'Capital Ideas' Or 'CRAP'?
John Mauldin's Outside the Box

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Introduction Today I am pleased to present to you an exceptionally interesting article for this week's Outside the Box. But before I do, let me say that it is roughly double in length as normal, so please read it at your leisure. Before I give my 2 cents on it, I would like to both acknowledge and thank Kathryn Welling for her permission to provide you with this. Kathryn is a partner of [email protected], a service provider of independent, timely and incisive news, research and analysis, to institutional investors. More info can be found on their site: http://welling.weedenco.com.

Her article "Capital Ideas or CRAP?" is an interview between her, Peter Bernstein and James Montier where they discuss an earlier piece written by Montier, which was featured as an Outside the Box. (You can view Montier's original article here.) In the interview, Bernstein takes on the criticism of the CAPM and, in the process, provides a wealth of insights and information. Montier also contributes to the dialogue by expounding upon his previous paper, in addition to sharing some intelligent remarks in reference to Bernstein's comments.

Again, despite the length, I urge you to take the time to read this conversation as the ideas discussed are paramount to gaining a more thorough understanding of the problems we face when making investment decisions. How do you invest in a world with so much competition for capital and ideas? This is one of those extremely insightful pieces you will want to read again and again.

I trust that you will find today's Outside the Box to be a superbly insightful teaching from some great investment thinkers.

John Mauldin, Editor

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'Capital Ideas' Or 'CRAP'?

Peter Bernstein Takes Up Cudgels To Defend CAPM Against Behaviorists

A cordial but pointed letter hit my inbox not long after [email protected]'s Dec. 1, '06 interview with Dresdner Kleinwort's James Montier appeared. None other than Peter L. Bernstein was taking exception to potshots James and I had aimed at the Capital Asset Pricing Model during our chat. Not the least of which was James' suggestion that CAPM should be renamed "CRAP," for "completely redundant asset pricing." And his charge that "an awful lot of the pseudo-scientific revolution in finance is...based on some very fraudulent assumptions."

Peter, the author of the financial classic, Capital Ideas, and a forthcoming sequel, called Capital Ideas Evolving, which is due to hit bookstores this Spring, quite naturally sprang to the defense of the financial theories that are, in considerable measure, his intellectual charges. "Your readers should understand," wrote Peter, where CAPM "fails and where it works." How could I refuse to give him the floor? I quickly read the partial manuscript Peter kindly sent to me, and arranged a conference call with James. Listen in.


I've enjoyed reading the selections from your new book that you sent, Peter. When will Capital Ideas Evolving actually be published?

Peter: We're hoping to get it out during April. There is a CFA Institute conference at the end of April at which I'm speaking and they have asked to have the book available. Wiley is going crazy to get it all done and so am I.

A publisher is actually rushing a book into print?

Peter: Yes. Of course, there's a cash register at the end of the line. Seriously, Wiley is a great publisher. I love them. This will be my fourth book with them.

James, you're also in the throes of authorship--

James: I am indeed. Also with Wiley, and I haven't got a bad word to say about them, either. So there's a deeply worrying consensus that they're quite competent.

Peter: Good for you.

Peter, correct me if I'm wrong, but your work-in- progress seems to be about how the theoretical underpinnings of finance have changed since your bible, Capital Ideas, was published--how long ago?

Peter: In 1992.

So 15 years later you feel a new book is necessary to defend the Capital Asset Pricing Model, and all the rest of the Efficient Market Theory, against the predations of behavioral finance theorists--like James?

Peter: Two thoughts at once: The original book was really about the development of the theory and only incidentally presented a few little illustrations of how it was being implemented. Since that book came out, and really since before that, since the options pricing model came out in 1973, there have been no new developments in the theories. But there has been an explosion in implementation, and that's what this new book is about.

Even the theorists who were described in the original book (the ones still alive) are all still active in business in one form or another. And they're all involved in implementation now. As Robert C. Merton, the Nobel Prize winner (he got his Nobel Prize for his work on the options pricing model) says, "I'm not really interested in theory anymore. I'm a plumber and I'm interested in putting all of this stuff to work." So the theme of the new book is that the ideas are alive and well, though not exactly as they were described in theory. They have profoundly influenced the way people manage money today. Our views of markets, our views of how to allocate resources, our views of how to manage risk, indeed, our views of the centrality of risk to the whole investment management decision, are colored by this literature. Nobody says that the world works the way the theory described it. But we view the world of investing today entirely differently from the way we viewed it before 1952, when Harry Markowitz wrote "Portfolio Selection." It's just a total break and these ideas infuse the strategies, the allocations, the risk; everything that active as well as passive managers are doing is colored by this. That's the theme of the new book.

Don't you write, at one point, that the influence what you call "capital ideas" have had is ironic, since their intellectual underpinnings have been shown, time and again, not to work? You say even Professor Markowitz expressed serious misgivings about the assumptions behind CAPM.

