Wednesday, May 16, 2007

Stephen Ross on Behavioral Finance: From the Ridiculous to the Sublime

Last night, my business partner and I attended a wonderful event hosted by the local alumni group of one of his alma maters, MIT. The occasion was a talk given by Stephen Ross, now the Franco Modigliani Professor of Finance and Economics at that august bastion of quantitative learning on the Charles River.

By the way, for what it's worth, the far better University in Boston than its better-known, non-empirical neighbor in Cambridge, which shall go unnamed. The only clue being, the seasons changed, and Summers' gone now.....

Anyway, back to last night's dinner and talk.

For the ridiculous, the evening began with polite talk over drinks on the breezy, brick patio of a pleasant catering facility. We engaged in conversation with another couple, the woman of which was the MIT graduate. Her partner is a recently-retired businessman who has just sold his enterprise. Upon learning of my equity portfolio work, he eagerly began to describe his latest interest- a web-based trading site/system known as WiseTrade. Suffice to say, WiseTrade is to equity investing what 'no money down' home buying is to real estate finance.

What was humorous about the episode is that, while the man excitedly discussed how easy it was to buy or sell green- or red- shaded stock tickers, based upon their appropriately colored-lines on a chart, his MIT-educated partner pointedly asked whether the use of such a program by perhaps thousands of people at the same time might not affect the ability of "the program" to mint money at unheard-of rates?

Now, to the sublime. My partner and I were fortunate in being seated at "the finance" table, with about eight other alumni, and Prof. Ross. We caught occasional wisps of his conversation, seated, as we were, across a rather large table.

If I had been a little more aware, I'd be posting a (admittedly posed) digital picture of Prof. Ross and myself, with me, no doubt, looking pensive as he appeared to be making a sage remark.

As we worked through a very serviceable catered-style dinner, Prof. Ross gave a talk of incredible lucidity, insight, sensibility, and humor. MIT is very fortunate indeed to have lured him to its classrooms and research facility.

As concerns my interests, and this blog, Ross' remarks provided the following insights and reinforcements.

First, he clearly stated his belief that there are many unresearched anomalies in finance. Thus, he noted, simply because we do not know why an anomaly exists, or how it works, does not mean that neo-classical finance does not, or, in time, will not explain why.

To simply throw up our hands and resort to behavioral finance explanations in the absence of any other research is mistaken.

Second, Ross chose the anomaly of closed-end funds well-known pricing at a discount to their net asset value, to illustrate this point. He provided an excellent survey of the phenomenon, prior research, and conclusions by other finance academics. He then described his own simple, sensible hypothesis, and subsequent research which confirmed his hypothesis.

It turns out that simply quantifying and modeling the effects of management fees on the value of income and asset value to a closed-end fund-holder explained the difference between the market price and NAV of such funds.

Third, and perhaps most important, Ross remarked that, in his opinion, the best research into various anomalies typically is not overly-complicated, nor dependent upon 'fancy statistics,' but, rather, usually involves sensible ideas and relatively straightforward quantification of the phenomenon to resolve the apparent anomaly. Higher-level math or complicated statistical models are not necessarily indicative of reliable research, in his opinion.

Fourth, he consistently focused on the fundamental neo-classical contention that returns and risk are linked. Excess, or unexpectedly high returns, are invariably linked to added risk, whether that risk is explicitly known, measured, or described.

In that vein, during the post-talk Q&A period, he fielded my question regarding the newly-developed dividend "index" funds by Jeremy Siegel, now allied with Wisdom Tree funds. His thoughts are that one can construct many different weightings for funds, which he pointedly did not call "index" funds, which outperform classical indices such as the S&P500. However, when such constructed weightings lead to higher returns than those of indices, he attributes the excess to unrealized risks inherent in the constructed portfolios. As such, he effectively said, without engaging in any personal comment on Siegel, that the dividend-weighted index funds owe any above-average returns to risks which they seem not to have yet identified.

Finally, in a review of various other 'schools' of finance theory- behavioral, physics, and biological, he stressed two of the hallmarks of neo-classical finance that remain important. One is the field's clear-cut theory of efficient pricing of risk and information in markets. The other is its ability to quanitfy effects, which, specifically, he believes behavioral finance cannot. He likened behavioral finance, with its focus on overall behaviors of investors, to economics, rather than finance. That is, as a professor of both, he noted that economics is concerned with average behaviors of many market participants who effect prices, whereas finance is concerned with behaviors of a few 'sharks' who ferret out and capture price and risk inconsistencies, at the expense of the many who are not similarly motivated or informed.

I came away from Prof. Ross' talk feeling that my own proprietary equity research, and the conclusions resulting from it, on which my equity portfolio strategy is based, are on very solid ground. According to Ross' views, I have identified a heretofore unrealized anomaly which may well continue to exist for decades. Due to some of the specific ways in which I classify and measure various attributes of stock performance, there may never be many, if any, other finance researches who identify precisely the type of return opportunities which I have found. Further, the research I designed and performed is remarkably simple. I used some fairly straightforward concepts from my quantitative market research background, off-the-shelf point-and-click statistical software, and basic analytical tools to discover the phenomena which I use in my portfolio strategy.

When a finance academic of Stephen Ross' caliber provides me with information and insights which dovetail with my own work and methods, I feel reassured and confident in the strength and longevity of the underpinnings of my equity portfolio management approach. While it is theoretically possible for all anomalies to eventually be reduced to understanding and, perhaps, eliminated, in practice, it's not possible. Further, as Prof. Ross pointed out with several examples, often times, explaining the anomaly does not eliminate it. It simply provides the reason why the particular investment approach works as it does.

As I told my business partner, it was a dinner well worth whatever he paid for it.

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