The Flawed Assumptions

1. The Flawed Assumptions Eric Falkenstein

2. 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?

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

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

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

6. 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)

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

8. 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%

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

10. 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

11. 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

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

13. Indifference Curves X Slope = Change in Y/Change in X = MU(Y)/MU(X) U4 U3 U2 U1 X O

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

15. Indifference Curves Y MRS = MUx/MUy= Px/Py a b c U4 U3 d U2 e U1 X O

16. A change in the price of X: Income and substitution effects Y a b U5 C’ Y1 c Yo U4 c” U3 d U2 e U1 X O Xo X1

17. Utility Theory and Risk Aversion • Utility not applied between goods, but applied to everything • Von-Neumann-Morgenstern (1944) • EU(x)=prob(x1 )U(x1)+prob(x2 )U(x2 ) • Friedman-Savage (1948) • Risk-averse people prefer less variance

18. Utility Theory and Risk Aversion

19. 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

20. 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: • +$100,000,000,000 if heads • -$100 if tails • Comes from global concavity of utility function • W+11th dollar worth less than 10/11 of W-10th dollar • W+11th+21th (W+32nd) dollar worth less than 10/11 of W+11 dollar. So W+32nd dollar worth 10/11*10/115/6 dollar • Etc.

21. 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.

22. 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

23. 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

24. 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