Peter: Nobody, nobody claims that the theories work. In particular, the Capital Asset Pricing Model has been proven, over and over again, even as far back as by Fischer Black, to not "work." But I think the best quote in my book is from a man named Louis Menand, a Pulitzer Prize-winning author and professor of English at Harvard University, who wrote an introduction to a new edition of Sigmund Freud's classic, "Civilization And Its Discontents." What Menand said about Freud I think exactly applies to Capital Ideas. Which is, "The grounds have entirely eroded for whatever authority it once enjoyed as an ultimate account of the way things are, but we can no longer understand the way things are without taking it into account." I think it's exactly the same case here. We know things about how markets work and the centrality of the risk/reward trade off and diversification and so forth that just weren't part of the investment process before these ideas were set forth.

Just to make sure no one's confused, when you talk about "capital ideas," you're referring not just to CAPM, but--

Ideas such as the dominance of risk in decision-making, the pricing of assets in competitive markets, the power of diversification, the huge hurdles involved in efforts to outperform the markets, and the giant step forward provided by the development of the options pricing model. In short, I use "capital ideas" to refer to Markowitz's work on portfolio selection, Franco Modigliani and Merton Miller's revolutionary views about corporate finance and the behavior of markets, the Sharpe-Treynor-Mossin-Lintner Capital Asset Pricing Model, Eugene Fama's explication of the Efficient Market Hypothesis, and the options pricing model of Fischer Black, Myron Scholes, and Robert C. Merton. They established the basic structure. So even though things aren't priced that way and the market isn't completely efficient or any of that stuff, they're the benchmarks by which we make judgments. That's how we can take the track record of a manager and say, did this guy perform or didn't he perform? In the old days, they just said that he beat (or didn't beat) the market. Today we have a more interesting and more thorough and more profound way of making a judgment about a money manager's performance.

More complex, certainly. But the human mind is also incredibly complex and still poorly understood, and I suspect George Soros is onto something when he talks about "reflexivity," and the ways in which our interpretations of reality actively shape that reality. If we start out from a theoretical base in CAPM and the Efficient Market Theory--which have been proven not to work in practice--how can we have confidence in the convoluted structures of modern finance that have been built atop them? The layers upon layers of derivatives markets, for instance, with all of their mechanisms for diffusing risk, upon which we now so heavily depend? What does that say about those markets?

Peter: Well, I can't in any way dispute what you just said and I have plenty of worries about those things. It's a little like the Sorcerer's Apprentice. We've gotten a toy and we began to do all sorts of things with it and now we don't know whether we can control it. There is a very important point that I emphasize in my new book, something that Paul Samuelson said in a dialogue with Robert Schiller: Markets are, to a large extent, micro-efficient. The market is hard to beat. Nobody says it isn't. But the markets are macro-inefficient and this means that risk and return for the market as a whole can go haywire. I don't think anybody disputes that. You can't, because reality shouts that back at you. And there is nothing in these ideas that says that markets won't go haywire, because there are human beings out there making the buy and sell decisions. My very first chapter is called, "The Behavioral Attack." There's no question that the analysis of irrationality in making decisions and the heuristics and so forth that behavioral finance has pointed to are for real. But it is also true that these behavioral theories are, in a way, making the market more efficient; making the basic theories closer to truth.

How so?

Because they present new opportunities for active managers to seek alpha. And the more mangers who find ways to seek alpha, or to try to beat the market; the more difficult it's going to be to do it. Throughout the new book, I cite major players in the market with great track records, like Jack Treynor, like David Swensen at Yale or Barclays Global Investors or Goldman Sachs. They all say that it's becoming increasingly difficult to beat the market. There are so many smart people out there.

Isn't that kind of a de rigueur demurrer?

Peter: Excuse me?

Isn't it pretty much pro forma for them to say something like that before going on to boast about what they've done?

Peter: Well, I think that it is true. It is increasingly difficult to beat the market. And the competition is fierce. The phenomenal growth of hedge funds is a very interesting development in this sense--because hedge funds are much less constrained in what they can do than somebody who's given a mission to beat the S&P 500 or beat EAFE or whatever. Most hedge funds are free to do whatever they want. This means that they can wander around the markets, wherever they see opportunities--and this means that opportunities are being closed because they are grabbing them. When I spoke with Bob Litterman at Goldman Sachs, he just kept repeating over and over again that the markets are not in equilibrium--but that's where they're heading all the time because people are trying to seek out returns where, relative to risk, they can do better. I also believe--and this comes directly out of the Capital Asset Pricing Model--well, let me step back a minute. In the 1970s, Fischer Black, who developed the option pricing model, and Jack Treynor, the longtime editor of the Financial Analysts Journal, wrote an article together on how to use all this stuff in securities analysis. They made the point that there is a profound difference between your asset allocation decision--how much you want to have in stocks, bonds and whatever--and deciding which particular items to include in each asset class. These are completely separate decisions. Two people could have entirely different views on the outlook of the market--I'm a bear and you're a bull--and yet we could still agree that whatever assets we have in the stock market should be invested in the same stocks. Because these decisions are so separate. It's from that idea that we've now developed a lot of strategies called "portable alpha," in which the whole search for performance that beats the market is entirely separate from the people who are doing the asset allocations. This is a big step forward in management and I think it's again something that will tend to make markets more efficient--because it exposes the opportunities in a way that we never thought about them before.

Or less efficient, if you're a real cynic like me. Because now you can add layers upon layers of consultants.

