Recent Quotes and News Clippings About My Research

Forbes, January 22, 2001 "Forget the Spread"
The Economist, December 19, 1998 "Shares are the Best Long Term Investment"
Businessweek November 9, 1998 "The Gurus Speak"
The Economist, August 22, 1998 "Hedge funds. Heroes or villains?"
The New York Times September 6, 1998""More Proof For the Dow Theory"
Real Audio of NPR Morning Edition 9/29/98Snigdha Prakash on The Bailout of Long Term Capital
Real Audio of NPR Morning Edition 9/08/98Snigdha Prakash on the losses at Long Term Capital
The Economist, July 18th, 1998 "Stockmarkets: The Equity Premium Puzzle"
Smart Money, July, 1998, "Good Timing,"
The Wall Street Journal 6/23/98"Keeping Tabs on Your Portfolio is Vital"
Forbes, April 6, 1998"The Dow Theory Still Lives"
Barrons On-line, February 26, 1998 "For Hedge Funds, Performance Doesn't Count"
Kiplinger's Personal Finance Magazine, March 1998, "The 7 Deadly Sins of Investing"
The Wall Street Journal 10/17/97, "Stocks Have Drubbed Bonds Historically, But Not All Investors Have Caught On"
Dow-Jones Asset Management September, 1997 "Footprints in the Global Sands"
International Herald Tribune, May 31, 1997 "For Many Investors, to Deny That You Err Is Human"
Forbes, June 12th, 1997, "History, as written by the winners" Forbes layout
Forbes, May 19th, 1997, "How now, Dow"
The Wall Street Journal 4/22/97(C1), "Risk-Adjusted Investment for the Meek: Making a Case For the Dow Theory"
Sound Money, 3/16/97, NPR "GO ABROAD, WARILY"
Reuters Financial Service 2/20/97 "Bad Data May Mislead Emerging Market Investors"
The Christian Science Monitor 2/3/97 "Ivy League Graduates Manage Money Better"
U.S. News and World Report, 2/3/97 "First, Pop the Hood: A fund's name may tell you nothing about how it acts"
The Wall Street Journal 5/28/96(2), "Going Global"
The Wall Street Journal 5/28/96(1), "Different Drummers"
USA Today (Magazine), January, 1996 "Has your mutual fund changed its personality?"
Businessweek 5/6/96 "Fixing Fidelity"
Forbes 2/96 "Absolutely No Guarantees"
Forbes 12/95 "Auctions on the Internet?"
Forbes 11/95 "Annual Reality Check"
Money 10/95 Why mutual fund investors need a truth-in-labeling Law
The Wall Street Journal 10/95 "Investors Stick With Duds to Keep Illusion "
The Economist 9/95 "Taking stock of history."
The Economist 7/95 "A question of style: mutual funds."
New York Times 3/95 "Funds watch: History repeats "
Worth Magazine 3/95 "The Mutual Fund Shell Game"
The New York Post 1/95 "Museums Take Their Artworks to Cyberspace"
The Wall Street Journal 1/94 "Savvy Mutual-Fund Investors Can Be a Bane to Some Brokers "

Three: Shares are the best long-term investment

THIS year's ups and downs in the world's stock markets have reminded investors that share prices can fall as well as rise, but has done little to dent the underlying cult of equity. With one voice, experts in Wall Street and the City of London have oozed reassurance. Sure, share prices may be a roller-coaster ride in the short run. But in the long run, their direction is clearly up. For anybody who is investing for the relatively distant future, especially those with retirement in mind, shares are best.

Nobody claims that this golden rule holds true for any individual company's equity. Buying a share in a company that underperforms or even goes bust would clearly be a lousy investment. But, the argument runs, such firm-specific risks evaporate when the investor holds a diverse portfolio of shares. Jeremy Siegel, an economist at the Wharton School, summed up the conventional wisdom in a book, "Stocks for the Long Run" (Irwin, 1994). Between 1802 and 1992, he calculated, investing in the American stockmarket generated a real return of nearly 7% a year on average. Long-term American government bonds produced an average real annual return of 3.4% in the same period; gold produced a mediocre real return of one-tenth of one percent a year. Even more impressively, says Mr Siegel, "one has to go back one and a half centuries, to the period from 1831 through 1861, to find any 30-year period where the return on either long- or short-term bonds exceeded that on equities! The dominance of stocks over fixed-income securities is overwhelming for investors with long horizons."

But how reliable is the past performance of shares as a guide to what will happen in future? Will Goetzmann, an economist at Yale, points out that by focusing only on the American stockmarket, Mr Siegel has chosen a sample of data that is likely to give misleadingly impressive results. During the past couple of centuries, the American stockmarket has far outperformed other stockmarkets. Indeed, in that time, many stockmarkets have gone out of business entirely, due to revolution, nationalisation or financial collapse. When Mr Goetzmann (with Philippe Jorion, an economist at the University of California, Irvine) looked at 38 other stockmarkets since the 1920s, including many that were closed for part of that period, the average real annual returns on them were just 1.5%. The high premium of American equities appears to be the exception rather than the rule, he concludes.

In the long term, most economists would expect equities to earn some sort of premium over bonds. They are riskier than bonds, and according to mainstream economic theory risky assets have to offer investors a higher average return. The trouble is, as Keynes observed, that in the long run we are all dead. For practical purposes, the crucial question is whether Mr Siegel's observation that stocks outperform over a 30-year period can be relied upon in future. Unfortunately, points out Michael Brennan, an economist at UCLA, there have not been enough distinct 30-year periods to draw cast-iron statistical conclusions.

