Loading summary

Transcript112 lines

[00:00]
A
This episode is sponsored by Raisin uk, the award winning online savings marketplace. Compare open and manage competitive savings accounts from over 40 FSCs, protected banks and building societies with a single login. Use the Raisin link in today's show. Notes for a hundred pounds. Welcome bonus. New customers. Only terms apply. Economists have spent half a century building elegant models of how markets work. And the markets have spent half a century cheerfully ignoring them. We investigate the great unsolved mysteries of why stocks pay too much, why the riskiest shares pay the least, and why the market makes all its money while it's closed.
[00:47]
B
And in today's dumb question of the week, if nobody can explain why stocks beat bonds, why are we confident they'll keep doing it? Alright, let's get into it. So, Romin, you're a scientist, you're a physicist, you like hard rules, laws of the universe. Economics is not really like that, is it?
[01:08]
A
No. I mean it's a social science and describing human behaviour with laws is something that we just can't do yet, certainly not mathematically. And there is no theory really of human behavior. So as a social science, economics has got a very hard task, a very difficult task. And when it comes to explaining what's going on in markets, it's completely hopeless.
[01:29]
B
There are a whole load of puzzles, as they're described, that have been outstanding for decades, where economists have their models often based on rational economic actors and the real world just doesn't seem to fit them. So let's start with maybe the biggest puzzle of all when it comes to markets. When I think back over our four and a bit years of doing this podcast, maybe the unifying theme across the whole thing is that stocks are a good thing to hold over the long term. You can go back 100 years and they've been paying you 4 or 5% more than bonds. That's wonderful. What's so puzzling about that?
[02:05]
A
Well, the capital raised by companies does come with different levels of risk. So the riskiest bit is equity. The least risky bit is senior secured bonds. The reason for that is when a company goes into bankruptcy, you eat away at the lower levels of capital first, so the equity gets wiped out completely. So the loss given default there is very high 100% usually. Whereas once you get to the senior secured bonds, there's actually capital set aside in the company's assets. So the loss given default is almost zero.
[02:37]
B
Yeah. So so far it's not very puzzling to me. If I'm holding equity, I want to be paid more than bonds.
[02:44]
A
But the Question is, how much more risky is that equity compared to the other stuff? And it turns out empirically not that risky. Not as risky as markets price in at least. So if you look at research from Mera and Prescott, this was published in 1985, it's a seminal paper about this. It's called the Equity A Puzzle. They said that stocks should Yield at most 0.35%. So that's vastly less than 1 percentage point over bills. Bills are short term government bonds.
[03:18]
B
That's quite a gap then to reality where we've seen up to 6%, say over bills across the last century, certainly in the US And I think that
[03:30]
A
teases at one of the potential reasons why there's such a big discrepancy. The US has been abnormally stable, both in terms of avoiding huge destruction of infrastructure during wars, but also due to economic stress. Okay, it wasn't plain sailing over the last century, but the US did avoid the level of destruction that we saw in the Second World War, the First World War in Europe and in Asia.
[03:57]
B
And it's avoided hyperinflation, it's avoided communist revolutions. You know, it hasn't seen its stock market be wiped out at any point in time, which other countries have. And so one potential solution to this equity premium puzzle is that investors are demanding compensation for these things that could happen and we've seen happen in other parts of the world these rare disasters. And so this whole premium puzzle is a kind of survivorship bias because we
[04:25]
A
calibrate our expectations based on the US but many of us don't actually live in the US So I think that's a reasonable way of explaining it. At least one of the explanations, and there are many.
[04:37]
B
So that claim is that 5 or 6% over bonds is a fair return. It's just the US has been lucky. But then the US isn't the only market to have seen great long term returns in stocks. There are many, if you look at Dimson, Marsh and Staunton. And so economists don't tend to think the idea of disasters completely explains the puzzle.
[04:59]
A
And again, I think this is to do with psychology and perception, which is that we aren't homo economicus. We're not people who look at the long term, who dispassionately look at the past and say, oh yes, well my long term returns will be such and such. And I can just look through this volatility. Of course not. We're excitable monkeys and we're scared we're not going to be able to look at markets in that dispassionate way. And we live day to day, hour to hour, and our fear and greed are driven by short term impulses.
[05:30]
B
Absolutely. That's the thing. When I look at that original research and they say, oh, a fair compensation for stocks is like 0.35% or something above bonds, I wouldn't be happy with that. And I wouldn't hold stocks for just that slender return advantage over a much safer asset. Yes, it might be the case that in these rational economic models, the long term returns should be much closer together. But we're not calibrated on the long term. Like you say, we're checking our portfolios daily. We shouldn't, but we do. We hate losses more than we like wins. That's the prospect theory. And so we probably demand outsized returns.
[06:07]
A
And I think there is a degree of companies adjusting the way they compensate investors based on what they think those investors want. We certainly see that when it comes to paying dividends in the uk, companies pay high dividends in the US they want growth. And I think the capital structure is also reflecting those expectations.
[06:27]
B
So the equity premium puzzle, that's a big one. And there's kind of an inverse one as well, called the risk free rate puzzle, which is looking at it from the perspective of bonds where it says if investors are impatient and they're hungry for risk, why are they willing to hold bonds at all if they're only paying like 1% in real yield? I mean, I guess a load of the assumptions here are about the relative volatility and the risk adjusted return of different assets. And generally stocks are more volatile than bonds, certainly short duration bonds. But are stocks too volatile? More than you'd expect based on the models?
[07:07]
A
And this is one of the coolest papers I've read in finance. This is by Robert Shiller, the guy who came up with the Cape ratio, excess Cape yield. All of that is his. And of course he's got a Nobel Prize for economics, and I think it's just a beautiful paper. So let's just step through the logic of this thing. What we should expect is that the volatility of stocks is due to uncertainty. We're uncertain what the dividends, what the future cash flows will be for those stocks, and that rolls through to the daily price fluctuations. More uncertainty means more price volatility. But what Shiller did, which is so cool, is he actually looked back in time where he actually knew the future, of course, and looked at the realized uncertainty in dividends and then worked back to see what level of Volatility would be consistent with that. And there was a huge disconnect.
[08:02]
B
So stocks are moving up and down in price far more than can be justified by the fundamentals and the change in expectations around earnings and cash flows and dividends.
[08:13]
A
Yeah, not just a little bit. It was 5 to 13 times too high compared to the expectations based on the actual dividend fluctuations.
[08:23]
B
So this is called the excess volatility puzzle. And I think Shiller's own view of a potential explanation is again, behavioral investors are not rational. We're not sitting there with our discounted cash flow models every day working out what our fair price for a stock is. We're chasing fads. Things go in and out of fashion and we overreact to little data points and to news. And so volatility is far higher than a rational robot would price it.
[08:53]
A
Schiller wrote the pop economics book Irrational Exuberance, which was essentially about that and why people aren't rational actors. And they do overreact. They are excitable. They get too much despair in a crash. All of this makes the volatility too high.
[09:09]
B
There are other potential explanations. So if you look at the people that talk about the efficient market hypothesis, so this is the kind of Eugene Farmer school of thought, they would argue that stock prices move not because investors are a bit crazy, but because other key inputs in the model move not just expected returns and cash flows, but things like the discount rate. And investors don't have a great picture of the parameters of the economy and are updating constantly. So prices are moving around more than you think, based on expected cash flows. But that's not all that matters.
[09:49]
A
And that leads into another factor, which is learning where perhaps we're anchored too much on particular views of the world. And then as new information comes in, we overreact to it. So it could just be us updating our views continually and too much because we were too anchored on a fixed view of the world.
[10:09]
B
Some of this just seems to defy explanation to me. Like when I look at returns in the past, you have some crazy daily movements and you can't really put your finger on why. So the obvious example is Black Monday in 1987, where U.S. stocks fell more than 20% in a single day with very little market moving news. It wasn't that there was a big crisis and so stocks fell. We've kind of covered it in the past, haven't we? There are some things you can tease out which are potential explanations. But a 20% move in a day is huge. That is not justified by a move in expected cash flows, is it?
[10:48]
A
No. And you've got things like meme stocks, we all remember that. And the huge surge we got in growth stocks post Covid. Had the fundamentals changed? Not really, but the expectations of investors had certainly changed.
[11:02]
B
There has been some academic research which shows that many of the biggest daily market moves happen when there's no identifiable news at all.
[11:11]
A
And I think perhaps we have too high an expectation of investors. They're not looking at updates in earnings. That's quite unusual. Not many people do that. Analysts do, perhaps economists do in research. But does the average investor look at all of the published earnings reports? I don't think so. What they may well look at is their portfolio. And what they see there is the price momentum of what they own.
[11:36]
B
Yeah. What they look at is the move in the price often so the stock price becomes the news. It's kind of self referential.
[11:44]
A
And if there is one factor that works exceptionally well, it's momentum. And that's what you'd expect if people were doing that, if they were all looking at the price going up. And you buy the stuff that goes up, you sell the stuff that's going down.
[11:57]
B
I mean, it's interesting that the momentum effect, which has been known about now for a long time, it's one of the handful of factors Farmer identified in his model. And he in fact called it the premier anomaly in markets. Why do things that are going up keep going up? And why do things that are falling keep falling?
[12:17]
A
And this is one of my favorite factors. So when I do factor investing, I usually like to roll up momentum with other factors like value, quality, because that usually works better. It's all very well having these fundamental drivers, but if you don't buy something which is doing what people want, then it'll probably turn against you.
[12:38]
B
But do you agree that this is a puzzle, that the momentum factor needs some explanation which has not really been nailed down in the literature as yet?
[12:47]
A
Yeah, I mean, Farmer said this. Momentum, in my view, is the biggest embarrassment for efficient markets.
[12:54]
B
This is the inventor of the theory of efficient markets. I think he said he's hoping it goes away as a factor.
