Understanding market behavior comes down to a question of reversion to the mean. If, like Fama and French, you believe that the risk in small cap and value stocks is real, and therefore the premium is real and will endure, even with the market turning against these stocks, we can eventually expect the return of their historical premiums. This is a critical point for asset allocation. If we can expect equity premiums and risk levels to continue at historical levels, we can feel confident investing in equity index funds over a longterm horizon, gradually decreasing our holdings in riskier equities and increasing our holding in bonds and money market funds as we near retirement. If equity pricing is more akin to a "random walk," or a coin flip, then (per Merton and Samuelson) it may make sense to determine an asset allocation and simply maintain it through continuous rebalancing.

Think Twice Before Trying to Time the Market

If there is some consistency in historical equity returns and valuations, the most obvious benefit to the savvy investor would seem to be an ability to time the market. Cochrane analyzes some recent studies dealing with market timing and emerges with healthy skepticism. The fact that the studies necessarily select limited ranges of data leaves their claims of extraordinary market-timing premiums open to suspicion. In the case of a study by Campell and Vicera, which holds that investors should buy into markets with a high dividend/price ratio and sell into markets with a low dividend/price ratio, returns predictablility in the 50-year sample were sliced in half by the past two years of low d/p ratios and high returns.

If there were a magical timing solution to the market, one would think that something more than one in four actively managed funds would be able to beat the market. As Cochrane so eloquently puts it "If the strategy is real and implementable, one must argue that funds simply failed to follow it." You can argue predictive theories until you are blue in the face. It is difficult to argue with returns. (though Fama and French attempt to do this in a forthcoming publication by arguing that the premium that equities have over risk-free investments may very well be much smaller than is held by conventional wisdom).

Remember the Basics

While it may be possible to come up with numbers that conform to virtually any economic theory imaginable, there are things you can control. Fees. Taxes. Narrowing the gap between your real returns and mean market returns.

Most basically, it doesn't seem to make a lot of sense to absorb the higher expense ratios and tax consequences of actively managed mutual funds for lower returns. It is all a lot of to-do to come back to one simple solution for your portfolio: index funds.

John H. Cochrane is the Sigmund E. Edelstone Professor of Finance at the Graduate School of Busniess at the University of Chicago, and works as a consultant for the Federal Reserve Bank of Chicago

06-07-00
<<Previous   
Printer Friendly Page