Even unlimited data might not be enough. Analysing stock prices is not a scientific task like, say, measuring the behaviour of steel at different temperatures--or even, though it is far more complex, studying and forecasting the weather. Share prices are the product of human opinions, which can be changeable and irrational. Some economists reckon that several human psychological biases mean that shares are more likely to be undervalued by most people compared with bonds, and so the wise, long-term investor should buy as many of them as possible. But humans are also quite capable of bouts of excessive optimism about the value of an investment. And sometimes this can take hold in a large enough part of the population to move prices well above anything that makes sense in terms of fundamental valuations. History is littered with financial bubbles.

The fact that shares--in America, at least--have performed well over long periods in the past does not mean that a bubble could not push prices to levels that, once it bursts, would not be reached again for decades. Japanese shares are currently worth less than half in real terms what they were at their peak in 1989. Who would bet on them ever being worth as much in the foreseeable future as they were then? In America, it was not until the late 1950s that the Dow Jones Industrial Average returned in real terms to the value it enjoyed immediately before the stockmarket crash of 1929. More recently, after peaking in the mid-1960s, the Dow lost two-thirds of its value in real terms by the mid-1970s, and did not achieve a new real high until 1994. Neither of these periods were quite long enough to pass Mr Siegel's 30-year test--but to investors stuck in the market, they must nevertheless have seemed like a lifetime.
Businessweek November 9, 1998 "The Gurus Speak"
SECTION: SPECIAL REPORT; Cover Story: THE PROS; Number 3603; Pg. 134 E2

LENGTH: 2414 words


HIGHLIGHT: Four experts reflect on the market turmoil and share their counsel

BODY: How are the pros playing this turbulent market? To get some answers, Contributing Economics Editor Christopher Farrell talked with Fiduciary Trust Co. International President Anne Tatlock, Sit Mutual Funds President Mary Stern, and two leading academic market watchers, Jeremy J. Siegel, finance professor at the Wharton School, and William N. Goetzmann, professor of finance at the Yale School of Management. ...


Unlike a lot of other economists, William N. Goetzmann of the Yale School of Management doesn't see a single trigger for a world slowdown. ''It's part of a long-term fluctuation in the global economy,'' he says. Nonetheless, Goetzmann, 43, worries that the crisis affecting Asia and other emerging markets could be different from those of the recent past. ''The threat is not short-term stuff, like default on debt, but revolution that will stop the global expansion of capital,'' he says.

What Goetzmann sees makes him wary of the world's emerging stock markets, feelings are behind this position: He is an authority on global stock market trends. For example, a paper he recently co-authored with Philippe Jorion, ''A Century of Global Stock Markets,'' constructed inflation-adjusted indexes, excluding dividends, for equity markets in 39 countries, including Germany, Japan, Portugal, and Peru. The paper (available on the Web at viking.som. showed the U.S. is the exception among markets too often wracked by financial crises, political upheavals, expropriations, and wars. Indeed, the U.S. recorded by far the highest uninterrupted inflation-adjusted rate of return, 4.73% a year, between 1921 and 1996. In sharp contrast, the median real appreciation rate for the other countries was only 1.5% annually.

Goetzmann says the data shed light on whether investing internationally pays. Many pros believe that adding international stocks or funds to your domestic equity holdings will reduce your portfolio's overall volatility over time. Goetzmann concedes that point but maintains it's oversold. His and Jorion's data show there is no sure way to hedge against a really big crisis. That was the case during the oil crises of the 1970s and 1980s, as well as the Persian Gulf war in the early '90s and the global financial upheaval of 1998.

Goetzmann says emerging economies' bourses are the ones to watch for signs of broader global trouble. While they thrive when the global economy is on an upswing, they're the first to get hit by slumps. That is why he invests his own money in a core group of countries, including the U.S., Britain, and Japan, where investors have well-established legal rights. By contrast, ''I would be concerned about East Asia, or anywhere [else] governments are trying to balance the desires of global investors and the needs of citizens.'' Like many finance professors, Goetzmann views market shocks as beneficial because they can teach people about their willingness to absorb risk. The trouble is, as markets become more interlinked, there is no safe haven. Yes, you should invest in equities for the long term. But even if you think you are well-diversified, you'll face some scary global market crashes along the way.

Hedge Funds. Heros or Villains?

Matthew Bishop

THE super-rich are different from other investors, and not just because theyhave more money. They alone are able to invest in hedge funds, those mysterious vehicles that seem to take the blame whenever a currency crashes or, as in Hong Kong, a stockmarket falls (see following story). Now, the merely rich want tojoin in, prompting every big Wall Street firm to investigate getting into thebusiness. The result may be disappointment. There are good reasons to thinkthat the impressive results hedge funds have produced were possible onlybecause the amount ofmoney invested was relatively small. Expansion may wellrob them of their magic.

The industry is growing fast. According to TASS, a consultancy, there are nowabout 4,000 hedge funds, more than double the number two years ago. Their assetsunder management have soared from under $ 150 billion in 1996 to an estimated $ 400 billion. This growth rate may accelerate, judging by the interest now being shown by institutional investors, such as pension funds, and stockbroking firms such as PaineWebber, which last month launched its first hedge fund.

The appeal is hedge funds' superior returns. A recent study by Goldman Sachs,an investment bank, and Financial Risk Management, a consultancy, found that,over the past five years, hedge funds earned far more, adjusting for the amount of risk taken, than more conventional investment vehicles. On average, fundswith an equity focus matched the S&P 500-share index with lower volatility, and did better than the index during periods when share prices fell more than 3%.