Peter: I agree! Layers of consultants do not add to market efficiency. Not all of them, anyway. There are some I would be happy to consult with. But are there a lot out there that specialize in BS? Yes. They create opportunities for the smart guys.

James: Can I jump into this conversation at this point?

That's why we invited you.

James: Yes, absolutely, the consultants create opportunities. But Peter has said several things that struck me. He mentioned Bob Litterman and his notion that markets are driven towards equilibrium. This strikes me as a fatally flawed idea--very few institutional managers stood up against the tech bubble; most decided to ride it (many in a cynical fashion, knowing what they were doing was "wrong" but keen to deliver short-term performance). If the arbitrageurs don't arbitrage then equilibrium has no real meaning. I would also question whether Samuelson was right about the market being micro-efficient but macro-inefficient. If that were the case, value managers wouldn't be able to outperform over the long term. So I think the evidence suggests that markets are both micro and macro inefficient.

Another of the things that has struck me is that Peter started off with a discussion on Freud. I find that most intriguing because modern-day psychology, as Peter identified, has quite clearly turned its back on Freudian thinking. Or, to be more precise, academic psychologists have moved a long way beyond Freud, and yet practitioners haven't. There are still an awful lot of clinical psychologists who allow themselves to use a Freudian framework for their analysis. I think the parallel is similar to the one that Peter is trying to draw. But it is just slightly different, in as much as CAPM and the whole idea of alpha or beta, it seems to me, are still really being taught. CAPM is still the only thing that is taught in business schools around the world--perhaps with arbitrage pricing theory, but the central formula is the same there. So students still come out with their MBAs, having been drilled in CAPM, and practitioners still use these models. Yet I can't help but think that the behavioral critiques that have been leveled at a lot of your "capital ideas" do actually invalidate the use of CAPM, for instance, in all sorts of ways.

Another of the points that Peter made was about the difference between a constrained and an unconstrained manager in reference to hedge funds versus, let's say, traditional long-only managers. Yet the constraints themselves really grow out of CAPM. Then too, whilst Peter is emphasizing the benefits that CAPM has provided in terms of alpha and beta separation, I suspect those benefits are probably clearer on paper than they are in practice, put it that way. But even if we accept that there are benefits from alpha and beta separation, it should also be recognized that CAPM has delivered some very undesirable side effects.

What sort of nasty side effects?

James: Take Wall Street's obsession with benchmarking. That undoubtfully comes from CAPM, as well as the constraints themselves. The ideas of benchmarking and of relative performance; this obsession with following a capitalization-weighted index falls out of CAPM. Also the whole idea of tracking error and of professional fund managers worrying more about tracking error than they worry about delivering positive returns. So whilst CAPM may have generated benefits, it has also generated some pretty severe problems for the financial system.

Peter: I can't disagree with that. But I'm not making a value judgment. I'm trying to say how the world works and making the observation that it works differently now. I still think this is a better way to think about investing than--I mean, I came into this business in 1951, which is not exactly yesterday--

No one will dispute that, either!

My point is that when I think of how we approached investing-- We did believe in diversification and there was a Benjamin Graham coloration to what we did. But otherwise, there wasn't any system beyond sort of trying to be diversified, which was a good idea. Yes, there were "businessmen's" stocks and "widows and orphans" stocks, but there was no systematic way of thinking about it. You can reject "capital ideas," and say, "I'm not going to run my portfolio this way," but CAPM and the rest provided a place to begin. Just as clinical psychology would not be what it is today if there hadn't been Freud, and just as we wouldn't think about savings and investments and fiscal policy in the same way if John Maynard Keynes hadn't been there--even if a lot of what Keynes wrote about how the economy works is not necessarily relevant today. So that's my point, the notion that these ideas give us a way of thinking. We can accept them or reject them or try to beat them or get around them, but they're there. We can't think about these things without CAPM.

My question--

If I could just go on to make one more point. There's a big step forward that I think came out of these "capital ideas," quite aside from the details. I'll just tell a short anecdote. When I was working on Capital Ideas, the first person I went to see, after Samuelson, who is a very old friend, was Harry Markowitz--because he started the whole thing in 1952 when he wrote about the trade off between risk and return. Markowitz had been in operations research; he didn't know anything about the stock market. Somebody suggested he should do his thesis about applying operations research to the stock market, so he went to his professor and asked, "How do I learn about the stock market?" The professor said, "Well, there's a book by John Burr Williams called, The Theory of Investment Value. Read that, it is a wonderful book." Well, John Burr Williams says that you should buy the one stock that has the greatest value. When Markowitz read that, he said to himself: Yes, but you have to think about risk as well as return. You can't just think about return. You have to think about risk at the same time. This was a thunderclap. From that point forward, sophisticated investors wouldn't make decisions without thinking about risk. Indeed, we have no control over return. Risk is the only element in the portfolio management process that we can control. When I think back to my early days in the business, in 1951, we used the word "risk" only casually. But now it is central to every sophisticated investment decision. That's like Freud. It's part of a huge leap forward. Risk is a very simple four-letter word but it has changed the investment process.

