-bills and have a higher expected return as compensation for this risk. But, and this is really important, to demonstrate statistically that this is true, you need 30 or 40 years of returns. Stocks can underperform for long periods (14 years in the 1960s and 1970s) so looking at a small sample period like 2000 doesn't allow anyone to draw any meaningful conclusions.

In "contrarian investment, extrapolation and risk" Journal of Finance 1994 Lakonishock, Shliefer and Vishny postulate that value strategies outperform because they expolit the suboptimal behaviour of investors and not because the strategies are fundamentally more risky.

But the evidence in several papers shows that value is a risk factor (Common Risk factors in Bonds and Stocks Journal of Financial Economics 1993) Size and Book to market factors in Earnings and returns Journal of Finance 1996 and Multifactor explanations of Asset pricing anomalies Journal of Finance 1996.

The explanation that we tend to use with value stocks  is that this is a risk story based on the premise that risk and expected return are related. Value does better on average than growth and therefore HAS to be more risky. Where academics disagree is with the reason for this outperformance. 

The market price is the key to "book to market" ratio. Stocks that have high book to market ratios are those companies where the accountants think that the business is worth more than the market does. The market price is the key and almost any price yield ratio works. Stocks that have high book values tend to be more distressed and distress is a form of risk. So, we tend to conclude that this is a risk story.

However, investors are naturally drawn to healthy companies or growth stocks. They are looking for a stock with good earnings potential. But expected returns for investors are driven by the firms cost of capital (Merton Miller) a healthy company has a low cost of capital and therefore a lower expected return than stocks with a high cost of capital. 

If you are a company in poor shape (or banks as we call them today) then the company is going to have to pay a higher interest rate to raise capital. So, when a company issues stock in the market, it has to offer a discount to embed investors with a higher expected return. So, the price of distressed company's stocks is lower than that of a growth company so that (adjusted for risk) an investor is indifferent between an investment in say Apple Inc or AIB plc.

The concept of healthy vs unhealthy companies was explored by an academic Michelle Clayman who decided to investigate the findings of a book "in search of excellence" by Tom Peters and Bob Waterman. They looked at various measures of an excellent company such as profitability and management techniques.

She analysed the criteria of the 40 companies in the book the excellent companies against 40 unhealthy companies and found that the Stock of unhealthy companies performed better than the healthy companies.

So, by these measures value is a rational pricing reaction by the market to additional risk. Importantly this risk does not show up in the volatility or standard deviation of the returns of value stocks. So, again I agreed that volatility is not the only measure of risk. You need a multifactor model to identify and expolit it.

So the conclusion is that there is no optimal portfolio (it depends on the choices an investor makes based on their own personal tastes) so I agree that risk is difficult to measure. Some investors may decide that they prefer the growth story.

From a portfolio perspective I have no quarrel with that decision. It is a matter of taste. But the evidence from the last 80 or so years says that an investor who increases their exposure to high book to market stocks can expect to outperform most of the time (perhaps 18 years out of 20) but as with everything in investing there are no guarantees - that is why it is a risk.


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## Chris

Very interesting discussion, thanks for all the lengthy posts.

I would agree with Brendan on the issue of risk and its definition; I would actually take it a step further and say that it is impossible to find a single measurable definition of risk. Risk is a purely subjective evaluation. For example, US treasuries are mentioned as being lower risk than equities and therefore earn a lower income/gain. In my personal opinion there is very little in this world that is of higher risk than 30 year US treasuries; absolutely nothing could convince me to invest a penny in them. But their prices command an incredibly high price.

It is similar with rationality of investors. Rationality is not something that can be measured, but some people are better at judging how rational the behaviour of investors is. In hindsight it is of course very easy to point to the dot com and housing bubble as examples of irrationality, but even then it cannot be measured. Bottom line is though that people are far more often irrational and wrong in the evaluations than EMH seems to accept.


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## Marc

Chris 

A common misconception of the EMH is that agents have to act rationally. The EMH does not say this.

