AMONG THE QUOTES wrongly attributed to Mark Twain is this one: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
This quip highlights one of the challenges of personal finance: that the data and the conclusions we rely on for decision-making can never be accepted with absolute certainty. That’s for a few reasons.
First, because the world changes and markets change, our approach must change as well. Second, academic research is necessarily imperfect. Because personal finance includes an element of human behavior, it can never be studied with scientific precision. Below are four areas where our understanding has evolved over time—and may evolve further still.
Market drivers. In the 1950s, a PhD student named Harry Markowitz developed a mathematical approach to building portfolios that’s now known as Modern Portfolio Theory. With detailed formulas, Markowitz showed investors how to build “efficient” portfolios—those which optimized the tradeoff between risk and return. For years, this approach was seen as the gold standard, and others built on it.
William Sharpe, a professor at Stanford University, developed a tool—now known as the Sharpe Ratio—to help investors compare the performance of different assets on a risk-adjusted basis. And Eugene Fama, a professor at the University of Chicago, proposed the idea that markets are “efficient,” meaning that stock prices adjust almost immediately to new information, making it virtually impossible to beat the market.
For their work, all three won Nobel Prizes in economics. More recently, however, a new school of thought has arisen. Behavioral finance, pioneered by Daniel Kahneman and Amos Tversky, challenged the old, strictly numerical approach. They were the first to argue that human emotion also plays a part in financial decisions.
Most notable among their contributions was prospect theory. Kahneman and Tversky found that when people experience a loss, it feels about twice as bad as an equivalent gain. This idea—that people are averse to losses—now seems intuitive, but it wasn’t previously understood. In the old world of Modern Portfolio Theory, investors were seen as being emotionless.
Since Kahneman and Tversky’s work, researchers have uncovered dozens more biases that affect financial decision-making. One result: Many people now view behavioral factors as being at least as important in explaining market movements as traditional quantitative factors.
In making financial decisions, we should acknowledge that the market is only sometimes rational. That’s why it’s so important to develop an investment strategy that’s durable enough to carry you through those periods when irrationality takes over.
Diversification. In 1970, Lawrence Fisher and James Lorie published a paper titled “Some Studies of Variability of Returns on Investments in Common Stocks.” They wanted to better understand the dynamics of portfolio diversification.
Their conclusion: “95% of the benefit of diversification is captured with a 30 stock portfolio.” As a result, for decades, a portfolio composed of 30 stocks was viewed as a magic formula. To be on the safe side, many investment firms included 40 or 50, but anything in that neighborhood was viewed as sufficient to diversify away the risk posed by any one stock.
That thinking has changed. In 2017, Hendrik Bessembinder, a professor at Arizona State University, published a paper titled “Do Stocks Outperform Treasury Bills?” His finding: Between 1926 and 2016, just 4% of stocks accounted for all of the net gains in the U.S. stock market above the return of Treasury bills. In other words, the other 96% of stocks, as a group, did no better than Treasurys, which delivered about 2% a year. Bessembinder has since found that the same conclusion holds outside the U.S.
This completely upended investors’ thinking about diversification. Where earlier research focused on the downside risk posed by the underperformance, or even failure, of an individual stock, Bessembinder focused on an entirely different risk: the upside risk when a portfolio fails to hold one of the market’s star performers.
This is yet another reason index funds make so much sense. Thanks to their “own everything” approach, S&P 500 and total stock market funds held the handful of stocks in the 4% that led the market over the past decade. Just as important, they probably hold the 4% that will lead the market over the next decade.
Risk. When Markowitz developed the concept of an efficient portfolio, he chose portfolio volatility as his preferred measure of risk. Volatility is a statistic that measures the degree to which an investment’s price bounces around. Markowitz deemed portfolios with more variable prices to be riskier.
Using this yardstick, Markowitz then argued that there’s an ironclad relationship between risk and return. If an investor wants higher returns, he or she needs to accept more risk. Or if an investor wants less risk, that can only be achieved by settling for lower returns. This fundamental tradeoff was an accepted truth for many years.
But today, many see it differently, including hedge fund manager Seth Klarman. He’s argued that the use of volatility to measure risk is “preposterous” and that investors don’t need to take on more risk to earn greater returns. Klarman’s firm, Baupost Group, specializes in securities that are distressed and selling at steep discounts. In interviews, he’s argued that this approach reduces risk while increasing potential returns:
“You’re buying things that are cheaper, which means that you have less downside, and more upside…If [a stock trading at $6] suddenly falls to $3, does that make it more risky because it’s more volatile, or does that make it a ludicrously good bargain because it’s now trading for half the price, and you could only lose half as much and you could make way proportionally more if things work out?”
What does this mean for individual investors? The stocks that Klarman is referring to are called value stocks. And though they have underperformed in recent years, they’ve outperformed over longer periods. Klarman’s argument, in my view, provides a logical explanation for that outperformance. For that reason, a value-oriented fund may deserve a place in your portfolio, especially today, when the broader market is heavily tilted toward growth stocks.
Beating the market. For years, textbook finance aligned with Fama’s assertion that it was impossible to beat the market. Because prices adjusted so quickly to new information, there was no way to buy or sell quickly enough to get in front of those price movements. But in recent years, evidence has mounted on the other side of this argument.
Though it’s exceedingly difficult, a number of investors have proven it’s possible to beat the market, because prices don’t adjust as quickly as Fama argued. Numerous funds have demonstrated this: For years, Renaissance Technologies beat the market with computer-driven trading. Gotham Capital delivered outsized returns with old-fashioned, value-driven stock-picking. Fidelity Magellan Fund under Peter Lynch did it by identifying growth stocks. And most recently, Pershing Square Capital Management did it through shrewd market timing when COVID-19 knocked down markets in 2020. To be sure, it’s not easy to beat the market, but these funds do nonetheless disprove the theory of market efficiency.