[13:02]
A
Yeah, I don't think that's going to happen. Well, maybe if there was more algorithmic trading, more computers doing the trading, that could happen.
[13:10]
B
Do we need more computers doing the trading? I mean, the thing is with computer and algorithmic trading is it's all conditioned on past performance. Right. So if there is a momentum effect, they're going to exacerbate it by buying into it. And you get these big momentum crashes every so often, driven by algorithms.
[13:26]
A
Yeah, I doubt there'd be an AI fundamentals cartel where they just nod to each other and say, yeah, let's just do it based on fundamentals.
[13:35]
B
I mean, are the proposed explanations for the momentum effect all due to human behavior and our quirks?
[13:42]
A
Yeah, I think that's mostly true. A lot of it is to do about information diffusion and the speed at which information diffuses and also how are anchoring on old prices. With a fairly small set of assumptions, you can mimic what happens in markets, the momentum effect. And of course you get overreaction, herding, behavior, all of that trend chasing that we see so often, that's the primary driver here.
[14:10]
B
The momentum effect does seem to have a lot of robust research behind it. It is a real thing and it dates back a long time. There's even academics that have claimed to look at the Victorian era and say that momentum was a factor back then in the 1800s when you look at asset prices. But weirdly, there's one place where it doesn't seem to have worked historically and that's Japan. And nobody knows why it's not all explained away by the big crash.
[14:35]
A
Maybe they're more rational. I mean, it's certainly more possible. But it's fascinating that there could be a cultural aspect to this and some investors, some cultures could be more rational than others potentially.
[14:49]
B
My guess is that it's more to do with market structure. And there are quite unique things historically about big Japanese companies. Lots of conglomerates, lots of family ownership. It hasn't been the kind of shareholder friendly market like the U.S. but if
[15:06]
A
there is a cultural difference, I wonder if it'll be steady over time. I wonder if Japan will become more like other countries now that we've had all of these reforms on how its stock market is run. A lot of these governance reforms may well introduce momentum to their market as well.
[15:22]
B
Time to pile in.
[15:25]
A
Not for me.
[15:26]
B
Jump on the momentum bandwagon that's about to emerge in Japan.
[15:32]
A
When it comes to your cash savings, making sure your hard earned money is working for you is important. But chasing competitive interest rates can mean dealing with a mountain of paperwork. Meet Raisin uk, the award winning online savings marketplace. Instead of the hassle of opening multiple bank accounts across different apps and providers to get a better interest rate, Raisin UK lets you compare, open and manage competitive savings accounts from over 40 FSCs, protected banks and building societies all through a single login. What's more New customers can claim a £100 welcome bonus. Simply register for an account using the code July 100 and open and fund a fixed rate bond of one year or longer with a minimum £25,000 single deposit by 31 July 2026. Don't let your savings sit idly in a low interest High street account. Visit the link in the description and use the code July 100 new customers only terms apply.
[16:40]
B
So one of the fundamental principles of investing is the trade off between risk and reward. If you're going to take on more risk, you expect a bigger payoff, or at least the potential of a bigger payoff. But when you look at individual stocks, that theory doesn't always seem to hold true.
[17:00]
A
And this is a really robust result, which is if you look at low volatility stocks because they're lower risk, at least by that measure, you'd expect expect them to have lower returns than high volatility stocks. Certainly that's one of the predictions of the capital asset pricing model, capm. But when you actually plot that graph, there's an anomaly, which is that the lower volatility stocks do surprisingly well, much better than you'd predict with capm.
[17:29]
B
Certainly when you look at the long term there are periods where that's not true. But over the very long term that does seem to be true. And it is indeed one of the explanations for why Warren Buffett has been so successful. He bought a lot of these low beta stocks and watched them compound over the years more than you would expect. Looking at the economic models now, you
[17:49]
A
might think this is just some kind of airy fairy statistical effect to do with the theory. But if you look at some of the numbers, they are astonishing. One of the papers did a simple race. They said if you invest a dollar in 1968 in low volume stocks, how much would it grow to compared to the highest volume quintile? The low volume stocks, the dollar invested in those grew to $60 by 2008. In the high volume quintile it fell to under a dollar. In other words, four decades of negative return for taking the highest risk. Now that is not a risk premium.
[18:29]
B
It's a shocking result, isn't it? It flies in the face of everything we've ever said about markets.
[18:36]
A
And recently of course, it's been growth which has outperformed. Those are typically high beta high growth stocks. So I think recently we've bucked that longer term trend. But certainly historically that's been the case.
[18:50]
B
Now the prime explanation for this strange effect seems to be around leverage and the fact that not everybody has access to cheap leverage, and certainly not in unlimited amounts. So if you're an investor who wants to take more risk, you can't always just borrow and lever up the broad market or any particular stock you like. Instead, what you do is you buy these lottery ticket high beta stocks. And so they're overbought because people who want risk pile into them, pushing up the price and pushing down the long term returns of volatile stocks.
[19:31]
A
Again, that hasn't been our recent experience. What we've seen is those high beta stocks doing very well. Maybe because we've just come out of a period of very low interest rates where leverage was easier to get. And so now that we've had normalization of rates, maybe we'll go back to that world, which is an interesting way of looking at it.
[19:49]
B
Yep. It's also funny that Warren Buffett did have access to very cheap leverage at massive scale. And the genius thing he did was lever up implicitly through the float at his insurance company. He levered up on these low beta stocks, so he sort of doubled the effect.
[20:08]
A
And there's another well defined effect, another psychological effect, which is that people overpay for lottery tickets. If you do have a very low probability high payoff, then people overpay for that. It might be meme stocks, it might be things like options, it might be IPOs. All of these carry these lottery ticket payoffs. And usually that lowers your long term returns because people overpay for them.
[20:35]
B
There's an interesting puzzle which is kind of related, I think, to the low volatility anomaly, which is called the distress anomaly. So this is looking at companies who are near bankruptcy. They're in a lot of trouble. And at that point, I guess they kind of become like lottery tickets. They could be the phoenix that rises from the flames and earn you a stellar return because you're getting them at a bargain. Or they could just disappear and you lose everything. So you'd expect them to be high risk, high reward. Once again, the distress anomaly finds that companies near bankruptcy in the aggregate earn the worst returns of all. Now, if you didn't know about markets, you might say, obviously they're near bankruptcy. But from what we know, in aggregate, the returns should be higher because you're being compensated for the risk.
[21:20]
A
Now bear in mind what we've been talking about here is within stocks. So if you talk about the equity universe in a country, this is where the anomaly shows itself. If we zoom out and compare different asset classes, you get this risk and Return relationship reappearing. So let's imagine we've got life strategy 20, 40, 60, 80, 100. As we dial up the equity risk, you see a steady increase in volatility and an increase in return. So it works. When we're comparing different asset classes, higher risk usually means higher return, at least the possibility for higher return.
[21:57]
B
But if we drill back down again to the level of the individual stocks, weird things happen. Some of it's idiosyncratic risk, and again, there are findings that companies with higher idiosyncratic risk are not being fairly compensated in terms of return. But there's also a weird effect called post earnings announcement drift. And this seems to be a real puzzle, one of the longest standing puzzles when it comes to markets.
[22:26]
A
And again, you might think that now that we've got almost immediately available information everywhere so anyone can see the earnings results on their phone, their tablet, their smartwatch, and everyone sees it. At the same time, you might think that when there's an earnings announcement that prices snap to a new level and that's it. But that's absolutely not what we see.
[22:51]
B
They do snap, but then they keep on snapping over the next 60 days. They tend to drift in the way. To me, it seems somewhat related to the momentum effect.
[23:02]
A
And again, it's great to hear what Farmer said about this. He just sounds so curmudgeonly. I love him. He grudgingly listed this among the anomalies that survive scrutiny. He actually said it was above suspicion.
[23:14]
B
Yeah, it takes a lot of data for someone who founded efficient markets theory to concede that markets are not perfectly efficient. But this is an effect that seems to have diminished significantly over the years. The original paper by Ball and Brown was published in 1968, before the Moon
[23:34]
A
landings and before I was born. So that is a long time ago.
[23:38]
B
Which showed that weirdly, markets take almost three months to digest earnings results and press releases fully. Whereas that effect now seems to have been eliminated in large cap stocks, at least in the US and more recently, arguably even in small caps and internationally.
[23:57]
A
So perhaps this is an IT effect. Maybe it is the fact that we are now better informed and anyone can access the information, whereas previously you had to call your broker and do all sorts of crazy things in order to get the information. Most people just couldn't be bothered, I suspect.
[24:12]
B
I also think it's potentially due to limited attention. Like we said earlier, there seems to be some suggestion that the drift effect is worse when these announcements cluster on busy days. Like lots of companies are announcing their earnings and the drift Effect seems to be more anomalous on Fridays when everyone's got their mind on what they're doing at the weekend. I mean, the thing about all these puzzles that puzzles me is that why haven't they gone away sooner? If markets are good at one thing, it's exploiting mispricings and arbitrage opportunities. So you'd have thought clever hedge funds would have sort of battered all these anomalies into oblivion, but it's not the case. There's even some really bizarre ones, like where you look at equity funds and you can literally see what's in the portfolio, the stocks that it holds and value that. And if it's a closed ended fund, it might trade at a discount to that, as we've seen in the UK recently. So there's one puzzle called the closed end fund discount puzzle where you get trusts that persistently trade 10% or so below the value of the things in the fund.
[25:25]
A
So let's just think about what the arbitrage trade would involve. If the investment trust is trading at a discount to its underlying holdings, what you do is you'd buy the investment trust, you'd short the stuff that it owned and then hope that the two would converge in the future and that you could close out the trade at a profit. But that's just not practical.
[25:47]
B
