Morningstar Advisor - February/March 2009 - (Page 47) In the 1960s, I found that the bell-curve models concerned only a part of nature. [They] failed to apply to the real world of finance. Benoit Mandelbrot for example, China has entered its own industrial revolution. I think over the coming decades, there’s very good reason to believe that the growth of the emerging markets will be a genuine powerhouse to improve the living standards of everybody on the planet. But there’s no doubt about it; we’re facing a very tough few years in the near term. Kaplan: Dr. Mandelbrot, in your book, The (Mis)behavior of Markets, you point out that the truly risky nature of stock market investing, which is not really adequately captured by the standard models, could provide an explanation for the so-called “equity risk premium puzzle.” As Dr. Ibbotson has documented, stocks over the past century have garnered enormous returns compared with fixed income. Yet, it’s a puzzle because we can’t square the theory with the data using models based on standard deviation. Soon afterwards, however, the same process was reinvented in physics by Norbert Wiener, and a huge theory developed on this basis. In a certain sense, it came to be viewed as the most basic and manageable model of variability that one can have. It was taught everywhere, and for reasons that are too complicated to explain, it became known as the Brownian motion. Now, I have the greatest admiration for Bachelier and Wiener. But the only data Bachelier mentions concerned a very peculiar and highly controlled market. He had limited experience in running some very small investments. He was so isolated that no one knew him well. In the 1960s, I found that the bell-curve models concerned only a part of nature. In particular, the standard Brownian models failed to apply to the real world of finance. Therefore, very thorough rethinking was necessary. I wrote a great deal on this topic, but, clearly, I did not speak loudly or convincingly enough. Kaplan: But financial advisors need some way of explaining to the ordinary investor what are the risks of different kinds of investments. Is there a way to explain the risks and rewards of the market to an investor who has no mathematical training, so that the next time a crash happens, it won’t be such a surprise? Ibbotson: I think the simple message is that there’s much more risk than there appears to be and that the standard deviation doesn’t capture all the risk. Whether it’s creating more-sophisticated statistical measures or whether it’s just using behavioral economics and seeing the way people behave in crisis situations versus how they react on a questionnaire—all these sorts of things suggest that there’s much more risk and much more risk aversion in markets than is revealed in the ordinary way we look at economics. To me, there’s never been a risk premium puzzle, because I’ve always thought that the risks are much higher and that there should be a payoff for this kind of risk. We’ll see that people will be much more averse to risk going forward and much more averse to the stock market going forward. If there is a positive equity risk premium, and I certainly think that’s the case, this crisis will make it more obvious. The crisis itself is creating a big negative return, but going forward in the long run, I’m quite confident that stocks will outperform bonds. K Paul D. Kaplan, Ph.D., CFA, is Morningstar’s vice president of quantitative research and a frequent contributor to Morningstar Advisor. You suggest, however, that investors, without the mathematical training that you have, do have some notion that stock markets are risky; they are aware that these crises occur and that the market moves erratically. Therefore, if you’re going to be a long-term stock investor, you deserve to get a high equity risk premium. So the problem is with our models. Mandelbrot: Indeed, the problem resides in the models. They began more than 100 years ago in the works of a man named Louis Bachelier. Little is known about him, but in 1900, he earned a Ph.D. in mathematics with a dissertation that put forward a theory of speculation. Unfortunately, his model for price variation was already very elaborate and I am sure far too mathematical for his time, so it fell into a black hole. MorningstarAdvisor.com 47 http://www.MorningstarAdvisor.com
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