Since such market-beating funds often aren’t available to everyday investors, what’s the lesson here for individuals? In my view, there’s a broader point: Because they disprove established research, they’re a reminder that we should be wary of any conclusion that seems too declarative. To be sure, academic research is useful as a guide. But it should never be seen as carved in stone.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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Hey Adam,
As always your writing is informative, clear and concise. Ever thought of writing a finance book?
with all these theories – those based on mathematics and also human behavior – it is real obvious the more we think and tinker, the worse we’ll be.
So best way to build wealth is to contribute regularly to a total market index fund, get our hands tied and don’t even look for decades and decades.
Theories get disproven, we are our worst enemy and the past has no standing.
I am sorry to have to tell you, but investing in an index is a theory too. It has worked out pretty well in the last 15 years, but there are absolutely no guarantees in investing.
Investing in a low-cost index fund will track the performance of it’s benchmark index minus tiny annual fees. Guaranteed. No theory required.
If indexing has worked out well over the past 15 years, it’s because the stock market has worked out well over the same period.
You need theory when you try to pick stocks that you hope will beat the market.
Mike Tyson: Everybody has a plan until they get punched in the face.
Mr Market: Everybody has a plan until they lose 50% of their equity value in 1 year!
Per usual, nice article!
Boy, value stocks have taken a beaten over the last few decades. Same with international. But I’m making a (relatively) small bet in their return. Fingers crossed.
Thanks Adam, this is a very helpful review of several fundamental financial concepts. I am particularly interested in your discussion of risk and volatility. You indicate that Markowitz “chose portfolio volatility as his preferred measure of risk,” while Klarman argues that “the use of volatility to measure risk is ‘preposterous’.”
There was a discussion on X a couple of months ago in response to a post from HonestMath.com: “Many investors and advisors believe all of the following are true … but why?
Higher return corresponds with higher risk (no free lunch)
Holding stocks long-term (20+ yrs) is not especially risky
Holding stocks long-term (20+ yrs) is expected to achieve a high return”
The post was apparently designed to point to a concept called the “equity premium puzzle,” a term coined by Mehra and Prescott in 1985 to refer to “the excessively high historical outperformance of stocks over Treasury bills.” My perhaps simplistic understanding of the puzzle is, “if holding stocks long-term is not particularly risky, why does it provide a high return?” I think the practical point of the post was to dissuade investors from an overly optimistic embrace of the “stocks for the long run” position of Siegel, et al.
It seems that part of the issue is confusing or equating volatility with risk. Or even more: failing to include time as a factor. As the time horizon lengthens, the relationship of volatility and risk becomes decoupled. In other words, for example, it’s risky for me to put money that I might need in a year or two in stocks because of volatility and the possibility of losses. But the longer my time horizon, the less that the short-term bouncing around of stock prices matters, because we have data that the long-term trajectory of returns is positive.
How confident can we be about that long-term trajectory? Cue the “what about Japan” question. Could we have a “Japan” on a global scale? It’s possible, I guess. How should I address the risk of a “global Japan?” That’s probably going to be a situation in which we have more fundamental things to worry about than our portfolios.
May I suggest that compound growth may help to, at least partially, explain the Equity Premium Puzzle.
Companies reinvesting some or all of their earnings to grow the business, as well as investors reinvesting their dividends, should increase stock prices and investor returns over time.
Since compound growth takes time to develop, perhaps this is one reason why long-term stock holdings appear less risky.
I love that Markowitz, leading light of MPT, used a behavioral basis for setting his own portfolio allocation to 50% stocks/50% bonds, or so the story goes.
So much conventional thinking turns upside down if your investing strategy involves buying and never selling your stock investments until you’ve left this vale of tears (except perhaps rebalancing).
This is a nice brief review of modern thinking about stock investing. It reinforces my notion that for an amateur investor like myself, owning the whole market provides the best tradeoff between risk and reward over the long term. Assuming this is really your goal.
I suspect that filling out a risk tolerance questionnaire to predict what you might do, versus living through a market crash and seeing what you actually did, may be different. Likewise many may give an answer if asked what their goals are. But if they haven’t considered this very carefully in advance, their emotions may well drive them to make poor decisions at precisely the wrong time. So I think its a mistake to label an asset as “safe or risky” based on its price volatility per se. Its true that buying a stock may be a good investment at one price yet a poor investment at another price. But if bought at a reasonable price up front, or over a long time period via cost averaging, and held long term, its not risky at all. The real risk in ownership of assets is the behavior of the owner. If he or she has carefully considered realistic goals, and sticks to their strategy, I see very little risk.
I enjoy playing golf. I’m no good, and I purely enjoy it as a social activity combined with being outdoors. If I take a lesson, I don’t harbor a secret wish to suddenly become a scratch player, to “beat the market”, so to speak.
That would be an absurd goal on my part. Improving my game a little bit on the other hand would be achievable and worth it to me.
Thanks for another interesting article Adam!
Thanks, Adam, for another very clear explanation. Your article speaks to the importance of adapting to new information as it becomes available and also to taking a nuanced approach. I always appreciate what you have to say!
I have been investing in the stock market for 40 years.
The first thing a stock investor should admit, is that you know nothing. Every time there is a theory about how to make money in the market, it is proven wrong by events.
One possible explanation is that investors act on the theories, causing distortions in the market that eventually resolve in unexpected ways.