Yeah, it doesn't really work with closed ended funds. You'd have to buy the trust, get on the board and liquidate the holdings and walk away with a profit equal to the discount, which you can't do easily. Some hedge funds try and there have been cases recently in the UK with Saba Capital where they have got onto the board or overthrown the board on investment trusts to try and close the gap. But why is the gap there?
[26:13]
A
I think one of the reasons is due to people not wanting to pay fees generally in the UK at least, investment trusts, because they're active funds, you have to pay quite high fees and people in the UK have grown more reluctant to do that. There has been a huge shift to passive investment, so they are out of favor for that reason.
[26:33]
B
But if a fee is really high, let's say it's 2%, that wouldn't explain a trust trading at a 10% discount.
[26:41]
A
It's also often the case that the holdings of an investment trust are illiquid, so they're very difficult to price and it may be that people don't like that illiquidity risk. Plus I think there's a level of distrust that you can actually price these things so when you see the net asset value for an investment trust, can you trust the investment trust and its valuation? They do go to great pains to ensure that there is a kind of independent valuation. But do people believe that? I think that's the real problem.
[27:13]
B
Even if you believe that you should be paid for the illiquidity risk, I would argue. I think finally there's also an additional risk buying an investment trust which owns a basket of stocks as opposed to just buying the basket of stocks yourself. As in you're pooled alongside a lot of other investors who might do irrational things and sell at bad prices, driving down the value of your holdings. So both the stocks inside the fund might move for irrational reasons and the fund itself might move due to sentiment or whatever. So you've got a sort of risk on top of risk.
[27:51]
A
Yeah, but bear in mind that the attraction of an investment trust is if people pull their money out of it, they're not for sellers of the assets inside the trust. It is closed ended. Someone sells, someone else has to buy.
[28:05]
B
That's true. But if lots of investors selling the trust forces down the share price of the trust and you want to sell, you are going to be receiving the prevailing market price. It is a risk to the value of your holding, even if the stuff inside the trust is immune from a fire sale.
[28:25]
A
But I think the arbitrage point for investment trust is an interesting one. The fact you can't do it easily. But there are anomalies where funds have been launched to try and profit from the anomaly. And what's interesting is that they always seem to collapse in fairly short order. One we've talked about in the past is the overnight return puzzle, which is if you look at the largest moves in prices, they happen overnight.
[28:50]
B
Which always sounds bizarre, the fact that the big gains are made while the market is shut. I mean there's some data that shows the aggregate return when the market's open is around zero. So you've got to hold overnight to make money.
[29:04]
A
So why don't we create a fund, Michael, where you buy the S and P at every close price and then sell it at every open because that way you could capture the whole equity premium.
[29:16]
B
I don't think we're the first people to have that idea, Romin.
[29:23]
A
So there were two ETFs that were launched to try and capture that anomaly, though US listed, of course, they were called knightshares. Great name. One tried to capture the anomaly for the s and P NSPY and the other one for the Russell 2000 Small Cap Index. Sadly, they didn't outperform during the short period while they existed and they were closed down in 2023.
[29:47]
B
It's a story as old as time though, isn't it? Rominous? The moment you launch funds to try and benefit from these weird things in markets, the markets turn against you.
[29:56]
A
Yeah, that one was a real pity. I was so much looking forward to tracking that anomaly and seeing whether it grew larger or smaller over time. But unfortunately the ETFs are gone. I wonder what would have happened if they carried on existing. I wonder if someone's done that calculation. I certainly haven't found it.
[30:13]
B
Well, it was never going to carry on existing when the S and p had gained 15% year on year, but the nightshares fund was down 3%. People pool their money pretty quickly when that happens. The CEO of the fund told ETF.com that the underperformance was due to colossally unlucky timing. Right. Presumably that's what it is, unless they really messed up their implementation of it. Yeah, he went on. It just turned out that the day has been performing well of late and certainly better than the historical period that we've seen.
[30:51]
A
I guess with the introduction of 24 hour trading, this is an anomaly which will become irrelevant anyway.
[30:57]
B
Shall we just wrap up then with my candidate for the biggest anomaly of all? When you look at economic models and what's actually happened in the past, and this is the seemingly straightforward question of why do bubbles exist at all?
[31:14]
A
Yeah, because if we were rational, what we'd say is, well, we all know that the price is too high and if I'm looking for a greater full, maybe they don't exist so I should never buy in the first place.
[31:27]
B
And it seems that pretty much every asset class is susceptible to bubbles, which suggests it's more about human behavior than it is about the mechanics of any individual market.
[31:39]
A
Now, you might think this is to do with imperfect knowledge. If we knew exactly what something was worth and we had a perfect discounted cash flow model, then these bubbles would never happen, right?
[31:51]
B
Well, it would make sense, but that seems to have been conclusively disproved in the lab. So there have been various experiments over the years where economists have sat a load of people down in a room and given them fictional assets with exact values and precise cash flows into the future and got them to trade them. And even in these experiments designed to eliminate bubbles, massive bubbles emerged around two thirds of the time, followed by a huge crash as it got near the end of the experiment. And People realized that the paper they were holding was worth what it said on the paper.
[32:33]
A
And what was interesting is the only thing which made people stop creating these bubbles was experience. So only by going through this bitter experience did the participants in the experiment learn that it's not a good idea to trade in such a way as to create a bubble. So markets only learn by crashing.
[32:54]
B
And there are various reasons proposed as to why bubbles might happen. One is that bubbles are in a way rational when you look at it from the point of view of an individual. Because everyone knows it's overpriced maybe, but expects to be able to exit before the crash. So they think they can profit from the bubble. And obviously if everyone thinks that the bubble gets bigger until everyone runs for those exit doors.
[33:20]
A
And again, there's a psychological reason why this happens. We just extrapolate short term trends. So shares have been going up, they'll carry on going up. That's the really naive way that people approach these things.
[33:33]
B
And Farmer's point to give him the last word is that the whole idea of bubbles is kind of meaningless. He doesn't recognize this as a real counterexample to efficient markets because he says it's impossible to identify bubbles in advance. Sometimes things have looked like bubbles and then turned out to be prices correctly anticipating where earnings will go in the future. But then again, he and Robert Shiller shared a Nobel Prize for their opposite views on this, which I think tells you a lot about the state of economics.
[34:05]
A
Historically, it was only me providing coaching one to one. But we now have Mark Howell who also does this. He's a recently retired chartered financial planner. He's got decades of experience in personal finance and he's now available to you. So if you're interested in learning more about that and booking an hour with Mark, just go to pensioncraft.com coaching to learn more.
[34:28]
B
Okay, today's dumb question of the week. If nobody can explain why stocks beat bonds, why are we confident they'll keep doing it?
[34:38]
A
I think the important point here is about horizon. There have been periods of time when bonds have beaten stocks. That's happened many times in the past. But the longer the horizon you look at, the less likely it gets. But as you've seen, there is no absolute reason to expect that the risk premium will carry on being as high as it's been historically. So let's say that it halved tomorrow. Would that be a shocking thing? No, because we can't really explain why it was so high in the past. And if that did happen, well, suddenly bonds would look much more attractive relative to stocks.
[35:11]
B
I do find it troubling that no one can really explain decisively why stocks have outperformed by so much. Because if you can't explain why, then you don't really know what conditions it's founded on and whether those conditions are still there.
[35:26]
A
I know that stocks certainly build in a lot of leverage. So if interest rates are low, you'd expect the leverage to give a bigger boost to the overall profits of the company and also its stock growth. So maybe if we're entering this higher interest rate regime, which we clearly are, then there's not going to be such great returns for stocks in the future while that remains.
[35:48]
B
And you can find serious people forecasting that bonds might beat stocks over the next decade.
[35:56]
A
Yeah, Goldman Sachs, for example.
[35:59]
B
I said serious people.
[36:04]
A
Oh dear.
[36:05]
B
But in a way, that's why we get paid a premium for holding stocks. Maybe the answer to the equity premium puzzle is that they pay you very well precisely because there are decades when they don't pay you at all.
[36:20]
A
Yeah, certainly looking at single countries, that's been the case. If you look broadly for a global index, it's been very unusual for that to happen. But single countries. Oh yeah.
[36:30]
B
But the world would look very different if the premise of this question somehow proved true. And in a hundred years time stocks in the aggregate had massively underperformed. That would be a very, very different world to the last hundred years.
[36:46]
A
But I think this is like looking at global temperature records. You do see these changes, but they occur very gradually. And I think one of the drivers behind this one might be things like demographics. If we do have an aging society and the earth's population starts to stabilize, well, yeah, you could have a case where you can't sell more stu because there aren't more people to sell it to. In which case bonds might become more attractive.
[37:13]
B
I guess to get a massive regime change where stocks shift from the best asset class to one of the worst ones, you would need something that was fundamentally important to stocks returns in the past, even if we didn't know it, which was now heading in the opposite direction. Obviously that could be demographics. We haven't seen a period of shrinking global population before, certainly not in the modern era.
[37:40]
A
Now, bond returns could well go down as well because if GDP growth is lower, then long term yields would also start to fall. So I don't think anything would be immune any returns from this global slowdown in growth. But on a relative basis, the equity risk premium I'd expect would then shrink and and then, yeah, you'd have a bigger allocation to bonds in your portfolio.
[38:04]
B
All you can really do is hold a diversified portfolio and cross your fingers that the future looks something like the past. Thank you for joining us for Many Happy Returns. Keep sending us your questions, no matter how dumb, @mhrtioncraft.com and do remember to
[38:21]
A
check out pensioncraft.com for all the information about our membership courses and investment coaching options.
[38:28]
B
Many Happy Returns is a Pensioncraft production co hosted and executive produced by Romin Nikiza and Michael Pugh. This podcast is for informational and entertainment purposes and is not financial advice. We do not provide recommendations or endorse any decision to buy, sell, or hold any security. We cannot be held responsible for any actions listeners may take and investors are encouraged to seek independent financial advice.

