Jamesian Philosophy Refreshed

Everybody's favorite avuncular billionaire, Warren Buffett, has said that the academic theory known as the capital asset pricing model and its underlying notion of beta  (the systemic risk of a particular portfolio versus the market as a whole) is worthless.  After all, he says, “ a stock that has dropped very sharply compared to the market … becomes ‘riskier’ at the lower price than it was at the higher price.” Value investors, like Benjamin Graham, know better. It may well be a bargain at the lower price, while it was an unreasonable risk while it was still at the higher price.   Avuncular Charm Is there really paradox here? Let us now let ourselves be lulled by Buffett’s avuncular charm into seeing paradox where there is none. Let’s analyze this in pieces. I won't make you wait for the conclusion though. My own view is that though there are problems with the CAPM, Buffett's aphorism (if that's what the above sentiment is) doesn't address them. Indeed, C...

The Nobel in Economics this year went to the dapper Frenchman pictured here,  Jean Tirole , a member of the Toulouse School of Economics, and with the Institut d'Economie Industrielle (IDEI). In fact, he chairs the board of directors of IDEI. Nonetheless, if you are an Anglophone, even if you are reasonably well informed about contemporary academic economics, the odds are good you've never heard of him. Which is just as well. The selection of a more widely-known figure, Krugman, Kahneman, Mundell, to take recent examples, doesn't really teach us anything. The selection of Tirole naturally leads some of us to wonder why, and so to teach ourselves something. In that teaching-moment respect, the choice is akin to that of Elinor Ostrom a few years back. Tyler Cowen got the goods, collecting a lot of material about Tirole quickly and effectively on his blog on the morning of the announcement. About a third of third of the way down Cowen's blog piece, this caught m...

Picking up a discussion we had been engaging in of late about the types of risk faced (and, one must hope, managed) by financial institutions....   Default risk is the risk that some counterparty with which the risk manager’s own concern is doing business, and from whom they are receiving contracted-for payments, will stop making those payments. They might stop payment either with malice aforethought (as with crooks who take your valuables, promise you a series of payments, and then skip town), or they may stop payment due to some financial crisis that leaves them incapable of doing so. In other words, your own liquidity risk as defined above is somebody else’s default risk. Interest-rate risk is the risk that a change in interest rates will undermine the value of an entity’s assets. For example: on any given day there is some risk that a central bank’s decision to increase interest rates will hurt the value of stocks (because it makes lending money relatively more attra...

Thinking this through. What happens to the value of shares of public stock if the company buys some of the stock back in the marketplace? Think of it first as a simple accounting matter, and let's assume for simplicity's sake that the actual or potential buyers of the stock in the marketplace (who constitute the market demand) know and care about the book value on the balance sheet: that is, the equity as defined by the formula Assets - Liabilities = Equity . Suppose the company has 1,000 shares of stock outstanding, each selling for $50. Its market capitalization, then, is $50,000.  Now, it uses some of its own cash (an asset) to buy back some of the shares of stock. This decreases the amount of stock still available to a would-be buyer.  So if 100 shares are retired and 900 are left, as a first approximation -- assuming demand for the stock stays the same, we might well expect the value of those to increase to $55.55 per. BUT something else has taken place, ...

One of the central elements in modern finance theory is that of a risk-return tradeoff. The idea is simply that investors are risk averse, and accordingly must be paid to incur risk. T here is, then, a constant trade-off in the investment world: safe investments carry low return, high-return investments aren’t so safe. Fortunately, this conforms with almost everyone’s intuitions. What exactly is risk, though? Yes, we have an intuitive idea. The guy jumping out of an airplane is taking a risk that the appreciative audience standing on firm ground below is not. Further, if he has neglected to    check his gear properly he is taking an extra, unwarranted, risk. But we can be a good deal more specific about what the word means in the world of investments. It means the size of the standard deviation of return. It means the width of that bell curve we've discussed in earlier posts.   Standard Deviation A standard deviation is the “average distance from ...

  We can reasonably hypothesize that “Mr. Market” is rational, and knows a lot of stuff, because there are a lot of people out there looking to make a buck off of any slip-up, looking to get an edge, to learn something he doesn’t know, and to trade on that basis. Further, all their trades on the basis of what they learn in that effort make him smarter. They contribute to determining prices, so that an “edge” that still worked a month ago may be outdated now, as Mr. Market has learned to factor it in. And that is why (especially according to advocates of the ECMH) stock prices move in a random walk. It is random to any observer not as smart as Mr. Market himself. Any given neuron will presumably see the thoughts of the whole of the brain as a random result of who-knows-what. There is nothing mystical about this – the confused neuron, in its own trading, helps to bring the situation about. Now, when I’m asked whether I believe in ECMH, I generally reply, “yes and no.” It ...