This sort of performance looks even better now that America's stockmarketsseem to have cooled. Those financial firms that prospered during the bull marketare urgently looking for ways to make money if shares stop going up, or, evenworse, slump. Hence the interest in funds that typically aim to make moneyregardless of the direction of markets, often by borrowing money to placeleveraged bets and by selling securities they do not own in anticipation ofprice falls. These are now being pitched to relatively low-brow customers.Paine-Webber's new hedge fund, for example, requires a minimum investment ofonly $ 250,000. By traditional hedge-fund standards, that is small change.

But hedge funds may not perform so well in future. Hunt Taylor, of TASS,points out that, except for 1994, the past few years have been a benignenvironment for hedge funds, many of which have made most of their profits from rising share prices. Whether these funds will be able to prosper in a bearmarket is uncertain: 1998 is starting to develop into a "difficult year". Hedge funds betting on mortgage-backed securities, emerging markets and commoditieshave been hurt. According to Mr Taylor, on average funds were up around 2-3% in the first half of this year, compared with around 10% at the same point in 1997.

There may now be too much money chasing too few profitable opportunities,says Will Goetzmann, an economist at Yale University. Many of the best-knownfunds seem to have concluded as much, and have returned money to investorsduring the past year. The much-admired Long Term Capital Management fund handed back almost $ 3 billion last September.

Why? One reason is that many hedge funds have drawn much of their profit fromarbitrage--spotting apparently unjustified differences in prices of assetswith similar risks andbetting that the prices will revert to their normalrelationship. Yet there may be only limited opportunities for arbitrage, so thatwhat is profitable on a small scale becomes much less profitable as the betgrows and more funds are involved. To earn the outsized returns hedge funds are known for, the new funds' managers may need to take more risks than their eager investors are expecting.

"More Proof For the Dow Theory"

The New York Times 9/6/98

Mark Hulbert

ON Aug. 5, early in a frenzied month for the stock market, there were no apocalyptic headlines heralding the significance of the 299-point drop the previous day in the Dow Jones industrial average. But there should have been. and William Goetzmann and Alok Kumar of Yale. They utilized neural networks -- artificial-intelligence software adept at pattern recognition -- to analyze Hamilton's work, examining chart patterns of the industrial and transportation averages before each of his buy and sell signals between 1902 and 1929. Then the professors analyzed the averages since 1929 in Hamiltonian terms to see where his buy and sell signals would have fallen if he were still alive. The results, published in the summer issue of the Journal of Finance, are astounding. A portfolio that followed the theory's signals from 1929 until today, buying and selling shares in a hypothetical index fund with no transaction costs, would have outperformed a simple buy-and-hold strategy by about two percentage points a year. But there's more. The theory-guided portfolio would have incurred one-third less volatility, or risk, than the market itself. That's a particularly potent combination. All well and good, but what if you can't load the latest artificial-intelligence software on your PC? Don't despair: Several investment newsletters are good at the pattern recognition needed to apply the theory. Mr. Russell's Dow Theory Letters has the best record among devotees of the theory tracked by the Hulbert Financial Digest. Mr. Russell's timing lagged behind a buy-and-hold system over the last 18 years by an average of 2.6 percentage points a year. But his advice was so much less risky than the market itself that, on a risk-adjusted basis, he actually beat a buy-and-hold strategy. Granted, trailing the market by 2.6 points a year may not seem all that alluring. But Mr. Russell's experience is right in line with what the professors found in their 70-year test: The Dow theory beats the market by the greatest margin during bear markets and shows least favorable results during bull markets. The theory is quite conservative -- willing, essentially, to leave a bit of money on the table in return for not getting caught holding the bag. How long will this bear market last, and how deep will it go? Alas, Hamilton himself said his theory was silent on that issue. But Mr. Russell is willing to venture that this one could be very severe indeed. "Every primary bear market in history has wiped out at least half of the preceding bull market's gains," he said. "I mark this great bull market as having started in 1974 at Dow 577, with the recent high this year at Dow 9,337. If the Dow was to wipe out just half its 1974-98 gains, the Dow would decline to 4,960 or lower." One reason that academics of years past so readily dismissed the theory is that it was subject to endless interpretation and revision. How long and deep a correction is necessary to set up the conditions for a sell signal? How much time should the averages be given to surpass pre-correction highs? Unfortunately, Hamilton wrote in editorial-page prose, not detailed explanatory text. Academics dismissed the theory as no more helpful than tea leaves. THIS deficiency was overcome recently by Stephen Brown of New York University and William Goetzmann and Alok Kumar of Yale. They utilized neural networks -- artificial-intelligence software adept at pattern recognition -- to analyze Hamilton's work, examining chart patterns of the industrial and transportation averages before each of his buy and sell signals between 1902 and 1929. Then the professors analyzed the averages since 1929 in Hamiltonian terms to see where his buy and sell signals would have fallen if he were still alive. The results, published in the summer issue of the Journal of Finance, are astounding. A portfolio that followed the theory's signals from 1929 until today, buying and selling shares in a hypothetical index fund with no transaction costs, would have outperformed a simple buy-and-hold strategy by about two percentage points a year. But there's more. The theory-guided portfolio would have incurred one-third less volatility, or risk, than the market itself. That's a particularly potent combination. All well and good, but what if you can't load the latest artificial-intelligence software on your PC? Don't despair: Several investment newsletters are good at the pattern recognition needed to apply the theory. Mr. Russell's Dow Theory Letters has the best record among devotees of the theory tracked by the Hulbert Financial Digest. Mr. Russell's timing lagged behind a buy-and-hold system over the last 18 years by an average of 2.6 percentage points a year. But his advice was so much less risky than the market itself that, on a risk-adjusted basis, he actually beat a buy-and-hold strategy. Granted, trailing the market by 2.6 points a year may not seem all that alluring. But Mr. Russell's experience is right in line with what the professors found in their 70-year test: The Dow theory beats the market by the greatest margin during bear markets and shows least favorable results during bull markets. The theory is quite conservative -- willing, essentially, to leave a bit of money on the table in return for not getting caught holding the bag. How long will this bear market last, and how deep will it go? Alas, Hamilton himself said his theory was silent on that issue. But Mr. Russell is willing to venture that this one could be very severe indeed. "Every primary bear market in history has wiped out at least half of the preceding bull market's gains," he said. "I mark this great bull market as having started in 1974 at Dow 577, with the recent high this year at Dow 9,337. If the Dow was to wipe out just half its 1974-98 gains, the Dow would decline to 4,960 or lower." Those would be sobering words coming from any adviser. They're especially so coming from Mr. Russell, who has been editing his newsletter since 1958 -- longer than many mutual fund managers have been alive. And his warning becomes especially compelling now that the Dow theory enjoys newfound academic respectability.