Summary6 min read

Many Happy Returns

Episode: Beta Noire: Unsolved Mysteries of the Market

Date: July 29, 2026
Hosts: Ramin Nakisa (@PensionCraft) and Michael Pugh

Overview

In this episode, Ramin and Michael explore the deep, persistent mysteries of the financial markets—puzzles that even decades of economic research have failed to fully explain. They walk through some of the most significant anomalies: why stocks have historically outperformed bonds by much more than theory suggests, why risky assets don't always pay more, how market volatility defies rational models, and why most of the stock market's gains occur when the market is closed. The discussion is rooted in research, history, and both hosts' behavioral insights—but emphasizes how these riddles remain, showing the limits of our understanding.

Key Discussion Points & Insights

1. The Equity Premium Puzzle

(Starts ~02:00)

Premise: For over a century, stocks have returned 4–6% more than safe government bonds—much higher than what financial models like those from Mehra and Prescott (1985) suggest is fair given the risk taken.
- Ramin: "They said that stocks should yield at most 0.35%... that's vastly less than 1 percentage point over bills." (03:00)
Potential Explanations:
- US Stability / Survivorship Bias: The US has been abnormally stable, avoided war or revolution—returns may be anomalously high because of this, but similar equity outperformance is observed in other countries too. (03:29–04:37)
- Behavioral Explanations: Investors aren't coldly rational—they're “excitable monkeys”, reacting emotionally to market moves and demanding a higher premium (05:00).

Notable Quote:
"We're not people who look at the long term, who dispassionately look at the past... We're excitable monkeys and we're scared we're not going to be able to look at markets in that dispassionate way." – Ramin (05:00)

2. The Risk-Free Rate & Excess Volatility Puzzles

(Starts ~06:26)

Stocks Move More Than Fundamentals Justify:
- Robert Shiller found that stock price volatility is 5 to 13 times higher than can be explained by actual changes in dividends and cash flow. (08:12)
- Explanations: Behavioral overreaction, news chasing, and, from the efficient markets school, shifting discount rates or ongoing “learning” and updating as conditions change. (08:23–09:48)

Notable Quote:
"Stock prices are moving up and down... far more than can be justified by the fundamentals..." – Michael (08:01)
"Schiller wrote 'Irrational Exuberance', which was essentially about... why people aren't rational actors." – Ramin (08:52)

3. Momentum & Anomalous Factors

(Starts ~11:01)

Momentum Effect: Stocks that have recently gone up tend to keep going up, and vice versa—defying efficient market expectations.
- Eugene Fama called momentum "the premier anomaly in markets." (11:57–12:46)
Is This Behavioral? Most explanations point to herding, trend-chasing, or information diffusion, though cultural and market structure aspects may play a role (e.g., momentum has not worked well in Japan) (14:10).