The efficient-market hypothesis requires that agents have rational expectations; that on average the population is correct (even if no one person is) and whenever new relevant information appears, the agents update their expectations appropriately. *Note that it is not required that the agents be rational*. EMH allows that when faced with new information, some investors may overreact and some may underreact. All that is required by the EMH is that investors' reactions be random and follow a normal distribution pattern so that the net effect on market prices cannot be reliably exploited to make an abnormal profit, especially when considering transaction costs (including commissions and spreads). Thus, any one person can be wrong about the market—indeed, everyone can be—but the market as a whole is always right.


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## Marc

Chris 

When you talk about t bills you need to distinguish two issues.

Return of money and return on money. 

US T bills guarantee a return of your money but not necessarily a return on your money.

Having stood on the deck of the USS Nimitz I am pursuaded of the USA's ability to guarantee a return of my money. 

You may however define risk as a risk of negative real returns after inflation. Or sensitivity risk associated with long duration bonds during a period of generally rising real interest rates. These are different risks.

In this sense I agree that risk is subjective to the individual. 

As Bill Sharpe says when questioned on the best portfolio for an individual "I'd want to know what they do for a living"

The concept of Human Capital is well understood by professional advisers and should always feature in the risk return trade off.

But irrespective of all that, it is still true that short term high credit fixed interest instruments are still a low risk investment and a good hedge against inflation.

But again these are differerent to 30 year bonds which still might be appropriate for a specific asset liability matching exercise such as an Insurance Company.

It's important not to generalise here as there is always someone for whom an investment could be suitable.


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## ringledman

Marc, 

How does the EMH deal with speculative bubbles?

Nikkei 1990
Nasdaq 2000
Irish property 2007
etc, etc

http://www.nytimes.com/2009/06/06/business/06nocera.html?pagewanted=all

_“There are incredible aberrations,” he told me over lunch not long ago. “The U.S. housing market in 2007. Japan in the 1980s. Nasdaq. In 2000, growth stocks were three times their fair value. We were quoted in The Economist in 2000 saying that the Nasdaq would drop by 75 percent. In an efficient world, you wouldn’t have that in a lifetime. If the market were truly efficient, it would mean that growth stocks had become permanently more valuable.”_


I would also be interested in your views on beavioural theory. Do you dismiss it in its entirety or do you think it has a place to sit alongside the EMH?

Cheers.


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## Marc

Markets don’t have to be *RIGHT *to be *EFFICIENT*

  The tech collapse of 2000 and more recently the focus on "behavioral finance" have people really questioning the Efficient Markets Hypothesis (EMH). This is nothing new. The EMH has been contested since its debut. 
  The very fact that the hypothesis still comes under assault is stronger testimony to its deep relevance. People don't argue about irrelevant ideas.
  The core ideas of the EMH are all too often misunderstood.

  The EMH purports that markets are full of people trying to maximize profit by predicting the future values of securities based on freely available information. Many intelligent participants compete to trade at a profit. The price they strike in trading a stock is the consensus of their opinions about the stock's value. This is based on all their information about the stock, everything they know that has happened in the past and everything they predict will happen in the future. The end result is that the *current price* of the stock is usually *a good estimate* of its intrinsic value.

  Critics often challenge the notion that investors on the whole are informed enough to price stocks correctly by consensus. Most investors can't possibly know that much about any given stock. But market efficiency doesn't require that most investors have information. It only requires that "many intelligent participants" have information. In fact, no single investor has that much information. Even the smartest people have only a tiny fraction of all the information out there. Information isn't a big secret squirreled away somewhere; it is widely distributed in little pieces. The market functions as a mechanism that gathers the information, evaluates it, and builds it into prices.
  This is what it means to say prices are a consensus view of a stock's value. At some level every investor includes (or doesn't include) a security in his or her portfolio until the stock's value to the investor is about equal to its market price. Since the price is the same for everyone, so is the value. 

