The Flawed Assumptions Eric Falkenstein Implications of

The Flawed Assumptions Eric Falkenstein

Implications of the Model Don't Work Assumptions: investor agreement and concave utility function lead to risk being priced Implication: Our marginal utility’s covariance with returns is priced as risky Implication: Something intuitive should be identifiable as our marginal utility As If! Where else does utility, or agreement on expected returns and volatility, fail?

The optimization process Securities’ expected returns Securities’ standard deviations Mean-variance optimization Optimal asset weights Securities’ correlations Portfolio choice 3

Mean-Variance Optimization Select {wi} so as to minimize: subject to: (i) E(Rp) > R* (ii) S wi = 1

Result of Optimization Expected Return CAPM, APT, etc. trivial implication Single Optimal Risky Portfolio Rf Standard Deviation Finding Alpha 5

Agents do not agree CAPM article originally rejected because the idea that everyone agreed on returns and covariances absurd. Editor changed, paper accepted. Rubinstein’s aggregation theorem (1974) Can model market as an individual if they all agree on probabilities and covariances Can’t model disagreement Milgrom-Stokey (1982) no trade theorem Trade if have private information—make gross profits Grossman-Stiglitz (1980) Kyle (1985)

Try to Forecast Returns Fundamental Analysis worthless Markets efficient: mutual funds do not outperform

Investors Trade Too Much NYSE turns over 100% per year Odean and Barber (2000): People turnover 75% of stocks in individual accounts. Highest quintile 250%

Investors have Too Many Funds Two-fund separation theorem: Investors hold unique optimal risky portfolio Practice: 1000 s of mutual funds and ETFs Less risk averse Expected Return More risk averse ‘the’ market everyone holds Rf Standard Deviation

Not Diversified Goetzmann and Kumar (2005): >25% have only 1 stock, >50% less than 3, 5 -10% have more than 10. Average portfolio volatility much greater than market for average investor Expected Return Rf Standard Deviation

Home Bias Should invest in world portfolio Chan, Covrig, and Ng (2005): Everyone is investing mainly in domestic portfolio Avoiding easy way to diversify risk Low covariance with risks from home economy

Basic Idea of Utility Fundamental to economic reasoning Marginal Revolution transformed economics c. 1860 s Walras, Jevons, Menger Pre 1860 s ‘classical’ economists: Marx, Smith, Ricardo, Mill Transformed theory of value

Indifference Curves X Slope = Change in Y/Change in X = MU(Y)/MU(X) U 4 U 3 U 2 U 1 O X

Budget Line Y Income = Px Qx + Py. Qy I/Py Slope = Px/Py X O I/Px

Indifference Curves Y MRS = MUx/MUy= Px/Py a b c U 4 U 3 d U 2 e O U 1 X

A change in the price of X: Income and substitution effects Y a b Y 1 Yo U 5 C’ c U 4 c” U 3 d e O Xo X 1 U 2 U 1 X

Utility Theory and Risk Aversion Utility not applied between goods, but applied to everything Von-Neumann-Morgenstern (1944) EU(x)=prob(x 1 )U(x 1)+prob(x 2 )U(x 2 ) Friedman-Savage (1948) Risk-averse people prefer less variance

Utility Theory and Risk Aversion

Buy Recommendations exclude low risk firms Half of all stocks have expected returns below the market Zero recommendations for firms with expected returns below the market return Buy! Expected Return Who cares? Risk

Utility Extrapolation Rabin (2000) Say you reject 50 -50 bet to make $11, risking $10 Then you reject any bet where you lose $100 Even: +$100, 000, 000 if heads -$100 if tails Comes from global concavity of utility function W+11 th dollar worth less than 10/11 of W-10 th dollar W+11 th+21 th (W+32 nd) dollar worth less than 10/11 of W+11 dollar. So W+32 nd dollar worth 10/11*10/11 5/6 dollar Etc.

Easterlin’s Paradox (1974) Within a society, rich people tend to be much happier than poor people. But, rich societies tend not to be happier than poor societies (or not by much). As countries get richer, they do not get happier.

Easterlin’s Paradox Progress and Happiness a Puzzle Gregg Easterbrook’s The Progress Paradox, David Myers’s The American Paradox, and Barry Schwartz’s The Paradox of Choice Japan: between 1958 -1987 per capita income rose 500% No change in subjective well-being Knight and Song (2006): Chinese villagers more affected by relative than absolute wealth, compared to their villages Choose between World A: $100, 000 a year in perpetuity while others earned $90, 000 World B: earn $110, 000 while others earned $200, 000 Most prefer World A

Wolfers and Stevenson (2008) Libertarians love this: • with pure greed, individual self-interest consistent with reciprocal altruism, growth • With pure envy, not Torture data to confess Japan ‘adjustment’ Still not true for USA

Bad Assumptions People do not approach the problem of investing as a mean-variance optimization, or factor risk, problem. Invest based on differing beliefs, taking lots of idiosyncratic risk when they do, reaching for absolute return Necessary and Sufficient Condition for Risk Aversion Wrong Absurd extrapolations Incorrect implications for happiness And, there appear no general priced risk factors