Memorable Moment:
"Momentum... is the biggest embarrassment for efficient markets." – Ramin quoting Eugene Fama (12:46)

4. Low Volatility and Lottery-Ticket Stocks

(Starts ~16:39)

Low Volatility Anomaly: Traditionally, more risk should = more reward (CAPM prediction). But in practice, low volatility stocks have outperformed high volatility ones over the long term.
- E.g., a dollar invested in low-volatility stocks in 1968 grew to $60 by 2008; in high-volatility stocks, it fell below $1. (17:49)
Possible Causes: Investors can't borrow easily to lever up safe stocks, so buy risky stocks for lottery-like returns, leading to their underperformance. (18:50)

Quote:
"Four decades of negative return for taking the highest risk. Now that is not a risk premium." – Ramin (17:49)

Distress Anomaly: Firms near bankruptcy do worse on average, even though you'd expect higher potential reward for the risk. (20:34)

5. Post-Earnings Announcement Drift

(Starts ~21:56)

Observation: Stocks keep moving in the direction of an earnings surprise for up to two months after the news, rather than instantly reflecting new information.
- Effect has diminished as markets and information flow have improved. (23:37)

Quote:
"It takes a lot of data for someone who founded efficient markets theory to concede that markets are not perfectly efficient." – Michael (23:14)

6. Closed-End Fund Discount Puzzle

(Starts ~24:11)

Phenomenon: Some closed-end funds trade at a persistent discount to the net value of their holdings, defying arbitrage.
Explanations include fees, illiquidity, distrust in valuation, and second-layer risks (fund sentiment in addition to underlying asset prices). (26:13)

7. The Overnight Return Puzzle

(Starts ~28:25)

Striking Fact: Most market gains occur overnight while markets are closed; trading during the day often yields little net gain.
ETFs launched to harvest this anomaly failed to outperform during their lifetimes, possibly due to poor timing or changing market dynamics. (29:23)

Memorable Moment:
"The moment you launch funds to try and benefit from these weird things... the markets turn against you." – Michael (29:47)
"With the introduction of 24 hour trading, this is an anomaly which will become irrelevant anyway." – Ramin (30:50)

8. The Mystery of Bubbles

(Starts ~30:56)

Question: Why do bubbles exist? If everyone knows prices are too high, rational actors shouldn't participate.
Experimental Evidence: Even with perfect information and rational incentives, humans still create bubbles—most participants learn only after repeated crashes. (32:33)
The Role of Psychology: Trend extrapolation and hope for a ‘greater fool’ drive the process. Some (like Fama) dispute that bubbles truly exist if you can't identify them ahead of time. (33:32)

Quote:
"Markets only learn by crashing." – Ramin (32:33)

Dumb Question of the Week

(Starts ~34:28)

“If nobody can explain why stocks beat bonds, why are we confident they’ll keep doing it?”

Host Responses:
- No guarantee: There are decades when bonds win; the longer the horizon, the likelier stocks win, but the mechanism is unexplained.
- Factors that may change the future balance: Interest rates, demographics (aging populations), and structural global shifts could shrink the historical equity premium.
- Final thought: “All you can really do is hold a diversified portfolio and cross your fingers that the future looks something like the past.” – Michael (38:03)

Notable Quotes & Moments (All Timestamps MM:SS)

“We’re excitable monkeys and we’re scared…” – Ramin (05:00)
“Stocks are moving up and down in price far more than can be justified by the fundamentals…” – Michael (08:01)
“Momentum, in my view, is the biggest embarrassment for efficient markets.” – Fama quoted by Ramin (12:46)
“Four decades of negative return for taking the highest risk. Now that is not a risk premium.” – Ramin (17:49)
“Markets only learn by crashing.” – Ramin (32:33)
“All you can really do is hold a diversified portfolio and cross your fingers that the future looks something like the past.” – Michael (38:03)

Timestamps for Key Segments

| Topic | Timestamp | |-----------------------------------------|---------------| | Equity Premium Puzzle | 02:00–06:07 | | Excess Volatility | 06:26–10:09 | | Momentum Effect | 11:01–15:05 | | Low Volatility/Lottery Stocks | 16:39–20:34 | | Post-Earnings Drift | 21:56–24:11 | | Closed-End Fund Discounts | 24:11–28:25 | | Overnight Return Puzzle | 28:25–30:50 | | Bubbles | 30:56–34:05 | | Dumb Question: Stocks vs. Bonds | 34:28–38:03 |

Tone & Takeaway

The tone is engaging, skeptical, and tinged with humor ("We're excitable monkeys", "serious people... Goldman Sachs, for example. I said serious people"). The big message: Markets routinely defy both simple intuition and elegant theory. Behavioral factors, access to leverage, information flow, market structure, and unexplained quirks all create real, lasting anomalies. The best tool is humility—and diversification.

For those who haven't listened:
This episode is a guided tour through the mysteries that make the market exciting and humbling. It will deepen your understanding of why solid models don't always match reality, and why experience, skepticism, and steady diversification still beat overconfidence when investing for the long haul.