  Now granted, if everybody investing is wrong, prices might conceivably be poor estimates of value. For this to happen on any scale, the ignorant investors would have to be overly optimistic or overly pessimistic as a group. Otherwise, the optimists will cancel out the pessimists and the price struck will be rational. Since stocks are more likely to trade when the person selling is pessimistic and the person buying is optimistic, prices on average are more likely to represent rational consensus.
  Admittedly, sometimes it can be hard to view prices as rational. The Tech boom was an example of this where we saw companies with no assets other than a website and with little or no profit suddenly rush up in price only to melt down a year later. How can such prices be good estimates of value? They seem so illogical.

  Let's suppose for the sake of argument that investors behave like lemmings and that the market systematically misprices stocks. Such a market would surely be child's play for any smart investor with any real analytical skills. 
  The reason such successes are hard to identify is that there's more than just one or two smart investors out there. There are thousands of savvy analysts looking for over- or under-valued securities. The opportunities to generate excess profit are diminished when these investors trade away disparities between a stock's price and its intrinsic value.

  The EMH does not claim markets are always perfectly rational or that the information reflected in prices is always correct. The consensus view of investors can temporarily result in prices well above or well below a stock's intrinsic value. The only condition efficient markets require is that a disproportionate number of market participants does not consistently profit over other participants.

  After taking risk into account, do more managers than you'd see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding "no." Mike Jensen in the Sixties and Mark Carhart in the Nineties both conducted exhaustive studies of professional investors. They each concluded that in general a manager's fee, and not his skill, plays the biggest role in performance. Since mutual funds report performance after deducting fees, the bigger the fee, the worse the performance. Aside from that, expert investors with nearly unlimited resources working around the clock can't seem to outsmart the market.

  This means investors are better off avoiding active managers—especially pricey active managers. History shows that in the long run a thoughtfully designed, diversified strategy of "passive" funds typically beats all but a few active managers. It's not easy to structure and maintain such a strategy. It requires some initial research and discipline to stay the course. But it's much easier than predicting which active managers will randomly beat this approach.


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## Duke of Marmalade

Lots of interesting stuff here. I just want to pick up on one aspect - are Value stocks riskier than Growth stocks? The following definition is taken from Investopedia:


			
				Investopedia said:
			
		

> *What Does Value Stock Mean?*
> A stock that tends to trade at a lower price relative to it's fundamentals (i.e. dividends, earnings, sales, etc.) and thus considered undervalued by a value investor. Common characteristics of such stocks include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio. ​


To me this definition points in either direction. 

At one level a Value stock is one which *looks* cheap. On the well worn adage that "if it looks to good to be true then..." that would point to there being some higher risk associated with Value stocks. 

But I'm with Brendan, I interpret Value stocks using the other characterisations of the above definition - a boring old stock with solid dividend and earnings performance and other good "fundamentals" and thus lacking scope for spectacular future growth. A growth stock on the other hand boasts its lack of dividends and its negative earnings! Intuitively, to me, a Value stock is a bird in the hand whilst Growth stocks are two in the bush, and Brendan's example clearly illustrates this.

It is indeed circular to argue that since Value stocks have outperformed Growth stocks _ergo_ they were more risky. This states that risk must *always* be rewarded. A more correct interpretation is that the risk in Growth stocks didn't pay off and one would have been better off in boring old Value stocks after all.


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## ringledman

Marc, the very fact that speculative bubbles are forever present in asset classes is a sign of the extent to which price and value can be so far removed from each other as to represent huge inefficiencies in the markets.

http://www.ritholtz.com/blog/2009/08/six-impossible-things-before-breakfast/

*'Prima facie case against EMH — Forever blowing bubbles*

_*Let me now turn to the prima facie case against the EMH. Oddly enough it is one that doesn’t attract much attention in academia. As Larry Summers pointed out in his wonderful parody of financial economics “Traditional finance is more concerned with checking that two 8oz bottles of ketchup is close to the price of one 16oz bottle, than in understanding the price of the 16oz bottle”.*_

_*The first stock exchange was founded in 1602. The first equity bubble occurred just 118 years later – the South Sea bubble. Since then we have encountered bubbles with an alarming regularity. My friends at GMO define a bubble as a (real) price movement that is at least two standard deviations from trend. Now a two standard deviation event should occur roughly every 44 years. Yet since 1925, GMO have found a staggering 30 plus bubbles. That is equivalent to slightly more than one every three years!*_

