Morningstar Advisor - February/March 2009 - 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
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Morningstar Advisor - February/March 2009

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2009

Morningstar Advisor - February/March 2009
Contents
New on MorningstarAdvisor.com
Letter from the Editor
Contributors
Inbox
How Do You Gauge and Measure Risk?
No Skinny-Dippers Here
Heading to Shore
Investment Briefs
Weapons of Mass Destruction?
Déjà Vu All Over Again
A Failure to Gauge Risk
Five Areas to Find Opportunities
Getting a Read on Risk
Heavenly Returns
Greenspring Comes to the Rescue
How to Spot a Trustworthy REIT
Four Picks for the President
Find Succor in These Large Dividends
These Stocks Are Fiscally Fit
Mutual Fund Analyst Picks
50 Most Popular Equity ETFs
Undervalued Stocks
Most Popular Variable Annuities
New at Morningstar
You Gotta Look Sharpe
Morningstar Advisor - February/March 2009 - Intro
Morningstar Advisor - February/March 2009 - Morningstar Advisor - February/March 2009
Morningstar Advisor - February/March 2009 - Cover2
Morningstar Advisor - February/March 2009 - 1
Morningstar Advisor - February/March 2009 - 2
Morningstar Advisor - February/March 2009 - Contents
Morningstar Advisor - February/March 2009 - 4
Morningstar Advisor - February/March 2009 - 5
Morningstar Advisor - February/March 2009 - New on MorningstarAdvisor.com
Morningstar Advisor - February/March 2009 - 7
Morningstar Advisor - February/March 2009 - 8
Morningstar Advisor - February/March 2009 - Letter from the Editor
Morningstar Advisor - February/March 2009 - Contributors
Morningstar Advisor - February/March 2009 - Inbox
Morningstar Advisor - February/March 2009 - How Do You Gauge and Measure Risk?
Morningstar Advisor - February/March 2009 - 13
Morningstar Advisor - February/March 2009 - No Skinny-Dippers Here
Morningstar Advisor - February/March 2009 - 15
Morningstar Advisor - February/March 2009 - 16
Morningstar Advisor - February/March 2009 - Heading to Shore
Morningstar Advisor - February/March 2009 - 18
Morningstar Advisor - February/March 2009 - 19
Morningstar Advisor - February/March 2009 - Investment Briefs
Morningstar Advisor - February/March 2009 - 21
Morningstar Advisor - February/March 2009 - Weapons of Mass Destruction?
Morningstar Advisor - February/March 2009 - 23
Morningstar Advisor - February/March 2009 - 24
Morningstar Advisor - February/March 2009 - 25
Morningstar Advisor - February/March 2009 - 26
Morningstar Advisor - February/March 2009 - 27
Morningstar Advisor - February/March 2009 - Déjà Vu All Over Again
Morningstar Advisor - February/March 2009 - 29
Morningstar Advisor - February/March 2009 - 30
Morningstar Advisor - February/March 2009 - 31
Morningstar Advisor - February/March 2009 - 32
Morningstar Advisor - February/March 2009 - 33
Morningstar Advisor - February/March 2009 - A Failure to Gauge Risk
Morningstar Advisor - February/March 2009 - 35
Morningstar Advisor - February/March 2009 - 36
Morningstar Advisor - February/March 2009 - 37
Morningstar Advisor - February/March 2009 - Five Areas to Find Opportunities
Morningstar Advisor - February/March 2009 - 39
Morningstar Advisor - February/March 2009 - Getting a Read on Risk
Morningstar Advisor - February/March 2009 - 41
Morningstar Advisor - February/March 2009 - 42
Morningstar Advisor - February/March 2009 - 43
Morningstar Advisor - February/March 2009 - 44
Morningstar Advisor - February/March 2009 - 45
Morningstar Advisor - February/March 2009 - 46
Morningstar Advisor - February/March 2009 - 47
Morningstar Advisor - February/March 2009 - Heavenly Returns
Morningstar Advisor - February/March 2009 - 49
Morningstar Advisor - February/March 2009 - 50
Morningstar Advisor - February/March 2009 - 51
Morningstar Advisor - February/March 2009 - Greenspring Comes to the Rescue
Morningstar Advisor - February/March 2009 - 53
Morningstar Advisor - February/March 2009 - 54
Morningstar Advisor - February/March 2009 - 55
Morningstar Advisor - February/March 2009 - How to Spot a Trustworthy REIT
Morningstar Advisor - February/March 2009 - 57
Morningstar Advisor - February/March 2009 - Four Picks for the President
Morningstar Advisor - February/March 2009 - 59
Morningstar Advisor - February/March 2009 - Find Succor in These Large Dividends
Morningstar Advisor - February/March 2009 - 61
Morningstar Advisor - February/March 2009 - These Stocks Are Fiscally Fit
Morningstar Advisor - February/March 2009 - 63
Morningstar Advisor - February/March 2009 - Mutual Fund Analyst Picks
Morningstar Advisor - February/March 2009 - 65
Morningstar Advisor - February/March 2009 - 66
Morningstar Advisor - February/March 2009 - 67
Morningstar Advisor - February/March 2009 - 50 Most Popular Equity ETFs
Morningstar Advisor - February/March 2009 - 69
Morningstar Advisor - February/March 2009 - 70
Morningstar Advisor - February/March 2009 - 71
Morningstar Advisor - February/March 2009 - Undervalued Stocks
Morningstar Advisor - February/March 2009 - 73
Morningstar Advisor - February/March 2009 - 74
Morningstar Advisor - February/March 2009 - 75
Morningstar Advisor - February/March 2009 - Most Popular Variable Annuities
Morningstar Advisor - February/March 2009 - 77
Morningstar Advisor - February/March 2009 - 78
Morningstar Advisor - February/March 2009 - New at Morningstar
Morningstar Advisor - February/March 2009 - You Gotta Look Sharpe
Morningstar Advisor - February/March 2009 - Cover3
Morningstar Advisor - February/March 2009 - Cover4
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