Tyler Cowen: evaluation

Transcript context

…He’s just trying to get me in trouble. I will tell you. I’m in public here, I’m with someone I admire greatly, this is going to be on the Internet. I’m still more scared of Gene. [laughter] With that said, one of the scariest moments — let me take you back — was telling him I wanted to write a dissertation on price momentum. I swear to God I mumbled the second part, “and I find it works really well.” Because it failing is a perfect Chicago, Gene Fama, efficient markets dissertation. “Look at what these crazy people on Wall Street do. They make all these indicators, and they’re throwing away their money.” To his credit, he immediately said, “If it’s in the data, write the paper.” Now, we don’t agree fully on it. We don’t agree on two things. For all I know, he changed his mind yesterday, but as of yesterday, I don’t think we agree on this. Value investing, remember, I think works for a mix of both behavioral and perhaps some risk reasons. I think they’re hard to identify, but I’m more than willing to say that might be a big part of it. I think Gene would say it’s mostly or all risk. I don’t think he’s very positive on the behavioral explanation. Momentum — Gene’s a risk guy, he’s an efficient markets guy. I think Gene is still cynical about it. I know his latest paper — he and Ken French write if not the best among the best papers in finance. I read every one to this day. It doesn’t mean I agree with every word. They started out with a so‑called three-factor model about 20 years ago. What drives return on an individual stock? The market’s return and your sensitivity to that. Value’s return and how much of a value stock you are. Size’s return, a small firm effect it’s called — how small you are. They’ve added to that over time. They’ve added an investment effect of firms that, for instance, reduce their share count tend to do better. There are theories as to why. And a profitability factor. All else equal, more profitable firms seem to outperform less profitable firms. Again, that’s a very strong effect that holds up. I wrote a piece on our blog saying something, “our factor model goes to six.” For those of you who are curious, it was a reference to Spinal Tap where our amps go to 11. I take the other side from them. I love these guys. We agree on 9 out of 10 things. I don’t see how momentum is not their sixth factor. It adds a tremendous amount of return versus their model. The numbers I gave you that you can add versus, say, the Russell 1000, 125 basis points, understates the power greatly because momentum is also in geek speak negatively correlated with value. In English, a good year for momentum is often a bad year for value, and vise versa. That’s easy to create, if you just do the opposite with your left hand as your right hand. It’s not easy to create two strategies that both go up on average. That’s difficult. That shows up statistically in a model. It becomes even stronger. So, I don’t understand why. I think they should have it as a sixth factor. If you can get Gene to leave Chicago, which is far more difficult than anything else we’re talking about, he can tell you why it’s not a six factor. But it should be. Let me ask you a question about risk, because this key concept comes up again and again in finance. A strategy may appear to have a high return, but risk-adjusted, what are you really getting? Now, when I read the very latest papers on risk, let me tell you what I see. I see talk of the third moment of probability distributions, the fifth moment, words like coskewness, terms like the U‑shaped pricing kernel, and talk of the volatility of volatility. I’m just waiting on the paper on the volatility of the volatility of volatility. When I read all this as an outsider, I conclude we don’t know anything about risk. These are Ptolemaic epicycles. Within a pretty broad range of asset classes, is it possible risk doesn’t really explain anything about asset prices? True or false? What do you say? The epicycle has held up for a long time. They even got the little tiny movements right. That’s not bad. OK. Of everything you said, a fair amount of those risk models I think are utter nonsense. I don’t think the fifth moment — I’m going to insult someone I care about now by accident, I don’t even remember who wrote this. I don’t think the fifth moment is a good measure. I don’t even think skewness — skewness is bad stuff. Even if selling worth makes money on average, occasionally really bad stuff happens, more often than really good stuff. Coskewness, which sounds like one of the geekier things Tyler said, very hard to identify, very hard to prove, very hard to isolate in the data. But coskewness at least makes sense to me as a real risk factor. What that means is not only do very bad things happen more often than you would imagine, but they happen while other very bad things — largely the market crashing, for instance. If something has occasional giant losses, but those are at very good times, and makes money on average, very reliably, that might stink occasionally, but it’s something you can live with. If something is extremely bad at the same time everything else in your life is extremely bad —…

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