_*In my own work I’ve examined the patterns that bubbles tend to follow. By looking at some of the major bubbles in history (including the South Sea Bubble, the railroad bubble of the 1840s, the Japanese bubble of the late 1980s, and the NASDAQ bubble1), I have been able to extract the following underlying pattern. Bubbles inflate over the course of around three years, with an almost parabolic explosion in prices towards the peak of the bubble. Then without exception they deflate. This bursting is generally slightly more rapidly than the inflation, taking around two years.*_

_*Whilst the details and technicalities of each episode are different, the underlying dynamics follow a very similar pattern. As Mark Twain put it “History doesn’t repeat but it does rhyme”. Indeed, the first well documented analysis of the underlying patterns of bubbles that I can find is a paper by J.S. Mills in 1867. He lays out a framework that is very close to the Minsky/Kindleberger model that I have used for years to understand the inflation and deflation of bubbles. This makes it hard to understand why so many amongst the learned classes seem to believe that you can’t identify a bubble before it bursts. To my mind the clear existence and ex ante diagnosis of bubbles represent by far and away the most compelling evidence of the gross inefficiency of markets.'*_

Taking a value based approach to investing is not so much about beating the market (although emperical evidence shows that value does beat growth) but more about reducing the risk of incuring large future losses.

Investing in boring value in which dividend yields are present, low P/Es and P/B is a less risky approach than investing in growth stocks or asset classes that are is a speculative boom that will one day pop as every bubble does. 

Value investing is less risky for the long term investor.

As Montier eloquently sums up the EMH - 

_*'The EMH would have driven Sherlock Holmes to despair. As Holmes opined “It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts”.*_

_*The EMH, as Shiller puts it, is “one of the most remarkable errors in the history of economic thought”. EMH should be consigned to the dustbin of history. We need to stop teaching it, and brain washing the innocent. Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH – pretty much everyone’s hand was up. Then he asked how many of them believed in it….only two hands remained up!'*_


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## ringledman

Duke of Marmalade said:


> Lots of interesting stuff here. I just want to pick up on one aspect - are Value stocks riskier than Growth stocks? The following definition is taken from Investopedia:
> To me this definition points in either direction.
> 
> At one level a Value stock is one which *looks* cheap. On the well worn adage that "if it looks to good to be true then..." that would point to there being some higher risk associated with Value stocks.
> 
> But I'm with Brendan, I interpret Value stocks using the other characterisations of the above definition - a boring old stock with solid dividend and earnings performance and other good "fundamentals" and thus lacking scope for spectacular future growth. A growth stock on the other hand boasts its lack of dividends and its negative earnings! Intuitively, to me, a Value stock is a bird in the hand whilst Growth stocks are two in the bush, and Brendan's example clearly illustrates this.
> 
> It is indeed circular to argue that since Value stocks have outperformed Growth stocks _ergo_ they were more risky. This states that risk must *always* be rewarded. A more correct interpretation is that the risk in Growth stocks didn't pay off and one would have been better off in boring old Value stocks after all.


 
Duke, 

I totally agree, value produces better returns over the longer term and at less risk than with growth stocks. Jeremy Grantham and James Montier at GMO have conducted much research into the area from a beahavioural point of view. The facts speak for themselves.



http://books.google.co.uk/books?id=rSLlFQ-gICEC&pg=PA57&lpg=PA57&dq=is+value+really+riskier+than+growth+dream+on&source=bl&ots=Oaa4wwRk30&sig=D978JNuuZPJf5rbBBKu-dc-Jtfs&hl=en&ei=Y_i2TpquHs2q8QPWqd2HBQ&sa=X&oi=book_result&ct=result&resnum=1&ved=0CBsQ6AEwAA#v=onepage&q=is%20value%20really%20riskier%20than%20growth%20dream%20on&f=false


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## darag

ringledman said:


> Investing in boring value in which dividend yields are present, low P/Es and P/B is a less risky approach than investing in growth stocks or asset classes that are is a speculative boom that will one day pop as every bubble does.