"Keeping Tabs on Your Portfolio is Vital"

, The Wall Street Journal 6/23/98

Getting Going

Jonathan Clements

KeePing Tabs on Your Portfolio Is Vital If you are so smart, why aren't you rich? Many investors think they are pretty astute at picking mutual funds, selecting individual stocks and calling market turns. Yet a lot of these folks don't know for Sure, because they don't track their portfolio's performance. "There are studies that show that people think their returns are higher than they really are," says Jerry Tweddell, an investment adviser in Sonora, Calif. By keeping close tabs on your portfolio, you can figure out whether your investments are paying off-or whether you should sell some laggard securities and maybe even change strategy. "It's difficult to do a precise measurement," Mr. Tweddell concedes. "But most people don't measure at all. If you monitor your performance and you're under-perform- ing the index, it's pretty foolish not to throw in the towel and buy index funds" that simply seek to match the results of the market averages. Here are some tips for, king your portfolio's progress

Measuring Your Mutual Funds
William Goetzmann, a finance professor at Yale University's School of Management, has studied how investors perceive their mutual- fund results. "Investors take a rosy view," he says. "What I've found is that even relatively sophisticated investors not only overestimate the returns of their funds, but they also overestimate the returns relative to a benchmark," such as Standard & Poor's 500-stock index. Mr. Goetzmann posits that investors typically prize the investments they already own and tend to ignore information that suggests they made a bad choice. "Make sure that you really look at the performance of your funds on a regular basis," he advises. "If a fund's been under- performing for two or three years, there's good reli son to get rid of it." Don't, however, compare all your stock funds to the S&P 500. That may be a good choice for funds that specialize in larger U.S. stocks. But if you own small-stock or foreign-stock funds, track their performance relative to similar funds or an appropriate market index. These days, that is easy to do. Many newspapers and personal-finance magazines offer regular updates on fund per fortunately, these "total return" results aren't readily available for individual stocks. The Wall Street Journal publishes this information for 1,000 stocks, but only once a year, in its Shareholder Scoreboard special supplement in February. How should you use the Scoreboard? While you might want to dump a fund that regularly lags behind an appropriate benchmark index, that is not the case with individual stocks. Indeed, lackluster performance may be the prelude to brilliant returns. On the other hand, if most of your stocks lag behind the market averages, it is a clear indication that your stock-picking prowess leaves something to be desired. "It's time to try your hand at mutual funds," suggests John Markese, presi dent of Chicago's American Association of Individual Investors. vestors. Roman Scott a Measuring Your Market Bets Some folks flit between stocks and conservative investments in an effort to catch bull markets and sidestep stock-market declines. If you are in this camp, make a point of writing down the current level of the Dow Jones industrials or the S&P 500 every time you make one of these portfolio shifts. Was the market higher or lower when you got back into stocks? If you turn out to be the world's first market forecaster with a working crystal ball, keep at it. If not, do your finances a favor and call it quits.

Tracking a Portfolio's Performance Many investors fixate on the performance of one or two investments and end up with a skewed impression of how their whole portfolio is really doing. Want a more accurate picture? Tote up your portfolio's value at the beginning and end of each year, Mr. Markese says. Next, adjust these two numbers for the amount you added or withdrew from the portfolio. If you made additional investments, add half of the amount involved to the beginning balance and subtract half from the ending balance. Conversely, if you withdrew money, subtract half the sum involved from the beginning balance and add half to the end. Finally, calculate the percentage gain or loss over the course of the year. "It's a pretty good approximation," Mr. Markese says. TTqp this fiLyure to Lyet a sense for whether you are earning

"Good Timing" Smart Money July, 1998


A study says Charles Dow's much-maligned theory was actually pretty good.

