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Markowitz and Timmermann: On Finance Todayby Michael Krause, MBA '12
For many investors, this post-financial crisis period seems even more perilous than the meltdown itself, compelling us to re-examine the very basis of the investment strategies the professional money-management industry espouses. As such, in this article, two of the Rady School's most accomplished professors of finance hashed out some issues related to this topic.
Nobel Laureate Harry Markowitz (HM) provides valuable insights on finance and related matters, and Professor Allan Timmermann (AT) offers his views on the global economy as a result of recent instability in Europe. In addition, Timmermann makes some relevant points about risk premiums, which are perhaps the most crucial variables determining stock prices.
Understanding and Investing in Today's Macroeconomic Environment
Because portfolios become difficult to diversify in crises, is there a good way to dynamically manage investments in the face of a calamity?
HM: I have an article in The Investment Professional (The Journal of the New York Society of Security Analysts) titled "During Crises All Correlations Go Towards One: Of Course!" [The journal] changed the title to "Portfolio Theory Under Pressure," but the article itself is almost untouched. To illustrate the point made in that article, suppose that the world worked according to William Sharpe's "One-Factor Model." That assumes that return on any security is its alpha plus its beta times an underlying factor plus an idiosyncratic random term. For such a model, a crisis is a time when the underlying factor makes a large downward move. In this case, systematic risk swamps idiosyncratic risk. Ex ante (before the fact) you make your estimates of betas, the volatility of the factor and the volatilities of idiosyncratic terms. As long as the movement in the market and the individual returns to various securities or asset classes, are consistent with your betas and other estimates, then what you see is what you should have expected. In particular, a portfolio with a high beta gets hit hard; one with a lower beta gets hit less hard in crises, but does not do as well on the average over the long run, assuming both portfolios are efficient. The short answer to your questions is: if you don't like such large downward movement in the times of crises, pick a portfolio which is lower on the mean-variance efficient frontier.
Given that the European Union is in crisis, can you take us through a thought experiment of what happens to Europe and the rest of the global economy in the event of a disbandment of the euro?
AT: Were the euro to get replaced with a system of national currencies, this would likely follow on the back of one or multiple sovereign defaults. The associated losses for European banks and the uncertainty surrounding individual banks' balance-sheet exposure could bring the European bank system to a standstill, with very little national or international lending activity happening over a period of time. This could lead to a severe recession in Europe that might spill over to other parts of the world through reduced international trade and financial linkages. Another consideration for international spillover effects is the negative wealth shocks following from depletion in the value of European assets held by non-European companies and investors. In this situation, a key question is how effective the ECB [European Central Bank], perhaps in conjunction with other central banks, would be in providing short- and long-term liquidity, and how orderly the dissolution of the euro could be handled. Another question is how high yields the former euro members would have to pay to raise money on bonds denominated in the new currencies, which would determine their ability to pay back current and future loans.
What are your thoughts on the long-term effects of recent European Central Bank moves?
AT: The Long Term Refinancing Operation (LTRO) has created some breathing room for the European economies, lowered stock market volatility and contributed to the recent mini rally we have seen in the stock market. However, I don't believe it is a solution to the long-term issues. Market reports suggest that it is predominantly Italian and Spanish banks that have taken advantage of the new money. Suppose some of those banks have to be bailed out. Sorting out who is going to pay for this will put further pressure on European government finances in a situation where many countries have already seen their debt ratings downgraded.
Stocks as an Appropriate Asset for Investment
Do you believe that acceptance of Modern Portfolio Theory accelerated share ownership among the public (whether it be in direct holdings or in retirement savings accounts)?
HM: I believe that it was the long bull market and the availability of 401(k) plans that encouraged direct stock ownership by individuals in the United States. Some of these individuals seek guidance from financial advisers, including [programs] like Bill Sharpe's Financial Engines and Guided Choice, for [which] I consult. Many financial advisers use Modern Portfolio Theory.
Has investment in stocks always been simply a bet that there will be more positive economic shocks in the future?