Stocks with low P/E and P/B are risky; e.g. Irish bank shares before they imploded.  A portfolio of value stocks will always include companies in very poor shape.  Value stocks are cheap because few people want to own them.

If you have discovered some reliable (quantitative) method to distinguish "good" value stocks (i.e. steady/undervalued) from "bad" value stocks (i.e. distressed companies), the world will be your oyster.  Wealth, fame, offers to run hedge funds, tenure in ivy league business schools, a seat on the board of Goldman Sachs, etc. all awaits.


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## ringledman

darag said:


> Stocks with low P/E and P/B are risky; e.g. Irish bank shares before they imploded. A portfolio of value stocks will always include companies in very poor shape. Value stocks are cheap because few people want to own them.
> 
> If you have discovered some reliable (quantitative) method to distinguish "good" value stocks (i.e. steady/undervalued) from "bad" value stocks (i.e. distressed companies), the world will be your oyster. Wealth, fame, offers to run hedge funds, tenure in ivy league business schools, a seat on the board of Goldman Sachs, etc. all awaits.


 

At least read the evidence and provide a better counter. I am happy to read why growth is less risky if it is backed up by some reasearch rather than the statement: 'banking stocks were value in 2007 and look at them now, hence value is risky'.

Sure banking stocks were a value trap back in 2007. But if you hadn't been stupid and thrown all your portfolio into this one sector alone then you would be in a decent position now. 

Supermarkets, consumer staples, telecoms, tobacco, utilities, pharmaceutical. Diversify across value.

A higher risk approach in my humble opinion is to invest in growth for which there is no shareholder dividend return, lofty p/e multiples, lofty p/b multiples. One bad earnings results and the share price can collapse. Sure these stocks can provide huge returns on the way up but also huge losses on the way down. If one is a momentum trader then perhaps money can be made. For the long term investor I believe that value is the only way of returning a decent return at considerably less risk.

Boring value produces more consistent returns over the longer term. The fact that value traps exist as a risk is no different from the fact that growth stocks are at risk of imploding to zero once the speculative and irrational bubble that it may be riding upwards is seen for what it is. 

Value is mostly based on sounder fundamentals (earnings, dividends, cash flow) than growth. 

Value is mostly based on past fundamentals (ie known) than future fundamentals (unknown). 

Growth stocks rely on future potential earnings for which no one can predict how they will play out. Hence a diversified portfolio of value stocks is less risky than a diversified portfolio of growth stocks.


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## Duke of Marmalade

I think we will all agree that if you seek out the stocks that look good value in a reasonably homogeneous sector you will be picking up the riskier stocks in that sector.

But sheer common sense dictates that to buy a sector which has never paid a dividend and has negative earnings, on the basis that it has explosive potential, must be higher risk than buying a stodgy traditional sector with robust divies and earnings but without spectacular growth potential.  Ans so it has proved to be the case.

To me that was what distinguished Value vs Growth strategies, not the search for cheap stocks.


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## Marc

What does the international evidence say about this question?
[broken link removed]

In the historic data, in every market except perhaps Europe Small Value vs Europe Small Growth, the volatility of a value strategy is greater than that of a growth strategy.

This would seem to support the argument that value is a more risky strategy at least as far as most of the major international markets and as far as we have recorded history is concerned.


[broken link removed]


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## Duke of Marmalade

Marc

I would need more detail to make a judgement.  What is that reference to simulations about?  Should it not be that Value stocks are higher than *70th* percentile and vice versa.

In recent years I have tended to identify Growth stocks with the Nasdaq and Value stocks with, say, S&P.  It was my understanding that Nasdaq was more volatile than S&P.


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## Marc

Duke,

What you are looking at is the output from empirical research. The reference to simulations is due to the fact that commercial index data is not available in all markets for all asset classes and for all time periods, so researchers must construct a simulation of an index to test a hypothesis.