MARKET TIMERS get no respect. Almost every time you read a money manager interview, there's a quote like this: "We pick stocks. Only fools try to predict the market." Cynical investors even use a composite of market-timer sentiment as a counterindicator--doing the opposite of whatever the sages recommend. Whenever there's a strong consensus that something is hogwash, it's probably worth a second look. So this month I'm going to let you in on a startling discovery. Dow Theory, the market's oldest, most regularly derided timing strategy, really does work-at least according to a study soon to be published in a leading academic journal. In what follows, I'll explain this research and offer a Dow Theory primer. I'll also provide the current stock picks of a 52-year-old newsletter (edited by a thirtysomething University of Chicago M.B.A.) that still treats Dow Theory as gospel. First, some history. In 1896, several years after he co-founded The Wall Street journal, Charles Dow created two stockprice averages, one for industrials and one for railroad companies. Until then, investors had to make do with one average that included both types of companies. By studying his averages, Dow realized that the market's broader trend had a major influence on prices. Dow and his successor, William Hamilton, saw patterns in the early averages and used them as the basis for editorials that predicted market moves. The most famous urged caution just days before the 1929 crash. The core assumption of classic Dow Theory is that a primary trend dominates the market and can last for years. It's possible to predict these bull and bear trends based on close study of the two Dow averages. Two key observations show what missed Dow Theory and its offshoots as bunk. But one day, in Will Goetzmann's investment-management class at Yale, a student asked a troubling question. Had anyone ever used modern statistical techniques to evaluate Hamilton's old recommendations? Goetzmann saw an opportunity-and soon realized that under sophisticated scrutiny, Dow Theory stands up remarkably well. to look for: An extende sideways movement precedes major trend reversals, and a trend won't continue without everhigher highs (or lower lows) in both averages. That's why Dow theorists are troubled that as of late May the Transportations (as the railroad average is now known) haven't "confirmed" the recent records posted by the Industrials. If this sounds like mumbo jumbo, don't worry. In 1934, a few years after Hamilton died, a skeptical economist named Alfred Cowles wondered if the famous 1929 call was just luck. So he took a close look at the predictions in 255 editorials Hamilton had written be d tween 1902 and 1929. Cowles calculated that a Dow Theory investor would have earned an average return of 12 percent for the period, while a buy-and-hold investor would have earned 15.5 percent. From that point on, most scholars dis- Dow's market- timing strategy has beaten the indexes for 100 years. Now it's signalling sell. Should you? The math is off-putting, but Goetzmann's conclusion is inescapable. On a call-by- call basis, Hamilton was right twice as often as he was wrong. And following his advice produced better-than- expected profits from portfolios that were remarkably stable. Sure, Cowles's buy-andhold numbers were winners over the full 27 years. But along the way, Dow Theory was more often ahead than behind- and these superior risk- adjusted returns are what many investors want. The professor was hooked. He recruited two colleagues (Stephen Brown from New York University and Alok Kumar from Yale) and started a high-tech detective project. Since Dow Theory has always been a matter of interpretation, the three academics tried their own version-based on artificial intelligence. First, they wrote a computer program to recognize the patterns that led to Hamilton's original calls. Then they let their machine train itself and turned it loose on more recent data. You probably know what's coming.

"The Dow Theory Still Lives" Forbes, April 6, 1998

Mark Hulbert

THOUGH JOE AND MARY INVESTOR may pay scant heed, the investment community is going to be buzzing about an article that will appear this fall in the nation's premiere academic finance journal. The article concludes-brace yourself-that the ancient Dow Theory actually works. Academic sneering notwithstanding, the theory has been successflilly timing the stock market for nearly 100 years, the authors claim.

The article is "The Dow Theory: William Peter Hamilton's Track Record Reconsidered," by professors Stephen Brown (New York University) and William Goetzmann and Alok Kumar (Yale). It will appear in the Journal ofEinance, but copies of the article are already circulating.

For those who came onto the investing scene in the past quarter of a century or so, the Dow Theory traces its roots to a series of Wall Street Journal editorials that were written between 1902 and 1929 by William Peter Hamilton. It is the oldest technically oriented market-timing system still in use today. A keystone of the theory is that if both the Dow Jones industrial and the Dow Jones transportation averages are in sustained uptrends, a market rise will continue. If the averages diverge, trouble lies ahead. Thus, if both averages had been declining and suddenly one of the two begins to rise, a bull market might lie ahead.

Though the theory doesn't have the following it once had, true believers still exist-and the forthcoming article will give them new prestige.

Take what happened m the market last fall. Even though the was rallying to record highs, the stubbornly failed to eclipse its previous high, set on Aug. 6, 1997. Noting the divergence, Dow theorist Richard Russell of Dow Theory Letters forecast market weakhess. Thus he was not surprised by the October crash.

That was fairly clear-cut, but it is not always easy to know what constitutes a significant divergence. Hamilton never codified the theory into a set of unambiguous rules. This has precipitated endless debates about what Hamilton really meant. In their

forthcoming article the professors demonstrate a way of resolving these debates. They used state-of-the-art artificial intelligence software to identily the precise technical trading patterns associated with the buy-and-sell signals Hamilton issued with his editorials. The software then applied those patterns to subsequent markets.

The study found that there was real merit in Hamilton's theory. Over the nearly 70 years since Hamilton's death, a portfolio that followed the signals identified by the software, using an index flind with no transaction costs, would have outperformed a buy-and-hold strategy by about two percentage points per year. In addition, such a portfolio would have incurred one-third less volatility (the professors' proxy for risk). That's a winning combination.

What does the profrssors' Dow Theory model say about the stock market right now? It recently issued a buy signal, following several months in cash in the wake of last fall's divergence. This illustrates how conservative the Dow Theory is: Hamilton was willing to leave the party early in return for not getting caught at the exit.

The professors found that their Dow Theory portfolio beat the market most handily during such bearish decades as the 1970s and the 1930s. It showed the least favorable results during strongly bullish decades such as the 1980s and the 1990s.