Not to denigrate Prof. Markowitz's contribution in putting risk front and center, but earlier investment thinkers, such as Ben Graham and Gerald Loeb, also considered risk. They perhaps also had a better grasp of the multifaceted nature of market risk.

Peter: Yes, that's what gives their works lasting importance. They talk about the consequences of being wrong and how you deal with that. That's what risk is really all about. I think risk control was more central to Gerald Loeb's thinking, because he says you should only invest a little bit of your money, but invest it very aggressively. So his consideration of risk is much more built-in than it is with Graham. Granted, Graham says one of the attractions of value investing is that it's a low-risk strategy, but that's different. Loeb had a very big impact on me when I first read him--more than Benjamin Graham did.

James: I just finished writing a paper on Keynes and Graham, looking at some of the similarities and differences between the two when it came to investing. This aspect of risk is interesting. What I would say is that Ben Graham defined risk in a way that is still used by deep value investors, like Tweedy Browne. In The Little Book of Value Investing, Christopher H. Browne talks a lot about how risk is defined in terms of business risk. It is the risk of buying a bad business. Whereas I think the problem with a lot of the financial theory is that, in it, risk is equated to price volatility. It's that--the equation of price volatility to risk--that is probably one of the worst aspects of modern finance. It's why risk really is a four-lettered word as it's used in finance, because it misleads. Price volatility is, of course, what creates the opportunities for us--as well as, obviously, inhibiting a large number of investors from actually exploiting those opportunities.

Peter: I both agree and disagree.

James: What a very balanced man you are, Peter!

Peter: Yes, I'm a balanced manager. There are two sides to it. You're right, volatility presents opportunities. But the meaning of risk itself is opportunity. It means we don't know what's going to happen, but just because we don't know doesn't mean that what's going to happen is necessarily bad. So risk-taking is a positive step, risk management is a negative step, but both things are going on there and I don't think that there has to be a confusion between them. For a longer-term investor, volatility is opportunity, no question about it. For a trader, it's a problem if he's wrong. But there's another element of volatility that I think is important. It is a proxy for risk in the sense that it hits you in the gut. When the market is jumping around, it's a lot different owning stocks than owning Treasury bills. It is an entirely different experience. If the market gets more volatile, we worry. "What's going on? Somebody knows something more than I do." So while I agree that volatility was made a proxy for risk because it works mathematically, I think it works in the gut, too. No matter how calm you are, no matter how a long-term an investor you are, no matter what your horizons, when the market is jumping around, you feel uncertainty in your gut and it's hard to resist that. So I don't think volatility is an altogether irrelevant proxy for risk, even though--to a cool, dispassionate investor with a long-term time horizon--volatility is wonderful.

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Shouldn't you refine that a bit, Peter? Volatility only hits you in the gut when it's going against you.

Peter: Yes, that's true.

James: And if you're a short-side manager, that leaves you worrying about upside risk.

Peter: Yes, it can be either way. But I don't think that takes away from my point--that volatility hits you in the gut. Aside from its mathematical malleability, which has been very useful to the theorists, volatility creates a greater sense of uncertainty than you have when things are smooching along and you think, "Oh, everything is fine." So I don't think volatility is irrelevant.

Not irrelevant. But it's a poor--misleading--definition of risk. After all, volatility is the lifeblood of all of the great investors and traders you profile in your new book. Whether we're talking about a trading firm like Goldman or a hedge fund manager like Cliff Asness, they need the action.

Peter: Yes, I mean, Litterman at Goldman is rhapsodic about volatility. But Litterman's every other phrase is "risk management." It's one thing to say, "This is where I'm going to make my goodies," but you can't just jump in and do it blind. Volatility puts a greater need on you to be able to manage the thing. You're in boiling waters, so you have to be sure you know what you're doing. That just proves my point: If you're a manager who eats volatility like ice cream, you've got to control yourself, too, and be sure that your portfolio as a whole is not subject to the kind of volatility that you have in your individual holdings.

But is that really possible? If all those calculations are based on assumptions that are, at bottom, bankrupt--like equating risk and volatility--aren't we just using all of those fancy models to delude ourselves that we're controlling risk? All of Goldman's computer programs quite evidently give it an edge--for now. But something always goes haywire where humans are involved.

Peter: If you're going to seek out volatility because that's where opportunity is, you don't want your entire portfolio to be volatile, you only want to make volatile bets within it. You have to be sure that there's some systematic arrangement of the bets that you make so that the portfolio risk in the total portfolio is not as volatile as the individual components. One of Markowitz's great insights was precisely that. That you can take a lot of high-risk bets--as long as they're not correlated--and come out fine. I don't see what's fraudulent about trying to do that.

Fraudulent may be too strong a word. The problem is with the measurement of "risk" and with the correlations. All sorts of "normally" uncorrelated bets have a way of becoming correlated at precisely the wrong time.

Peter: Well, this is what Litterman gets paid for, but this is the risk that any investor takes. Suppose you're not Litterman; suppose you're Joe Blow. You're exposed to that risk all the time. As I said, the markets are macro-inefficient. They can go haywire. That is a matter that you deal with through your asset allocation in the first place, so that you don't get killed if the totally unexpected hits you in the face. But I don't think that the existence of that macro-inefficiency negates what Litterman is trying to do. I'm sure that Goldman's asset allocation is very carefully done with that possibility in mind. Any rational investor would do that. My own affairs are run that way because I know that extreme outcomes can happen and I don't want to get killed. But that doesn't mean that I'm not making bets in the middle of the portfolio somewhere.