In order to prevent random and inconsistent definitions of asset classes, researchers must also employ a standard definition of the value and growth asset classes. The top 30% of book to market ratio stocks was selected as the breakpoint between value and neutral book to Market ratios.

The important thing is not to use some arbitrary definition of value and growth or this would result in endless semantic arguments around stocks or sectors that one might feel or seem like they should be value.

An asset class is a section of a Market with common risk return characteristics (see post below) Failure to define what we mean by value sets up endless futile debates.

So to reference the original researchers why they use book to Market as the preferred definition of value.

"A stock's price is just the present value of its expected future dividends, with the expected dividends discounted with the expected stock return (roughly speaking). A higher expected return implies a lower price. We always emphasize that different price ratios are just different ways to scale a stock's price with a fundamental, to extract the information in the cross-section of stock prices about expected returns. One fundamental (book value, earnings, or cashflow) is pretty much as good as another for this job, and the average return spreads produced by different ratios are similar to and, in statistical terms, indistinguishable from one another. We like BtM because the book value in the numerator is more stable over time than earnings or cashflow, which is important for keeping turnover down in a value portfolio.

Nevertheless, there are problems in all accounting variables and book value is no exception, so supplementing BtM with other ratios can in principal improve the information about expected returns. We periodically test this proposition, so far without much success."


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## Marc

Sometimes the NASDAQ is referred to as an asset class, but it's not. It's an exchange that contains several asset classes. A partial index of NASDAQ stocks might proxy for a tech stock "asset class"—but there's little theoretical reason to think tech stocks are an asset class either.

Talking about what is or isn't an asset class might seem trivial, but it's important because people use asset classes as key components of diversified portfolios. For this purpose each asset class needs to have a specific risk-return function.

Sorting securities on anything other than the dimensions of expected returns can fudge the clarity of the investment process and undermine portfolio diversification. When investors mistake where returns come from, the asset classes they assemble become arbitrary. This can lead to inadvertent tilts on the underlying factors that actually determine returns.

For example, investors sometimes manage industry exposure, as if sectors constitute asset classes. Analysts on TV talk about what companies produce and how it affects the prospects for their stock prices. As Adam Smith pointed out over 200 years ago, a company's industry bears no direct relation to the flow of capital.1 Expected returns relate far more to a company's health and size than to whatever it is that the company makes or does.

In "Industry Costs of Equity", 2 Fama and French cast Adam Smith's notion in an empirical light. They find that risk factors of market, size, and book-to-market seem to account for virtually all the differences in returns across industry groups (except real estate stocks, which for that reason probably constitute their own asset class). For example, if technology stocks had spectacular performance in the late 1990s, it wasn't because of a new business model, but because tech stocks happened to be growth stocks in a market that strongly favoured growth. Lots of investors projecting ahead to a "new economy" were left holding the bag when growth stocks went out of favour.

We should instead set out to sort stocks along the true explanatory dimensions—in the above case by forming a growth portfolio—and include whatever industries happen to fit that asset class. After all, industries drift in and out of asset classes. They get bigger and smaller, healthier and more distressed through time. Tech stocks might have been growth stocks back in 2000, but many stocks are now considered smaller companies or perhaps in the value category. Sorting stocks on secondary criteria like industries can therefore cause a portfolio to drift across asset classes.

Investors should determine how much exposure to have to stocks in general (market risk), and how much of a tilt to have based on company size and value which represent dimensions of equity markets with their own risk-return profiles. 

Asset classes are most relevant when sorted along these dimensions, as combinations of "small cap," "large cap," "value," and "growth." These asset classes are transparent, focused, and consistent with research.


1. Smith, Adam, "Employment of Capitals", The Wealth of Nations, 1776.
2. Fama, Eugene F., and French, Kenneth R., "Industry Costs of Equity", Journal of Financial Economics, 1997.


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## Duke of Marmalade

Marc,

Fair play to you for engaging so thoroughly in this useful debate.