A similar pattern emerges from Richard Russell's Dow Theory Letters. Since 1980, according to the Hulbert Financial Dzgest, a portfolio that switched in and out of the market on Russell's signals would have lagged a buy-and-hold by about 2.7 percentage points per year. Not surprisingly, many investors have grown disillusioned with this market-lagging performance. They forget that Russell's portfolio also was 35% less risky than the market as a whole. On a risk-adjusted basis Russell beat the market.

Sooner or later, of course, the bull market will end. When it does, I suspect the Dow Theory will become popular again. In the meantime, the professors' Dow Theory model is on a buy signal.

"The 7 Deadly Sins of Investing"

Robert Frick

You know that greed and sloth can do you in. But pride? Lust? Envy? Anger? Gluttony? They, too, can ruin your portfolio. If you want to irk a financial planner, try this: Don't take money out of your fat savings account to pay off credit card bills. It drives planners nuts. Of course, you're making only 4% on your bank account and paying perhaps 18% on your credit cards. So paying off those credit cards is like earning an instant 18% on your money. Wasting that kind of money is, well, a sin. But planners report that not taking that simple step is a common problem with clients, and one that's not easy to fix. "You can run charts, show the numbers, spin around in your chair and stand on your head," says New York City financial planner Gary Schatsky. "But some people won't budge." No doubt about it: We have all sinned and fallen short of financial perfection. And, as Schatsky points out, rationality often isn't enough to make us break bad investment habits. What may help is understanding some solid (though subliminal) psychological and emotional reasons we perpetuate the credit card paradox and other seemingly irrational--even ridiculous--ways we handle money. For example, consider the following scenarios that help explain the credit card conundrum: You travel to the theater with a $40 ticket in your pocket. At the box office, you discover the ticket is missing and that to buy a new one will cost another $40. Do you do it? Or this: You were planning to buy a ticket once you got to the theater, but when you open your wallet at the box office, you discover you are missing $40. Do you still buy the ticket? If you decide to see the play, the result is the same in either case--at the end of the evening your wealth will have been reduced by $80. But while almost 90% of people say they would buy a ticket after having lost $40, fewer than half as many would replace a lost ticket by spending another $40. The reason for the discrepancy is that we separate money into "mental accounts," according to the late Amos Tversky, one of the fathers of "behavioral finance," which studies how our quirks and predilections affect our investing. So in the case of the lost ticket, the $40 it cost represented a debit to the "theater account," and an extra $40 for a new ticket would have meant spending $80 in total on the play. However, losing $40 cash is for most of us a debit from another mental account, so the cost of the play would still be just $40. In the same way, we may separate our "credit card" from our "savings" mental accounts. Hoarding money in a savings account can be a deadly financial sin, akin to gluttony, because it represents an unrestrained desire for an asset that isn't being put to its best use. For Schatsky, the first step toward repentance is to acknowledge that your hoarding is actually costing you money. "Only when someone will say to me, 'I know that costs me $1,000 a year,' will I rest," he says. Gluttony is but one of the Seven Deadly Sins passed down to us from the Catholic Church of the Middle Ages. We've also found financial parallels to the other six. Avoid all of them and you just might be able to keep your portfolio out of purgatory.


As this sentence is being written, some colleagues sit at the corner Starbucks checking $130 worth of lottery tickets bought in a pool in the hope of hitting a $48-million pot. Now if anyone should know better, it's a pack of personal-finance journalists. But sometimes the lure of a big score just cannot be resisted. The reason is that it's human nature to overweight low probabilities that offer high returns. In one study, subjects were given a choice between a 1-in-1,000 chance to win $5,000 or a sure thing to win $5; or a 1-in-1,000 chance of losing $5,000 versus a sure loss of $5. In the first case, the expected value (mathematically speaking) is making $5. In the second case, it's losing $5. Yet in the first situation, which mimics a lottery, more than 70% of people asked chose to go for the $5,000. In the second situation, more than 80% would take the $5 hit. If like many people you can resist anything but temptation, the answer may be to limit your "mad money" by setting up a small, separate account for such things as trading speculative stocks. To limit completely irrational risks, such as lottery tickets, try speculating only with money you would otherwise use for simple pleasures, such as your morning coffee. If you buy it at Starbucks, that can add up to a hefty sum--but you won't bounce the mortgage check.


In hindsight, it's easy to see that no matter how lovingly you waxed your first car or upholstered the dashboard, it was, in fact, a heap. Yet at the time you truly cherished that pile of corrosion. In the same way, we tend to let pride of ownership inflate the value of our investments. For example, researchers gave a group of volunteers a coffee mug and asked them to write down their lowest selling price for it. Other volunteers were asked to write down the highest price they'd pay for the mug. Because both groups were chosen at random, you'd expect some commerce. But very little took place because sellers priced the mugs at $5.75 on average, and buyers at $2.25.

In investing, this so-called endowment effect leads us to value our own investments more highly than the market does. Some who fall prey to it hold on to securities too long and don't sell when the market is telling them to bail or to seek new and better opportunities. One solution is to set limits when you first purchase a security--such as a stop-loss order, which will sell a security automatically when its price falls to a certain level.