James: I have a wonderful quote here, if you're interested, from Ben Graham, and another one from Maynard Keynes. It always strikes me when I look at this that Ben was a little bit more wordy than Maynard Keynes. I'm not going to put that down to Ben being an American; I can't get away with that because effectively they were both English. But Ben once said, "The investor with a portfolio of sound stocks should expect their prices fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of, or to be ignored." I think people do get hooked up on what prices are doing, perhaps far too hooked up, or maybe we've reached a sort of final state of informational deluge where we actually can't separate out noise from news anymore. But here's the quotation from Keynes, which as promised is much shorter: "It is largely the fluctuations which throw up the bargains, and the uncertainly due to the fluctuations which prevents other people from taking advantage of them." That one, to me, just sums up the whole essence of the investment problem. In order to actually be a half-decent investor, you have to do something that is different. Far too many people today are busy worrying about their tracking error and their distance from benchmarks, rather than worrying about whether they're buying good or bad businesses at reasonable prices or at ridiculous ones.

Peter: The source of the tracking error problem is not the portfolio manager, but the client.

James: Yes, that's a fair point; absolutely a fair point.

Peter: This is a point I didn't make in the new book but I probably should have: That clients are the villains of the piece all-too-often and, as Kate suggested, consultants. They are the villains to a much greater extent than the managers, who would love to be freer. But both these statements, which are extremely wise and wonderful, relate to capital that has no liquidity needs, and a lot of capital does have liquidity needs in one form or another. I mean, a pension fund maybe has a longer horizon than a brokerage prop desk. But particularly in an era like the present, where the current cash return (the dividend returns and interest rates) is low, spenders do have to think about liquidity needs. So it's not irrelevant to care what prices are--because you may have to make use of them. Sure, if you don't have to make use of prices, if you're locked up or if it's a pool that has no claims on it, then--I'm a consultant to a very big family trust--it's in the billions of dollars--that was set up so that it could not distribute the principal for a very long time to the family. Actually, it's based on the life on an individual who has turned out to live to 102 years old, so far. So everybody is sitting around waiting for this poor lady to meet her maker.

I hope she employs a taster!

Peter: She is just fine. This trust was set up in the early 1970s. They put the money 100% into common stocks and said: We don't care what happens between here and there, because liquidation is a long way off and we want to be sure we can beat inflation and have an income stream that rises. They've been religious about this and perfectly happy and they see market declines as opportunities because they can take lower capital gains if they want to make a change to the portfolio. But that sort of investor is a very rare bird. In particular, the steadfastness with which these people have held to their policy is extremely rare. And it is beginning to weaken now because the lady is 102.

James: At that age, I'm sure. But I have always thought the world would be a much better place if all fund managers were forced to ask themselves, would they do something in their own portfolio. If the answer is no, then why are they doing it for clients?

Peter: They've got another 10 years before they have to distribute, but it's going to change the flavor of the portfolios.

Clearly, liquidity needs vary all over the map. Yet hasn't much about the way modern portfolio "science" evolved conspired to push investors into short-term strategies? Now that portable alpha and active management have supplanted passive indexing as the styles du jour, we have the spectacle of pension funds with very long-term liabilities rushing into hedge funds employing very short-term strategies--often while tying up chunks of their assets in highly illiquid investments. All because that's what David Swensen did so successfully 15 years ago. And there's no small element of truth in the complaints of corporate-types that shareholders' relentless pursuit of short-term performance hobbles their ability to manage their businesses.

Peter: I agree with what you're saying. But I don't think you can blame that on portfolio theory. And, in part, there is some diversification element to all this which is positive. I don't know whether it's true that we live in a time when we're going to have low returns. But certainly, on the basis of the pricing in the markets and so on, we are in a period of low expected returns--without any diminishing in the liabilities that we have to meet. So there is pressure to find returns in places that we didn't find them before. Whether this is a good set of choices and whether the pension funds, for instance, can execute on them, I don't know but--

Want to place a bet?

Peter: I agree that what David Swensen did at the beginning of his tenure at Yale, when it was easy to pick the good alternative investments, and when he was very welcome in that space, is very different from the situation today. I'm uncomfortable about this and have expressed that, too. Sometimes it's better--if it's a period of low expected returns--to be patient. Because that's not going to be the case all the time. But again, I don't think you can pin this on "capital ideas."

What would you pin it on instead?

Peter: Just how the hell do we make a living when dividend yields are less than 2% and long-term interest rates are under 5%; when real rates are this low? Where are we going to make a buck? That's a fair question to ask. Whether today's answer to it is the optimal one, we'll only know in time. Somebody as thoughtful and skilled and, I think, as brilliant as Marty Leibowitz [of Morgan Stanley] feels that there's enough diversification in the alternative investment area to justify doing it. Sure, you have to limit to how far you go, but that is a perfectly decent place to go. Just putting assets into the bread and butter stock market is not always the best decision, either. So I don't see any reason not to mix it up. But to think that it is easy; that going into alternative asset classes is easier than picking stocks or that the managers of those things have some inherent ability that somebody else lacks, is an oversimplification. On that, I certainly agree, but the scheme is not a crazy one.