On the definition of Value v Growth stock I was simply wondering whether the definition was mistated. Seems to me that anything between 30th and 70th percentile would qualify as both. Look again at the definition, I may be misinterpreting it.

Back to the substantial point. I was led to believe that Value stocks were boring old traditional stocks with a proven track record whilst Growth stocks were exciting new ventures which might shoot the lights outs. Ergo, the former were boring but safe whilst the latter were exciting but risky.


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## darag

ringledman, I am well aware of the evidence that shows a value portfolio historically has offered a return premium over growth.  (But as an aside, I've also recently read that this premium seems to have reduced.)

But the point I was trying to make is that unless you are advocating beauty contest style stock picking, then you need to state your objective definition of what represents a "boring" value stock before you can advocate safe value investing.  Otherwise you have to accept what Marc has so well explained about the quality of the returns from a diversified value strategy.

An general recommendation to pursue value investing can not be given without qualification.  Finding higher investment returns with lower volatility is far more difficult than what was being suggested.


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## Marc

Duke

The benchmark portfolios are rebalanced quarterly using two independent sorts, on size and book-to-market (the ratio of book equity to market equity, BE/ME). The size breakpoint (which determines the buy range for the Small and Big portfolios) is the median NYSE market equity. The BE/ME breakpoints (which determine the buy range for the Growth, Neutral, and Value portfolios) are the 30th and 70th NYSE Percentiles.

So, everything between value and growth is neutral.

Your comment about the substantial point takes us full circle.

If one defines a value stock as an "unloved" security then "value" is a pricing mistake. The Market has screwed up and left money on the table for an analyst to collect by identifying undervalued securities. 

Growth and value in this sense would be trends. Stocks would be cyclical based on investors taste. Somehow analysts would become trend following lemmings and leave unresearched stocks seemingly to be  "discovered" by some genius with a laptop and access to the Motley Fool - which will show you (and only you mind) the "secrets" of investing.

This could possibly have been true in the 1930s when Graham and Dodd came out but it just doesn't seem credible in the 21st Century that despite the widespread availability of the internet that we must have all failed to notice that say Tesco has a boring but highly profitable business and has a good dividend yield. Yep, the Market is insane, it's got it all wrong chasing some tech dream based on electronic tablets. No, I've got it all figured out nobody else could possibly have the same information as me, therefore the price is wrong, only I know the correct price so I can profit from the value I have uncovered.

People genuinely believe some version of this nonsense. 

However if you subscribe to the view that the Market does a pretty good job of pricing securities then value has little to do with trends and fashion for sexy tech stocks vs boring value industries.

Under the conditions of "fair" prices then Value and growth are risk factors.

Growth companies are healthy companies with good balance sheets . Investors are willing to pay more for a "safer" company. If an investment is safer then it has a lower expected return. They are low book to Market.

Whereas value companies are unhealthy they are in some distress they have weaker balance sheets. So they are less safe. Investors are willing to pay less to own these companies so they have lower share prices. The are high book to Market and have higher expected returns as compensation for the extra risk.

Clearly the leap of faith for many investors is that the price in this ratio is correct.


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## Duke of Marmalade

Marc,

This topic asks a question. I agree with you (I think) that the answer is No.

On a technical point, look again: is the def of a value stock right? Seems to me that everything between 30 and 70 qualifies as both.  Maybe that is the intention, seems corny to me.


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## Marc

_*Duke,

The investopedia definition you referenced is as follows:

What Does Value Stock Mean?*
A stock that tends to trade at a lower price  relative to it's fundamentals (i.e. dividends, earnings, sales, etc.)  and thus considered undervalued by a value investor. Common  characteristics of such stocks include a high dividend yield, low  price-to-book ratio and/or low price-to-earnings ratio.

This seems to capture most of the important issues.

The price trades at a discount to some fundamental which shows up in a ratio.

This is consistent with the widely accepted version that it is some fundamental price ratio that counts. Above some cut off is value and below is growth the middle is neutral.