Loading summary

Transcript112 lines

[00:00]
A
This episode is sponsored by Raisin uk, the award winning online savings marketplace. Compare open and manage competitive savings accounts from over 40 FSCs, protected banks and building societies with a single login. Use the Raisin link in today's show. Notes for a hundred pounds. Welcome bonus. New customers. Only terms apply. Economists have spent half a century building elegant models of how markets work. And the markets have spent half a century cheerfully ignoring them. We investigate the great unsolved mysteries of why stocks pay too much, why the riskiest shares pay the least, and why the market makes all its money while it's closed.
[00:47]
B
And in today's dumb question of the week, if nobody can explain why stocks beat bonds, why are we confident they'll keep doing it? Alright, let's get into it. So, Romin, you're a scientist, you're a physicist, you like hard rules, laws of the universe. Economics is not really like that, is it?
[01:08]
A
No. I mean it's a social science and describing human behaviour with laws is something that we just can't do yet, certainly not mathematically. And there is no theory really of human behavior. So as a social science, economics has got a very hard task, a very difficult task. And when it comes to explaining what's going on in markets, it's completely hopeless.
[01:29]
B
There are a whole load of puzzles, as they're described, that have been outstanding for decades, where economists have their models often based on rational economic actors and the real world just doesn't seem to fit them. So let's start with maybe the biggest puzzle of all when it comes to markets. When I think back over our four and a bit years of doing this podcast, maybe the unifying theme across the whole thing is that stocks are a good thing to hold over the long term. You can go back 100 years and they've been paying you 4 or 5% more than bonds. That's wonderful. What's so puzzling about that?
[02:05]
A
Well, the capital raised by companies does come with different levels of risk. So the riskiest bit is equity. The least risky bit is senior secured bonds. The reason for that is when a company goes into bankruptcy, you eat away at the lower levels of capital first, so the equity gets wiped out completely. So the loss given default there is very high 100% usually. Whereas once you get to the senior secured bonds, there's actually capital set aside in the company's assets. So the loss given default is almost zero.
[02:37]
B
Yeah. So so far it's not very puzzling to me. If I'm holding equity, I want to be paid more than bonds.
[02:44]
A
But the Question is, how much more risky is that equity compared to the other stuff? And it turns out empirically not that risky. Not as risky as markets price in at least. So if you look at research from Mera and Prescott, this was published in 1985, it's a seminal paper about this. It's called the Equity A Puzzle. They said that stocks should Yield at most 0.35%. So that's vastly less than 1 percentage point over bills. Bills are short term government bonds.
[03:18]
B
That's quite a gap then to reality where we've seen up to 6%, say over bills across the last century, certainly in the US And I think that
[03:30]
A
teases at one of the potential reasons why there's such a big discrepancy. The US has been abnormally stable, both in terms of avoiding huge destruction of infrastructure during wars, but also due to economic stress. Okay, it wasn't plain sailing over the last century, but the US did avoid the level of destruction that we saw in the Second World War, the First World War in Europe and in Asia.
[03:57]
B
And it's avoided hyperinflation, it's avoided communist revolutions. You know, it hasn't seen its stock market be wiped out at any point in time, which other countries have. And so one potential solution to this equity premium puzzle is that investors are demanding compensation for these things that could happen and we've seen happen in other parts of the world these rare disasters. And so this whole premium puzzle is a kind of survivorship bias because we
[04:25]
A
calibrate our expectations based on the US but many of us don't actually live in the US So I think that's a reasonable way of explaining it. At least one of the explanations, and there are many.
[04:37]
B
So that claim is that 5 or 6% over bonds is a fair return. It's just the US has been lucky. But then the US isn't the only market to have seen great long term returns in stocks. There are many, if you look at Dimson, Marsh and Staunton. And so economists don't tend to think the idea of disasters completely explains the puzzle.
[04:59]
A
And again, I think this is to do with psychology and perception, which is that we aren't homo economicus. We're not people who look at the long term, who dispassionately look at the past and say, oh yes, well my long term returns will be such and such. And I can just look through this volatility. Of course not. We're excitable monkeys and we're scared we're not going to be able to look at markets in that dispassionate way. And we live day to day, hour to hour, and our fear and greed are driven by short term impulses.
[05:30]
B
Absolutely. That's the thing. When I look at that original research and they say, oh, a fair compensation for stocks is like 0.35% or something above bonds, I wouldn't be happy with that. And I wouldn't hold stocks for just that slender return advantage over a much safer asset. Yes, it might be the case that in these rational economic models, the long term returns should be much closer together. But we're not calibrated on the long term. Like you say, we're checking our portfolios daily. We shouldn't, but we do. We hate losses more than we like wins. That's the prospect theory. And so we probably demand outsized returns.
[06:07]
A
And I think there is a degree of companies adjusting the way they compensate investors based on what they think those investors want. We certainly see that when it comes to paying dividends in the uk, companies pay high dividends in the US they want growth. And I think the capital structure is also reflecting those expectations.
[06:27]
B
So the equity premium puzzle, that's a big one. And there's kind of an inverse one as well, called the risk free rate puzzle, which is looking at it from the perspective of bonds where it says if investors are impatient and they're hungry for risk, why are they willing to hold bonds at all if they're only paying like 1% in real yield? I mean, I guess a load of the assumptions here are about the relative volatility and the risk adjusted return of different assets. And generally stocks are more volatile than bonds, certainly short duration bonds. But are stocks too volatile? More than you'd expect based on the models?
[07:07]
A
And this is one of the coolest papers I've read in finance. This is by Robert Shiller, the guy who came up with the Cape ratio, excess Cape yield. All of that is his. And of course he's got a Nobel Prize for economics, and I think it's just a beautiful paper. So let's just step through the logic of this thing. What we should expect is that the volatility of stocks is due to uncertainty. We're uncertain what the dividends, what the future cash flows will be for those stocks, and that rolls through to the daily price fluctuations. More uncertainty means more price volatility. But what Shiller did, which is so cool, is he actually looked back in time where he actually knew the future, of course, and looked at the realized uncertainty in dividends and then worked back to see what level of Volatility would be consistent with that. And there was a huge disconnect.
[08:02]
B
So stocks are moving up and down in price far more than can be justified by the fundamentals and the change in expectations around earnings and cash flows and dividends.
[08:13]
A
Yeah, not just a little bit. It was 5 to 13 times too high compared to the expectations based on the actual dividend fluctuations.
[08:23]
B
So this is called the excess volatility puzzle. And I think Shiller's own view of a potential explanation is again, behavioral investors are not rational. We're not sitting there with our discounted cash flow models every day working out what our fair price for a stock is. We're chasing fads. Things go in and out of fashion and we overreact to little data points and to news. And so volatility is far higher than a rational robot would price it.
[08:53]
A
Schiller wrote the pop economics book Irrational Exuberance, which was essentially about that and why people aren't rational actors. And they do overreact. They are excitable. They get too much despair in a crash. All of this makes the volatility too high.
[09:09]
B
There are other potential explanations. So if you look at the people that talk about the efficient market hypothesis, so this is the kind of Eugene Farmer school of thought, they would argue that stock prices move not because investors are a bit crazy, but because other key inputs in the model move not just expected returns and cash flows, but things like the discount rate. And investors don't have a great picture of the parameters of the economy and are updating constantly. So prices are moving around more than you think, based on expected cash flows. But that's not all that matters.
[09:49]
A
And that leads into another factor, which is learning where perhaps we're anchored too much on particular views of the world. And then as new information comes in, we overreact to it. So it could just be us updating our views continually and too much because we were too anchored on a fixed view of the world.
[10:09]
B
Some of this just seems to defy explanation to me. Like when I look at returns in the past, you have some crazy daily movements and you can't really put your finger on why. So the obvious example is Black Monday in 1987, where U.S. stocks fell more than 20% in a single day with very little market moving news. It wasn't that there was a big crisis and so stocks fell. We've kind of covered it in the past, haven't we? There are some things you can tease out which are potential explanations. But a 20% move in a day is huge. That is not justified by a move in expected cash flows, is it?
[10:48]
A
No. And you've got things like meme stocks, we all remember that. And the huge surge we got in growth stocks post Covid. Had the fundamentals changed? Not really, but the expectations of investors had certainly changed.
[11:02]
B
There has been some academic research which shows that many of the biggest daily market moves happen when there's no identifiable news at all.
[11:11]
A
And I think perhaps we have too high an expectation of investors. They're not looking at updates in earnings. That's quite unusual. Not many people do that. Analysts do, perhaps economists do in research. But does the average investor look at all of the published earnings reports? I don't think so. What they may well look at is their portfolio. And what they see there is the price momentum of what they own.
[11:36]
B
Yeah. What they look at is the move in the price often so the stock price becomes the news. It's kind of self referential.
[11:44]
A
And if there is one factor that works exceptionally well, it's momentum. And that's what you'd expect if people were doing that, if they were all looking at the price going up. And you buy the stuff that goes up, you sell the stuff that's going down.
[11:57]
B
I mean, it's interesting that the momentum effect, which has been known about now for a long time, it's one of the handful of factors Farmer identified in his model. And he in fact called it the premier anomaly in markets. Why do things that are going up keep going up? And why do things that are falling keep falling?
[12:17]
A
And this is one of my favorite factors. So when I do factor investing, I usually like to roll up momentum with other factors like value, quality, because that usually works better. It's all very well having these fundamental drivers, but if you don't buy something which is doing what people want, then it'll probably turn against you.
[12:38]
B
But do you agree that this is a puzzle, that the momentum factor needs some explanation which has not really been nailed down in the literature as yet?
[12:47]
A
Yeah, I mean, Farmer said this. Momentum, in my view, is the biggest embarrassment for efficient markets.
[12:54]
B
This is the inventor of the theory of efficient markets. I think he said he's hoping it goes away as a factor.