James: I guess the problem is the one you identified. There is almost a first-mover advantage in these markets. That is what someone with the foresight of a David Swensen recognized. Now, the very great problem is that everybody is doing exactly the same thing.

Peter: Yes.

James: And the correlation amongst hedge funds themselves has soared. It's .7 or .8 on a range of strategies supposedly as diverse as convertible arbitrage and emerging market equities. Obviously, these things should have zero correlation, but they don't, because everybody is doing the same thing.

Hedge fund managers are theoretically unconstrained but in reality they're just as much a part of the herd as everyone else.

James: Yes.

Peter: Yes. Clearly, this was not the vision when it began and I have not had the chance to go back to Swensen and ask him how he feels about the little monster that he's created. He was a pioneer when he said that the only way to have a successful institutional portfolio is to make uninstitutional decisions. But those uninstitutional decisions have now become institutionalized, yes.

One of the scourges of modern life is that the crowd very quickly catches up with innovators. In fact, I'm wondering if the ubiquity of the computer isn't more responsible than "capital ideas" for the changes we've been talking about in finance, Peter.

Peter: I think they go together. The computer is--I can't find the word. The magnitude of its influence is pretty obvious. The computer has provided the means for implementing some of these "capital ideas" in ways that you couldn't have imagined with a slide rule. The real thing about computers is the speed at which they work and the volume of information that they can process. The other day I was reading the new Wall Street Journal. They now say: We have this free internet page for you if you want to see what's happening in the market. When I clicked on that thing, I thought: "My God, who needs Bloomberg? This is unbelievable." So my view is that the development of "capital ideas" and the introduction of ever-more powerful computers have gone hand in hand.

But haven't computers allowed a lot of models to be implemented, in size, without--necessarily--a whole lot of thought? (Something that we humans tend to be all-too-happy to do without.)

Peter: They screwed up pretty good before the computer too--

Yes, but everything happened much more slowly. And had many fewer zeros attached.

Peter: After all, 1929 and 1962 and 1974 were all events that took place before the computer. The computer just adds different ways of doing it.

But those train wrecks happened in relatively slow motion. Even crises like Penn Central and Drysdale Government Securities that I recall from early in my career unfolded at a pace I'm sure my kids would consider antediluvian.

Peter: Well, there's an even bigger difference. In every one of those financial crises, some big financial institution went bust, or New York City nearly went bust. There were major bankruptcy problems in every one of them. I'm not sure that I'm secure about this as a prediction, but just consider that the crash in 2001 was a big shock. The market decline started from a very high level. God knows, there had been a lot of crazy speculation--and yet no financial institutions blew up. The only companies that blew were things like Enron, where they were doing crappy accounting, and those failures didn't matter. They were independent events. That's pretty amazing. I don't know whether it's going to be that way the next time. But when you think about the magnitude, the suddenness, of that crash and the number of people who were involved in the market in some way, and that no institution blew--well that took me by surprise. I was waiting for it any minute. It's very interesting.

That surprised me, too. But I'm still not certain that some sort of systemic crisis or washout hasn't merely been postponed.

Peter: I'm not nearly as secure about the next one, whenever it comes, because the derivatives business has gotten so much more complex and involved and financial institutions--I'm talking about the banks, who used to be in the business of collecting deposits and lending money--are now deep into derivatives and the whole mortgage business is a derivatives business. How that will hold up when the heat gets into the boiler next time, I'm not nearly as confident. To say nothing of the world's currencies and what goes on there.

You didn't gather any particular insights into that while working on your new book--any reassurance or lack of assurance?

Peter: The book didn't provide the answer to that, no. But I have been preaching for several years that we don't know what's going to be the trigger. Nonetheless, the conditions are in place for extreme outcomes, particularly in the dollar, and these have to be hedged. You can do all the normal kinds of investing you want in the center of your portfolio, but the outsides of your portfolio should have hedges against these extreme outcomes. The necessary conditions are there. I still don't know whether it's going to happen. But if I knew when, I wouldn't just be hedged, I'd have a whole different portfolio. It's like the story about the man in the lunatic asylum who receives a visitor, and the visitor says, "You don't have any clothes on." The crazy man replies, "Well, nobody ever comes to see me." Then the visitor says, "But you have a hat on." To which the crazy man retorts, "Well, somebody might come." I think this as a very good investment lesson.

James: The power of the option.

Peter: Yes, the power of the option.

Assuming you believe someone will make good on it.

Peter: This is why Gerald Loeb is basically in my soul.

So at the same time that you're celebrating the whole financial construct built on "capital ideas," you're standing back and saying, "But don't trust it."

