Blogs | December 19, 2012

My top five lessons of 2012

It’s often said that economics is in crisis because of its failure to forecast the slump of 2008. This is wrong. Foreseeing the future is not the proper function of economics – any more than evolutionary biologists are expected to forecast what new species will evolve, or doctors are expected to forecast what our next illness will be.


Instead, the function of economists lies in their ability to discover facts and ideas about the world which might help us manage our lives better. In this regard, economics is thriving. Pretty much every week, I see new research which is useful for our financial planning. What follows are five of my favourite examples from the last 12 months.

1. Be wary of glamorous growth “opportunities” First, Nardin Baker of Guggenheim Investments and Robert Haugen of Haugen Financial Systems have found that low-risk shares out-perform higher risk ones. They sorted shares according to their monthly volatility in the previous two years, and found that the least volatile 10 per cent of shares subsequently out-performed the most volatile between 1990 and 2011. This was true for every one of the 33 major stock markets they looked at. And except for the three year periods to 1999 and 2006, it was true for every three-year sub-period of those 21 years.
This warns us to be wary of glamorous growth “opportunities”. In this context, the old saying “you’ve got to speculate to accumulate” is wrong.

2. “Buy on Halloween” and “sell on May Day”? My second paper comes from Ben Jacobsen and Cherry Zhang of Massey University in New Zealand. They studied the entire history of world stock markets and found that the rules “buy on Halloween” and “sell on May Day” work well. Averaged across all markets and all history, equity returns are 4.5 percentage points higher between October 31 and April 30 than they are between April 30 and October 31.

3. “There’s no free lunch” If these two papers suggest it is easy to profit in stock markets, my third offers a cautionary note. Sassan Zaker at Bank Julius Baer says there’s a trade-off between alpha (risk-adjusted returns) and uncertainty. A high alpha might be just a reward for exposing yourself to uncertainty, in the sense of unquantifiable dangers. For example, if you buy lower-risk stocks, it might seem that you’re making good risk-adjusted returns. But in fact you’re taking on the uncertainty that investors might finally have cottoned onto the fact that low-risk stocks do well, with the result that they are now over-priced and so will subsequently do badly. Many other alpha-generating strategies, says Zaker, also entail taking on uncertainty. In this sense, the old saying, “there’s no free lunch” is actually true.

4. More proof of emotional investing My fourth paper comes from the growing field of neuroeconomics. Scientists at Emory University got MBA students to forecast companies’ earnings and then used fMRI scanners to study their brains’ responses to earnings announcements. They found that share price moves were more closely correlated with brain activity than they were with the size of the earnings’ surprise. If two companies beat expectations by the same amount, the one that triggers the more dopamine releases will see the larger immediate share price move. This corroborates one of the basic presumptions of behavioural finance – that what matters for share prices isn’t just the “real world” but what goes on in investors’ heads.

5. Try to reward the best My final paper is by Bjorn-Christopher Witte. He shows how competitive markets sometimes weed out not the worst performers but the best. To see his point, imagine two types of fund manager. One type follows investment strategies that have expected returns of 10% a year with a standard deviation of 10%. The second type follows strategies which have expected returns of five per cent and standard deviation of 20%. Obviously, the first type of fund managers is better; they have higher returns and less volatility. But what would happen if, at the end of a year, all fund managers with returns of less than 20% were to lose their jobs? More of the second type would survive than the first. Competition then selects against skill and in favour of blind, lucky risk-taking. In financial bubbles – such as we saw in tech stocks in 1999 or in mortgage derivatives in the mid-00s – this is just what happens.
There is, perhaps, only one common theme to these five papers. It’s that financial markets don’t necessarily work as neatly as simple theories imply. They are not always “efficient” in the textbook sense. But nor is it as easy to make money as the more simple-minded investors believe. If you want to understand markets, you have to forget your prejudices, study and think.

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Chris Dillow
Chris Dillow

Investors Chronicle writer and economist

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