Dovetailing with this pride of ownership is the tendency to fall in love with companies you may feel particularly proud of or are familiar with. A study done by Gur Huberman, a finance professor at Columbia University, looked at investment patterns of the regional Bell holding companies, commonly called the Baby Bells. In all but one state, his study found, people tend to hold many more shares of the closest Baby Bell than any of the others--an average of $14,400 worth of the local, versus $8,200 for the others. Every parent thinks his or her baby is the prettiest, but not all of them are correct. Likewise, not every Baby Bell investor who believes his or her stock to be the best can be correct. Huberman says that while Baby Bells nicely make the point, a more depressing example is lopsided 401(k) portfolios. According to the Profit Sharing/401(k) Council of America, the average investor's defined-contribution plan has about 24% of its assets in company stock; for employees of the largest public companies, the amount is about 40%. Huberman says that while the risk "may not be huge" in choosing to invest in one phone company versus another, concentrating so much of your net worth in one stock is unwise. We're not suggesting that the hundreds of Microsoft and Intel employees who became millionaires by owning an inordinate number of shares of their companies were stupid. But if you feel your company is rocketing along a similar trajectory, just remember that fate is fickle when dealing with pride. Could you get by--could you achieve your goals--if the stock you own in overabundance were to lose three-fourths of its value?

Penance, in this case, is doing a thorough job of comparing companies close to home with their peers in other parts of the country. And in the case of your 401(k) account, unless you have strong, logical reasons for holding a large percentage in your company's stock, don't let it dominate your assets.


Temptation leers at us from so many sources today: the Internet, new TV channels, new magazines, to name a few. We're not talking about smut, but financial information. "I think we're bombarded with news," says Needham, Mass., financial planner Constance Barber, a former psychologist who thinks this overload of stock prices, economic reports and flashy business programs gives investors itchy trigger fingers when buying and selling investments. Compounding this overload is a tendency by many investors to lust after even more tidbits of undigested information. Thus, they jump into or out of a stock when the latest blip doesn't have anything to do with the long-term health of the company. Terrance Odean--an assistant professor of finance at the Graduate School of Management at the University of California at Davis who has studied the trading patterns of individual investors--suggests two strategies to combat snap decisions: One is buy and hold, while remembering the reasons you bought. The other is, "Don't open the paper." Personally, Odean says, he hasn't checked the price of a stock mutual fund he has in an IRA in about a year. That may be extreme, but weaning yourself from reacting to too much news may save not only time, but dollars and angst as well.


The tendency to want what other investors have can lead you to chase stocks or mutual funds with the biggest recent returns, but that can be a losing strategy. Consider Lexington Troika Dialog fund, up an impressive 68% in 1997. Yet many of its investors actually sent their portfolios to the gulag by chasing the fund's returns, which at one point in 1997 were around 130%. Those investing at the top--before Russia caught a case of the Asian flu--lost almost 50% of their investment. Considering that the fund started late in 1996 and by mid 1997 had assets of more than $200 million, a legion of investors apparently succumbed to its charms. In the case of stocks, a study by three finance professors found that "glamour" stocks, those with the most robust sales growth and highest ratio of price to cash flow during the previous five years, were miserable performers during the subsequent five years, compared with stocks at the opposite extreme. So to buy stocks with the highest past rates of growth and hold them indefinitely may be perilous to your wealth. You'd be better off buying and holding stocks whose past earnings growth was least impressive. The psychological phenomenon here is called "representativeness," or the tendency for us to believe even short-term trends will continue into the future. Overcoming the follow-the-leader mentality is particularly tough because the stocks that brokers promote tend to be the glamour issues, says University of Illinois finance professor Josef Lakonishok, an author of the study. What's worse, even analysts who should know better tend to "extrapolate past performance way too far," he says. If you're blinded by glamour, you might consider tempering your portfolio with a dose of unadulterated value. One mutual fund that fits the bill is Vanguard Index Value fund (minimum initial investment, $3,000; no sales fee; for a prospectus, call 800-662-7447), which is based on the S&P 500/BARRA Value index. That index contains the 250 cheapest stocks in Standard & Poor's 500-stock index based on their ratio of price to book value. Its five-year annualized return to January 5 is 21%. Also, consider Oakmark fund ($1,000; no sales fee; 800-625-6275), which manager Robert Sanborn packs with big-company stocks he figures trade at 60% or less of what they would fetch were the company to be sold in its entirety. Oakmark's five-year annualized return is 23%.


For investors, anger takes a couple of forms, the most damaging of which may be anger with yourself for making poor investment decisions. In psych terms, this is called "aversion to regret" and comes from our irrational tendency to beat ourselves up for making bad decisions. Say you began last year invested in the tried-and-true Fidelity Magellan fund. You'd heard Russia was where the investment action was going to be, so you thought about switching your Magellan money to Lexington Troika Dialog, then decided to pass. Your friend, on the other hand, began the year in the Russia fund, but figured President Yeltsin's health was too iffy and played it safe by switching to Magellan. In 1997 you both would have earned Magellan's respectable 27% and lost out on the Lexington fund's 68%, but your friend would be kicking himself more than you because we regret taking action more than inaction. This often leads to poor investment choices, especially not selling a losing investment. That's because to sell is to admit to a loss--and feel regret. If aversion to regret has you frozen, focus on your portfolio's goals, not on individual investments or what returns others may be earning.


Perhaps the most amazing thing about the Steadman Technology & Growth fund isn't its truly appalling performance--an average annualized loss of 27% over the past five years. The most amazing thing is that $300,000 is still invested in the fund, which points to one of the great mysteries in the mutual fund industry: how consistently bad funds manage to keep any investors at all. Researchers have come up with a number of reasons for such investor inertia--read sloth--ranging from irrational behavior to fear of high transaction costs. But a recent study has shown that mutual fund investors may keep their money in laggards because they can't come to grips with how poorly these funds are performing. A survey of presumably well-informed investors--members of the American Association of Individual Investors--showed that they overestimated the annual total returns of laggard mutual funds by an average of 3.4 percentage points.