Peter: I don't see any contradiction there. I mean, the markets can go crazy. Nobody can deny that. But what I'm saying is that the way we think about investments and the way we lead up to our decisions and the kinds of judgments that we make are the not the same as they were before all these ideas came to the fore. What I call "capital ideas" have opened insights and opportunities to people that they probably would not have seen before. God knows, the options pricing model, which was the last of these ideas to be developed and grew out of all of the others, has changed the world. In many ways, it has done so for the better because it has opened so many different kinds of opportunities for risk management. But it also has, like everything in life, the seeds of its own destruction within it. Somebody has referred to the option-pricing model as a bombshell and that really describes it.

James: The problem with bombshells is that they tend to explode.

Peter: But I don't see how that dilutes my theme. The theme is not that everything is going to be benign and wonderful because of Harry Markowitz and his followers, but that the ideas they promulgated have changed the way that people invest in a very profound way. "Capital ideas" have, in many ways, exposed opportunities and means of dealing with risk that people didn't think about before. They've made risk a central part of the investment equation. For sophisticated investors, risk is the beginning and the end of every investment decision.

But there's the rub, Peter. If we're using a definition of risk that elegantly fits mathematical models but doesn't begin to capture true investment risk, what does that say about the investment processes and all of the convoluted financial structures built on top of it?

Peter: I didn't say that you have to define risk in terms of beta volatility. I define it in terms of the consequences to me if I'm wrong; that's how I measure risk. If I make a decision that turns out to be wrong, how much do I care?

How much can you lose, you mean?

Peter: Yes, What are the consequences to me?

But you're an extraordinarily clear-eyed practitioner--while legions of portfolio managers and institutions hang their hats on much more simplistic definitions of risk.

Peter: I do not cheer that. You don't have to buy beta as the definition of risk to manage risk. But it depends what your client wants. In my case, I am my own client. I brought up that family trust because they clearly understood what their risks were. But very few investors do. That's true. Nonetheless, there is no law that says, because you have to think about risk as well as return, that you have to define the word "risk" only in the sense of volatility. I mean, covariance is an important part of risk. In fact, that's really where Harry put his emphasis: That diversification is the beginning of risk management. Indeed, that's my religion. Diversification is an explicit statement that I don't know what's going to happen. Nobody knows what's going to happen. If they act as though they know what's going to happen, they're going to get screwed. That's where the truth lies.

James: Part of the problem is that all of these terms, "diversification," "risk," have so many different interpretations. One interpretation is a very narrow one, which is the one from the academic literature: "Risk equals price volatility, diversification, covariance and correlation." However, the way you are talking about interpreting them, Peter, is in a much broader sense.

Much richer.

James: Yes, a much deeper sense, which is probably right. In many ways, it is the same way that some of the all-time great value investors have also defined risk. They run concentrated portfolios, say of 20 or 30 stocks, but they are diversified in terms of the industries that those firms are operating in and so forth. So they have a degree of diversification there, which would not come up in the traditional academic sense of diversification. The problem is that there is a tendency to follow the mathematical attraction of the simplistic definitions of risk and diversification, which sort of bedevils our industry as a whole, whereas a broader perception of the concepts is probably more important to grasp than the technical details of the calculations. But too many people in our industry prefer math over thinking.

Peter: I guess. How many of them really use the math and how many think the other way, I don't know. But I agree that math does not provide answers. It may provide insights, start you going someplace, but it can't rule the decisions--unless you do a particular strategy where it works. You can't be in the options business without doing math--

James: That's the reason I'm not in the options business!

Peter: But when it comes to stock picking or bonds--well, bonds are all math. But what's going to happen to the rate of inflation, which is really where the bond business starts, is not a matter of math.

Doesn't it come down to this: The super investors you're writing about are people who've been able to take your "capital ideas" and profitably turn them on their heads, in one way or another, before anyone else?

Peter: Yes, yes.

While the great unwashed, all the portfolio managers who dutifully apply the calculations they learned in school, produce at best mediocre returns?

Peter: Yes.

James: That's something that we're all agreed on.

It's not a particularly grand insight--

Peter: But there's a bigger insight than the one you just expressed. Portfolio theory says that the market is the dominant influence on returns. So those people may screw up and may not beat the market, or maybe they get lucky and beat it, but ultimately the market is going to determine how they come out. The market is the dominant influence. It's a simple idea but a very, very important one.

But what is "the market," Peter?

Peter: What do mean, what is the market? If the market goes up, I get wealthier. Whether I get as wealthy as I would have liked or as wealthy as I expect or anything like that is secondary. I am wealthier today than I was a year ago, without even trying, if the market is up 15%.

Only if you were in the market, "without really trying," or passively. And only because of price movements that were produced by the collective actions of active investors--and of whoever you delegated to manage your passive investments. The market is an auction.

Peter: Yes.

With prices set when bids and asks meet, usually, but not necessarily, along a relatively orderly continuum.

Peter: Well, I commented to my wife yesterday about how well we had done this year and she said that's because I have such a great manager. I said, "Don't thank me, thank the nice people who are willing to pay higher prices for the assets we own." That's really how it works.

I used to have a client when I was managing money who loved to give money away and he'd tell me, "Thank you so much for what you've done to enable me to do this." I would say, "Don't thank me, I'm not the guy who pushed the prices up so you could do it, it's the other investors out there who are willing to pay more for what you own. They're your friends." That's a very important lesson: your wealth is in many ways dependent upon what other people will pay for your assets.