[13:02]
A
Yeah, I don't think that's going to happen. Well, maybe if there was more algorithmic trading, more computers doing the trading, that could happen.
[13:10]
B
Do we need more computers doing the trading? I mean, the thing is with computer and algorithmic trading is it's all conditioned on past performance. Right. So if there is a momentum effect, they're going to exacerbate it by buying into it. And you get these big momentum crashes every so often, driven by algorithms.
[13:26]
A
Yeah, I doubt there'd be an AI fundamentals cartel where they just nod to each other and say, yeah, let's just do it based on fundamentals.
[13:35]
B
I mean, are the proposed explanations for the momentum effect all due to human behavior and our quirks?
[13:42]
A
Yeah, I think that's mostly true. A lot of it is to do about information diffusion and the speed at which information diffuses and also how are anchoring on old prices. With a fairly small set of assumptions, you can mimic what happens in markets, the momentum effect. And of course you get overreaction, herding, behavior, all of that trend chasing that we see so often, that's the primary driver here.
[14:10]
B
The momentum effect does seem to have a lot of robust research behind it. It is a real thing and it dates back a long time. There's even academics that have claimed to look at the Victorian era and say that momentum was a factor back then in the 1800s when you look at asset prices. But weirdly, there's one place where it doesn't seem to have worked historically and that's Japan. And nobody knows why it's not all explained away by the big crash.
[14:35]
A
Maybe they're more rational. I mean, it's certainly more possible. But it's fascinating that there could be a cultural aspect to this and some investors, some cultures could be more rational than others potentially.
[14:49]
B
My guess is that it's more to do with market structure. And there are quite unique things historically about big Japanese companies. Lots of conglomerates, lots of family ownership. It hasn't been the kind of shareholder friendly market like the U.S. but if
[15:06]
A
there is a cultural difference, I wonder if it'll be steady over time. I wonder if Japan will become more like other countries now that we've had all of these reforms on how its stock market is run. A lot of these governance reforms may well introduce momentum to their market as well.
[15:22]
B
Time to pile in.
[15:25]
A
Not for me.
[15:26]
B
Jump on the momentum bandwagon that's about to emerge in Japan.
[15:32]
A
When it comes to your cash savings, making sure your hard earned money is working for you is important. But chasing competitive interest rates can mean dealing with a mountain of paperwork. Meet Raisin uk, the award winning online savings marketplace. Instead of the hassle of opening multiple bank accounts across different apps and providers to get a better interest rate, Raisin UK lets you compare, open and manage competitive savings accounts from over 40 FSCs, protected banks and building societies all through a single login. What's more New customers can claim a £100 welcome bonus. Simply register for an account using the code July 100 and open and fund a fixed rate bond of one year or longer with a minimum £25,000 single deposit by 31 July 2026. Don't let your savings sit idly in a low interest High street account. Visit the link in the description and use the code July 100 new customers only terms apply.
[16:40]
B
So one of the fundamental principles of investing is the trade off between risk and reward. If you're going to take on more risk, you expect a bigger payoff, or at least the potential of a bigger payoff. But when you look at individual stocks, that theory doesn't always seem to hold true.
[17:00]
A
And this is a really robust result, which is if you look at low volatility stocks because they're lower risk, at least by that measure, you'd expect expect them to have lower returns than high volatility stocks. Certainly that's one of the predictions of the capital asset pricing model, capm. But when you actually plot that graph, there's an anomaly, which is that the lower volatility stocks do surprisingly well, much better than you'd predict with capm.
[17:29]
B
Certainly when you look at the long term there are periods where that's not true. But over the very long term that does seem to be true. And it is indeed one of the explanations for why Warren Buffett has been so successful. He bought a lot of these low beta stocks and watched them compound over the years more than you would expect. Looking at the economic models now, you
[17:49]
A
might think this is just some kind of airy fairy statistical effect to do with the theory. But if you look at some of the numbers, they are astonishing. One of the papers did a simple race. They said if you invest a dollar in 1968 in low volume stocks, how much would it grow to compared to the highest volume quintile? The low volume stocks, the dollar invested in those grew to $60 by 2008. In the high volume quintile it fell to under a dollar. In other words, four decades of negative return for taking the highest risk. Now that is not a risk premium.
[18:29]
B
It's a shocking result, isn't it? It flies in the face of everything we've ever said about markets.
[18:36]
A
And recently of course, it's been growth which has outperformed. Those are typically high beta high growth stocks. So I think recently we've bucked that longer term trend. But certainly historically that's been the case.
[18:50]
B
Now the prime explanation for this strange effect seems to be around leverage and the fact that not everybody has access to cheap leverage, and certainly not in unlimited amounts. So if you're an investor who wants to take more risk, you can't always just borrow and lever up the broad market or any particular stock you like. Instead, what you do is you buy these lottery ticket high beta stocks. And so they're overbought because people who want risk pile into them, pushing up the price and pushing down the long term returns of volatile stocks.
[19:31]
A
Again, that hasn't been our recent experience. What we've seen is those high beta stocks doing very well. Maybe because we've just come out of a period of very low interest rates where leverage was easier to get. And so now that we've had normalization of rates, maybe we'll go back to that world, which is an interesting way of looking at it.
[19:49]
B
Yep. It's also funny that Warren Buffett did have access to very cheap leverage at massive scale. And the genius thing he did was lever up implicitly through the float at his insurance company. He levered up on these low beta stocks, so he sort of doubled the effect.
[20:08]
A
And there's another well defined effect, another psychological effect, which is that people overpay for lottery tickets. If you do have a very low probability high payoff, then people overpay for that. It might be meme stocks, it might be things like options, it might be IPOs. All of these carry these lottery ticket payoffs. And usually that lowers your long term returns because people overpay for them.
[20:35]
B
There's an interesting puzzle which is kind of related, I think, to the low volatility anomaly, which is called the distress anomaly. So this is looking at companies who are near bankruptcy. They're in a lot of trouble. And at that point, I guess they kind of become like lottery tickets. They could be the phoenix that rises from the flames and earn you a stellar return because you're getting them at a bargain. Or they could just disappear and you lose everything. So you'd expect them to be high risk, high reward. Once again, the distress anomaly finds that companies near bankruptcy in the aggregate earn the worst returns of all. Now, if you didn't know about markets, you might say, obviously they're near bankruptcy. But from what we know, in aggregate, the returns should be higher because you're being compensated for the risk.
[21:20]
A
Now bear in mind what we've been talking about here is within stocks. So if you talk about the equity universe in a country, this is where the anomaly shows itself. If we zoom out and compare different asset classes, you get this risk and Return relationship reappearing. So let's imagine we've got life strategy 20, 40, 60, 80, 100. As we dial up the equity risk, you see a steady increase in volatility and an increase in return. So it works. When we're comparing different asset classes, higher risk usually means higher return, at least the possibility for higher return.
[21:57]
B
But if we drill back down again to the level of the individual stocks, weird things happen. Some of it's idiosyncratic risk, and again, there are findings that companies with higher idiosyncratic risk are not being fairly compensated in terms of return. But there's also a weird effect called post earnings announcement drift. And this seems to be a real puzzle, one of the longest standing puzzles when it comes to markets.
[22:26]
A
And again, you might think that now that we've got almost immediately available information everywhere so anyone can see the earnings results on their phone, their tablet, their smartwatch, and everyone sees it. At the same time, you might think that when there's an earnings announcement that prices snap to a new level and that's it. But that's absolutely not what we see.
[22:51]
B
They do snap, but then they keep on snapping over the next 60 days. They tend to drift in the way. To me, it seems somewhat related to the momentum effect.
[23:02]
A
And again, it's great to hear what Farmer said about this. He just sounds so curmudgeonly. I love him. He grudgingly listed this among the anomalies that survive scrutiny. He actually said it was above suspicion.
[23:14]
B
Yeah, it takes a lot of data for someone who founded efficient markets theory to concede that markets are not perfectly efficient. But this is an effect that seems to have diminished significantly over the years. The original paper by Ball and Brown was published in 1968, before the Moon
[23:34]
A
landings and before I was born. So that is a long time ago.
[23:38]
B
Which showed that weirdly, markets take almost three months to digest earnings results and press releases fully. Whereas that effect now seems to have been eliminated in large cap stocks, at least in the US and more recently, arguably even in small caps and internationally.
[23:57]
A
So perhaps this is an IT effect. Maybe it is the fact that we are now better informed and anyone can access the information, whereas previously you had to call your broker and do all sorts of crazy things in order to get the information. Most people just couldn't be bothered, I suspect.
[24:12]
B
I also think it's potentially due to limited attention. Like we said earlier, there seems to be some suggestion that the drift effect is worse when these announcements cluster on busy days. Like lots of companies are announcing their earnings and the drift Effect seems to be more anomalous on Fridays when everyone's got their mind on what they're doing at the weekend. I mean, the thing about all these puzzles that puzzles me is that why haven't they gone away sooner? If markets are good at one thing, it's exploiting mispricings and arbitrage opportunities. So you'd have thought clever hedge funds would have sort of battered all these anomalies into oblivion, but it's not the case. There's even some really bizarre ones, like where you look at equity funds and you can literally see what's in the portfolio, the stocks that it holds and value that. And if it's a closed ended fund, it might trade at a discount to that, as we've seen in the UK recently. So there's one puzzle called the closed end fund discount puzzle where you get trusts that persistently trade 10% or so below the value of the things in the fund.
[25:25]
A
So let's just think about what the arbitrage trade would involve. If the investment trust is trading at a discount to its underlying holdings, what you do is you'd buy the investment trust, you'd short the stuff that it owned and then hope that the two would converge in the future and that you could close out the trade at a profit. But that's just not practical.
[25:47]
B