AT: By definition, "shocks" are unpredictable — otherwise we wouldn't get so shocked by them. So if stocks were simply a bet on positive future shocks, we would expect stocks to produce positive returns only roughly half of the time.
Fortunately, there is more to it than that. There is also the risk premium, which is more of a story about what happens in equilibrium. The idea here is that there is only a limited amount of risk capital available in the economy. To induce investors to hold risky stocks, they must be offered a risk premium. This is why investors' beliefs about the equity risk premium are a key driver of how much money they need to allocate to stocks.
Interestingly, the fact that the post-war period has in many regards been benign has led some observers to expect a somewhat lower equity premium than what we have experienced historically. This view has important consequences both for how much individual households need to save for retirement through 401(k) plans and other sources, and also for how much money public pension plans need to set aside to ensure funding of future liabilities. Even finance textbooks have revised downwards the equity premium estimate by around 3 percent per annum over the last couple of decades. This may not sound like a lot, but once you do the math for long-term investments, it makes a big difference.
If excess historical returns in stocks came from such effects, are people over-owning stocks with an incorrect expectation that such effects will continue just because they've occurred in the past?
HM: It is certainly true that many people believe that what has worked well in the past will work well in the future, including future returns on assets or asset classes, which have had unsustainable run-ups. I recommend "Extraordinary Popular Delusions and the Madness of Crowds" by Charles MacKay. The book recounts great bubbles of the past.
Do you think the overall performance of stocks throughout the last century was driven by a sort of economic growth that may have been a one-off occurrence not to possibly be seen again in our lifetimes?
AT: It is certainly the case that we cannot take the historical equity risk premium — the average amount by which stocks outpaced treasury bills — of around 6 1/2 percent per annum for granted as we look ahead. One might think that a long period such as a decade is sufficient to even out good and bad times, but this is far from the case. Since the '60s, the 10-year average equity premium has fluctuated between -4 percent and +14 percent per annum, suggesting that even over a decade, stock-market performance can vary quite a bit. Unfortunately, one of the 10-year periods where stocks underperformed T-bills occurred between 2000 and 2010, so stocks' downside risk is certainly on people's minds.
Productivity gains, access to scalable sources of energy and technological innovation, all played a role in the growth in stock prices, as did economic and political stability. Each historical period offers its unique combination of these factors. Combine the very different stock returns observed in recent decades with the fact that we don't have much data at the decade-long frequency, and it becomes clear that it is very difficult to come up with accurate predictions of stock returns over the next few decades.
Some Final Thoughts from Harry Markowitz
What are the accomplishments you are most proud of in your career? Do they all have a common thread uniting them?
HM: I [had] a book published recently called "Selected Works," which has what I would consider Markowitz's greatest hits. Of these, I am particularly proud of "Portfolio Theory," "Sparse Matrix Techniques," the "SIMSCRIPT Programming Language," a 1952 paper called "Utility of Wealth," a paper I wrote with Haim Levy on "Mean-Variance Approximation to Expected Utility," work with Erik van Dijk published in a paper on "Single-Period Mean-Variance Analysis in a Changing World" and a paper that I wrote solo called "CAPM Investors Do Not Get Paid for Bearing Risks."
In our previous discussions, your love for music, particularly that of Johann Sebastian Bach, came up. As well, your recitation of the poetry of Robert Frost will forever stick in my mind. What role have the arts played in your life? Do you play any instruments?
HM: I have an interest in great artists, especially the Impressionists, and architecture. But I have a passion for music. I played the violin in my high school orchestra, but gave it up when I went to college. Recently I took it up again. I am not a very good violinist; I play for my own entertainment. I enjoy Shakespeare, especially live performances rather than reading his plays. I also enjoy poetry, especially Robert Frost, Robert Browning and Shakespeare.
If J.S. Bach were to have a second career away from music, what discipline do you think he would have excelled in?
HM: I presume that J.S. Bach would have been great at math, especially the kind of abstract math that connects many specific applications. If I may add a final comment, I always say that if I get to heaven, I will first check in, or whatever one has to do, and then see when the next time Johann Sebastian Bach will give an organ recital.