James: It's an interesting point you raise, Kate: "What is the market?" Because going all the way back to where we started, with CAPM, there is a very precise definition of "the market" embedded in CAPM. According to CAPM, the market is the capitalization-weighted index. That is the efficient market that everybody is supposed to hold under CAPM. But that means, to my mind, that you get a blurring of alpha and beta and that's why I'm not yet convinced that these concepts are terribly helpful to investors. When you look at things like Rob Arnott's [of Research Affiliates LLC] work on fundamental indices, where he re-weights the index using dividends and earnings and sales and so forth and adds 2% to 3% to performance with less volatility than the capitalization-weighted benchmark--that makes no sense in a CAPM world because in a CAPM world, the cap-weighted benchmark is the mean variance-efficient benchmark.

Peter: That's right.

James: It intrigues me that you can blur the line between alpha and beta quite as easily as Rob has managed to do. Some of the work around CAPM, I think, almost distracts from the fundamental problem in the investment business, which is how do we generate returns for the ultimate investor?

Peter: Rob Arnott doesn't claim that his fundamental index represents the market. He says this is a different way to do a passive investing fund without doing the capitalization weighting. There are problems with cap weighting. But Rob doesn't say this is the market. He is simply saying this is a different way to index or to be passive, and that's a different kind of statement. The market is the market. Exxon has got the biggest capitalization in the world. And some pipsqueak company has the smallest capitalization. You can't argue with that. If investors took a little drug company and gave it the capitalization of Exxon, it would have Exxon's weight in the market.


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Well, look at Google--

Peter: Well, yes, right. So that's what the market says. That's what investors have said and--

Is that rational? The basis of CAPM and the rest of the "capital ideas," is that these are rational decisions. But since when are human decisions rational, especially about money?

Peter: Nobody claims it's rational, but there is this: It is not a crazy idea that the market knows more than any individual knows. This is a very basic idea and it's an important one. All the information is there in one form or another and I don't have it all. Now, I manage my affairs accordingly, with humility. But the market--this is what the market says. It doesn't necessarily mean it's right or wrong. This is what the market says and experience shows that the number of people who can consistently outperform that bogey is a small group. It doesn't say that there is nobody who can outperform the market. Whether they are identifiable or not is a question. But they are a very small group. We talk about them all the time as being counted on the fingers of one hand or two hands. In any event, these are not contradictory ideas and Rob is not saying that his fundamental index is the market. He's just saying that it is a better way to do passive investing--and I think he's right.

James: I guess my problem is that his re-weighting of the benchmark improves on the benchmark's performance, which in CAPM is theoretically impossible.

Peter: Well, he's earning an alpha--

James: He's earning an alpha by re-weighting passive investing, which is beta, which why I think these things are not as clear as perhaps some people make them. Because alpha and beta can be blurred in this fashion.

Peter: I know, you say beta and I say beta.

You say tomato and I say tomato.

Peter: You're right. I just can't train myself to say it that way. We have a Greek associate who assures me that the correct pronunciation is beta, but I was educated in America. And now I've lost my train of thought. What were you saying, James, about beta?

James: The whole idea that you can create alpha by re-weighting beta seems to me to just demonstrate that the nature of alpha and beta can be blurred. Another example, if you like, is hedge fund replication, the fact that some of the investment banks have launched clone funds of hedge funds. Again, the supposed alpha engines are now being duplicated with six-factor effectively beta-style models. So I doubt that alpha and beta are as distinct as CAPM says.

Peter: I think they are distinct but there's no law that says if somebody is generating an alpha and other people begin to copy it, it doesn't turn into beta. There's no question about it. Alpha is very ephemeral and transient in a market that is, if you'll pardon the expression, as efficient as we have. Everybody is looking for opportunities like crazy and you've got computers transmitting these great volumes of information, so it's very likely that alphas will turn into betas. And if enough people-- Rob is very aware of this, we're close friends; had dinner just the other night--if a lot of people copy fundamental indexing, then the character of fundamental indexing is going to change. No question. If everybody did it, it would become the market. I met years ago a guy named Jonathan Berk, who is now the Sylvan C. Coleman Chair in Finance & Accounting, at the Haas School of Business, UC Berkeley. He wrote an article pointing out that small-cap stocks are not necessarily small companies. They're very often the depressed stocks of larger companies. This was the genesis of Rob's idea that the market capitalization and the size of the company aren't necessarily identical and they surely aren't.

James: Yes.

That says to me that the market is as imperfect and inefficient as the people making the buy and sell decisions. Still, we all have great hopes for how "the market" will perform this year.

Peter: Yes.

James: Well, apart from me. I am, as always, perennially bearish.

That doesn't mean that you don't hope for better.

James: That's true. Being a pessimist is a wonderful thing. I always get surprised on the upside.

Do you want the last word, Peter?

Peter: I've had a wonderful opportunity to discuss "capital ideas" and the arguments have been terrific. I'm so glad there were three of us in on this conversation.

Well thanks, then, to both of you.


Your can't wait for Peter's new book analyst,

John F. Mauldin
[email protected]


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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Posted 02-19-2007 4:00 PM by John Mauldin