Yeah, it doesn't really work with closed ended funds. You'd have to buy the trust, get on the board and liquidate the holdings and walk away with a profit equal to the discount, which you can't do easily. Some hedge funds try and there have been cases recently in the UK with Saba Capital where they have got onto the board or overthrown the board on investment trusts to try and close the gap. But why is the gap there?
[26:13]
A
I think one of the reasons is due to people not wanting to pay fees generally in the UK at least, investment trusts, because they're active funds, you have to pay quite high fees and people in the UK have grown more reluctant to do that. There has been a huge shift to passive investment, so they are out of favor for that reason.
[26:33]
B
But if a fee is really high, let's say it's 2%, that wouldn't explain a trust trading at a 10% discount.
[26:41]
A
It's also often the case that the holdings of an investment trust are illiquid, so they're very difficult to price and it may be that people don't like that illiquidity risk. Plus I think there's a level of distrust that you can actually price these things so when you see the net asset value for an investment trust, can you trust the investment trust and its valuation? They do go to great pains to ensure that there is a kind of independent valuation. But do people believe that? I think that's the real problem.
[27:13]
B
Even if you believe that you should be paid for the illiquidity risk, I would argue. I think finally there's also an additional risk buying an investment trust which owns a basket of stocks as opposed to just buying the basket of stocks yourself. As in you're pooled alongside a lot of other investors who might do irrational things and sell at bad prices, driving down the value of your holdings. So both the stocks inside the fund might move for irrational reasons and the fund itself might move due to sentiment or whatever. So you've got a sort of risk on top of risk.
[27:51]
A
Yeah, but bear in mind that the attraction of an investment trust is if people pull their money out of it, they're not for sellers of the assets inside the trust. It is closed ended. Someone sells, someone else has to buy.
[28:05]
B
That's true. But if lots of investors selling the trust forces down the share price of the trust and you want to sell, you are going to be receiving the prevailing market price. It is a risk to the value of your holding, even if the stuff inside the trust is immune from a fire sale.
[28:25]
A
But I think the arbitrage point for investment trust is an interesting one. The fact you can't do it easily. But there are anomalies where funds have been launched to try and profit from the anomaly. And what's interesting is that they always seem to collapse in fairly short order. One we've talked about in the past is the overnight return puzzle, which is if you look at the largest moves in prices, they happen overnight.
[28:50]
B
Which always sounds bizarre, the fact that the big gains are made while the market is shut. I mean there's some data that shows the aggregate return when the market's open is around zero. So you've got to hold overnight to make money.
[29:04]
A
So why don't we create a fund, Michael, where you buy the S and P at every close price and then sell it at every open because that way you could capture the whole equity premium.
[29:16]
B
I don't think we're the first people to have that idea, Romin.
[29:23]
A
So there were two ETFs that were launched to try and capture that anomaly, though US listed, of course, they were called knightshares. Great name. One tried to capture the anomaly for the s and P NSPY and the other one for the Russell 2000 Small Cap Index. Sadly, they didn't outperform during the short period while they existed and they were closed down in 2023.
[29:47]
B
It's a story as old as time though, isn't it? Rominous? The moment you launch funds to try and benefit from these weird things in markets, the markets turn against you.
[29:56]
A
Yeah, that one was a real pity. I was so much looking forward to tracking that anomaly and seeing whether it grew larger or smaller over time. But unfortunately the ETFs are gone. I wonder what would have happened if they carried on existing. I wonder if someone's done that calculation. I certainly haven't found it.
[30:13]
B
Well, it was never going to carry on existing when the S and p had gained 15% year on year, but the nightshares fund was down 3%. People pool their money pretty quickly when that happens. The CEO of the fund told ETF.com that the underperformance was due to colossally unlucky timing. Right. Presumably that's what it is, unless they really messed up their implementation of it. Yeah, he went on. It just turned out that the day has been performing well of late and certainly better than the historical period that we've seen.
[30:51]
A
I guess with the introduction of 24 hour trading, this is an anomaly which will become irrelevant anyway.
[30:57]
B
Shall we just wrap up then with my candidate for the biggest anomaly of all? When you look at economic models and what's actually happened in the past, and this is the seemingly straightforward question of why do bubbles exist at all?
[31:14]
A
Yeah, because if we were rational, what we'd say is, well, we all know that the price is too high and if I'm looking for a greater full, maybe they don't exist so I should never buy in the first place.
[31:27]
B
And it seems that pretty much every asset class is susceptible to bubbles, which suggests it's more about human behavior than it is about the mechanics of any individual market.
[31:39]
A
Now, you might think this is to do with imperfect knowledge. If we knew exactly what something was worth and we had a perfect discounted cash flow model, then these bubbles would never happen, right?
[31:51]
B
Well, it would make sense, but that seems to have been conclusively disproved in the lab. So there have been various experiments over the years where economists have sat a load of people down in a room and given them fictional assets with exact values and precise cash flows into the future and got them to trade them. And even in these experiments designed to eliminate bubbles, massive bubbles emerged around two thirds of the time, followed by a huge crash as it got near the end of the experiment. And People realized that the paper they were holding was worth what it said on the paper.
[32:33]
A
And what was interesting is the only thing which made people stop creating these bubbles was experience. So only by going through this bitter experience did the participants in the experiment learn that it's not a good idea to trade in such a way as to create a bubble. So markets only learn by crashing.
[32:54]
B
And there are various reasons proposed as to why bubbles might happen. One is that bubbles are in a way rational when you look at it from the point of view of an individual. Because everyone knows it's overpriced maybe, but expects to be able to exit before the crash. So they think they can profit from the bubble. And obviously if everyone thinks that the bubble gets bigger until everyone runs for those exit doors.
[33:20]
A
And again, there's a psychological reason why this happens. We just extrapolate short term trends. So shares have been going up, they'll carry on going up. That's the really naive way that people approach these things.
[33:33]
B
And Farmer's point to give him the last word is that the whole idea of bubbles is kind of meaningless. He doesn't recognize this as a real counterexample to efficient markets because he says it's impossible to identify bubbles in advance. Sometimes things have looked like bubbles and then turned out to be prices correctly anticipating where earnings will go in the future. But then again, he and Robert Shiller shared a Nobel Prize for their opposite views on this, which I think tells you a lot about the state of economics.
[34:05]
A
Historically, it was only me providing coaching one to one. But we now have Mark Howell who also does this. He's a recently retired chartered financial planner. He's got decades of experience in personal finance and he's now available to you. So if you're interested in learning more about that and booking an hour with Mark, just go to pensioncraft.com coaching to learn more.
[34:28]
B
Okay, today's dumb question of the week. If nobody can explain why stocks beat bonds, why are we confident they'll keep doing it?
[34:38]
A
I think the important point here is about horizon. There have been periods of time when bonds have beaten stocks. That's happened many times in the past. But the longer the horizon you look at, the less likely it gets. But as you've seen, there is no absolute reason to expect that the risk premium will carry on being as high as it's been historically. So let's say that it halved tomorrow. Would that be a shocking thing? No, because we can't really explain why it was so high in the past. And if that did happen, well, suddenly bonds would look much more attractive relative to stocks.
[35:11]
B
I do find it troubling that no one can really explain decisively why stocks have outperformed by so much. Because if you can't explain why, then you don't really know what conditions it's founded on and whether those conditions are still there.
[35:26]
A
I know that stocks certainly build in a lot of leverage. So if interest rates are low, you'd expect the leverage to give a bigger boost to the overall profits of the company and also its stock growth. So maybe if we're entering this higher interest rate regime, which we clearly are, then there's not going to be such great returns for stocks in the future while that remains.
[35:48]
B
And you can find serious people forecasting that bonds might beat stocks over the next decade.
[35:56]
A
Yeah, Goldman Sachs, for example.
[35:59]
B
I said serious people.
[36:04]
A
Oh dear.
[36:05]
B
But in a way, that's why we get paid a premium for holding stocks. Maybe the answer to the equity premium puzzle is that they pay you very well precisely because there are decades when they don't pay you at all.
[36:20]
A
Yeah, certainly looking at single countries, that's been the case. If you look broadly for a global index, it's been very unusual for that to happen. But single countries. Oh yeah.
[36:30]
B
But the world would look very different if the premise of this question somehow proved true. And in a hundred years time stocks in the aggregate had massively underperformed. That would be a very, very different world to the last hundred years.
[36:46]
A
But I think this is like looking at global temperature records. You do see these changes, but they occur very gradually. And I think one of the drivers behind this one might be things like demographics. If we do have an aging society and the earth's population starts to stabilize, well, yeah, you could have a case where you can't sell more stu because there aren't more people to sell it to. In which case bonds might become more attractive.
[37:13]
B
I guess to get a massive regime change where stocks shift from the best asset class to one of the worst ones, you would need something that was fundamentally important to stocks returns in the past, even if we didn't know it, which was now heading in the opposite direction. Obviously that could be demographics. We haven't seen a period of shrinking global population before, certainly not in the modern era.
[37:40]
A
Now, bond returns could well go down as well because if GDP growth is lower, then long term yields would also start to fall. So I don't think anything would be immune any returns from this global slowdown in growth. But on a relative basis, the equity risk premium I'd expect would then shrink and and then, yeah, you'd have a bigger allocation to bonds in your portfolio.
[38:04]
B
All you can really do is hold a diversified portfolio and cross your fingers that the future looks something like the past. Thank you for joining us for Many Happy Returns. Keep sending us your questions, no matter how dumb, @mhrtioncraft.com and do remember to
[38:21]
A
check out pensioncraft.com for all the information about our membership courses and investment coaching options.
[38:28]
B
Many Happy Returns is a Pensioncraft production co hosted and executive produced by Romin Nikiza and Michael Pugh. This podcast is for informational and entertainment purposes and is not financial advice. We do not provide recommendations or endorse any decision to buy, sell, or hold any security. We cannot be held responsible for any actions listeners may take and investors are encouraged to seek independent financial advice.