We can argue where the buy and sell ranges should be but in principle it fits with my earlier post that said;

We always emphasize that different price ratios are just different ways  to scale a stock's price with a fundamental, to extract the information  in the cross-section of stock prices about expected returns. One  fundamental (book value, earnings, or cashflow) is pretty much as good  as another for this job.​_


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## Duke of Marmalade

Marc said:


> _Above some cut off is value and below is growth the middle is neutral._​


Strange how difficult it is to communicate in this medium. Your footnote clearly states Value is above 30% and Growth is below 70%. I think you mean the other way round.


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## Marc

Ah I see what you mean.

No I think it is the right way round. 

High book to market are value stocks. So a high book value numerator relative to a low price denominator and vice versa for growth stocks.

So value stocks are the top 30% by book to Market ratio.


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## Duke of Marmalade

Marc said:


> Ah I see what you mean.
> 
> No I think it is the right way round.
> 
> High book to market are value stocks. So a high book value numerator relative to a low price denominator and vice versa for growth stocks.
> 
> So value stocks are the top 30% by book to Market ratio.


jayz why is this so difficult? I think you are a smart guy. I know I am You state in the footnote Value stocks are above 30%, surely you mean above 70%.


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## Chris

Duke of Marmalade said:


> Marc,
> 
> Fair play to you for engaging so thoroughly in this useful debate.


I second this, fair play to very well researched posts and comments. 

Marc, where I agree with you is that the current price of an asset is a representation of the opinion of all buyers and sellers based on all available information. But that is basic economics about price formation. 
You stated in an earlier post that "Markets don’t have to be RIGHT to be EFFICIENT" and "The end result is that the current price of the stock is usually a good estimate of its intrinsic value." This is where I think that the whole EMH theory does not have good enough premisses. Prices are the result of buyers and sellers coming together, but they may be wrong, and they may be wrong a lot more often than is assumed by EMH.



darag said:


> Stocks with low P/E and P/B are risky; e.g. Irish bank shares before they imploded.  A portfolio of value stocks will always include companies in very poor shape.  Value stocks are cheap because few people want to own them.
> 
> If you have discovered some reliable (quantitative) method to distinguish "good" value stocks (i.e. steady/undervalued) from "bad" value stocks (i.e. distressed companies), the world will be your oyster.  Wealth, fame, offers to run hedge funds, tenure in ivy league business schools, a seat on the board of Goldman Sachs, etc. all awaits.


Yes indeed, banks were a perfect value trap at that time, but one way to avoid bad value stocks is to factor in the debt level of companies. Highly indebted companies that show other value characteristics should trigger a warning signal.



Marc said:


> In the historic data, in every market except perhaps Europe Small Value vs Europe Small Growth, the volatility of a value strategy is greater than that of a growth strategy.


But again you are choosing to use the definition of risk being measurable by volatility. I would not agree that risk can be measured or that volatility is a good characteristic to use.


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## Marc

Duke

I see your frustration. We are counting from one from the top of the Market so 1% is the most value and 100% is the end of the series. The percentage isn't a measure of how much value but rather a measure of progression through the series.

I guess when you look at it it is counterintuitive but as I have always looked at it the other way round I had a blind spot to your point. A two faces or a candlestick moment.


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## Duke of Marmalade

Ok Marc, I'll buy that but maybe your footnote needs a bit more clarity.

I agree with your general argument.  Personally I have been burnt enuff by stock markets and my humble little pile is almost entirely on deposit, which contradicts everything I was weaned on in the financial services industry.


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## Marc

http://www.sensibleinvesting.tv/Default.aspx


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## Marc

Given the spread between growth and value currently this really old thread deserves a bump

oh, and everyone arguing that value was a less risky strategy has been proved categorically wrong by subsequent  events


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## Gordon Gekko

Marc said:


> Given the spread between growth and value currently this really old thread deserves a bump
> 
> oh, and everyone arguing that value was a less risky strategy has been proved categorically wrong by subsequent  events



It does to be fair. Lots of active management can be smoke and mirrors, but there are parts of the market where managers with proven track records can do very well. Imagine buying an ETF that tracks the FTSE versus an active manager like Nick Train who serially outperforms.


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