The reason, speculates the author of the study, Professor William Goetzmann of Yale University, is something you may remember from your Psych 101 class: cognitive dissonance. Basically, this means we change our beliefs to support past decisions. So in the same way nobody admits the car they bought turned into a financial sinkhole, some people can't come to grips with the fact that the fund they own is a dog, so the dog is never put to sleep. Another reason for inertia is the emotional attachment we may form with a particular stock. Financial planner and psychologist Maury Elvekrog, based in a Detroit suburb, often finds himself in the sticky situation of parting a client from inherited General Motors shares. "They do take it personally," says Elvekrog, even after he tells them that GM's earnings today are "about the same as they were 15 years ago." His advice is a worthy exercise in contrition for all financial sins: "Always look at investments as if you were looking at them from scratch. It's not whether you like something. It's a matter of intellectual evaluation."

For Hedge Funds, Performance Doesn't Count

Howard R. Gold

In the bull market of the 1990s, money managers have become celebrities. And few are more celebrated than the elite group who run hedge funds. George Soros, Julian Robertson and Leon Cooperman generate the kind of awe in some circles that Michael Jordan, Ken Griffey, Jr. and Barry Sanders get in sports arenas. To some people, hedge-fund managers are demigods with guts of steel, making huge bets and winning even bigger for their select group of well-heeled investors. But a recent study by three eminent academics suggests that at least when it comes to performance, hedge fund managers don't outshine your garden-variety mutual fund. In a paper published in 1997 -- and revised for publication again later this year -- Professors Stephen J. Brown, William N. Goetzmann and Roger G. Ibbotson throw cold water on the idea that most hedge fund managers bring something extra to the party. "We find that the average annual return to offshore hedge funds was 13.26% from 1989 through 1995, compared to the S&P 500 return of 16.47% over the same time period," the paper says. "In contrast to the mounting evidence of differential manager skill in the mutual fund industry, the hedge fund arena provides no evidence that past performance forecasts future performanceÖIt is striking to find absolutely no evidence of differential skill among offshore hedge fund managers." The study tracked the performance -- after management fees -- of hedge funds listed in The U.S. Offshore Funds Directory since that guide began publication in 1990. By the end of 1995 that comprised 399 funds with some $40 billion in total capitalization. The database included defunct funds as well as existing ones to eliminate what the academics call "survivorship bias" -- i.e., winning funds stay in business while losers tend to fold their tents. (To see the paper, go to Hedge funds are so elusive that many people can't agree on a definition -- let alone their performance or the actual number out there (estimates range from 400 to 5,000). So, here's our crack at it: Hedge funds are specialized investment vehicles, generally for high-net-worth individuals or institutions, that get certain tax and regulatory treatment and are often headquartered offshore. They typically charge investors 1-2% annual management fees plus incentive fees of 20% of the fund's total return over a certain benchmark, like three-month Treasury bills. According to MAR/Hedge, a New York-based company that follows the hedge fund universe, hedge funds have a wide variety of investing styles, from so-called "global macro managers" (like Soros and Robertson) to those that use conservative hedging techniques to funds that go long and make leveraged bets on stocks and markets. But the definition has been stretched to the breaking point as hundreds of money managers have left "mainstream" firms like Fidelity to start or join hedge funds in the current bull market. How are they doing? By the benchmarks most of us use, not so hot. "They did OK, but they didn't do outstandingly well," says Brown, the David Loeb Professor of Finance at NYU's Stern School of Business, in an interview with Barron's Online. His explanation: hedge funds are becoming increasingly correlated with the markets; most managers don't bring any special knowledge or skill to the table; attrition is high, and, as with most active managers of all kinds, superior performance doesn't persist over long time periods. "Buying any one specific fund is a highly risky venture," he adds. Not surprisingly, some people in the business didn't think much of the professors' findings. "Hedge funds are not supposed to outperform raging bull markets," says Martin J. Gross, who operates a 'fund of funds' out of Livingston, NJ. "Hedge funds are for the absolute-return investor who may not want a lot of risk." "There are 'hedged' funds and there are hedge funds," says Patrick J. Moriarty, partner and senior vice-president for Evaluation Associates Capital Markets, a Norwalk, CT firm that invests over $1 billion in hedge funds. The firm's own index of hedge fund performance, the EACM 100, just about matched the S&P 500's compound annual return from 1990 to 1997, with much lower standard deviation -- a traditional measurement of risk. That's pretty much in line with the professors' findings that all types of hedge funds, except for short sellers, outperformed the broader market on a risk-adjusted basis from 1989 to 1995. "ÖOffshore hedge funds as a group have done relatively well on a risk-adjusted basis," the paper says. So, what does this all mean? First, hedge funds aren't bad investments as a group -- just not as good as most people think they are. Or, as Professor Brown puts it: "They do earn a reasonable return after an appropriate adjustment for risk, but they don't earn the spectacular returns you'd expect." Second, if total return is your game, it's hard for anyone to beat an index fund -- even the smart risk-takers who tend to run hedge funds. But if you want a solid double-digit return at a lower risk than the market, the right hedge fund or fund of funds may be a good idea. Third, the field is getting crowded with hotshot money managers who chafed at the constraints of established organizations and now are looking to swing for the fences. Even Marty Gross and Patrick Moriarty acknowledge that could be a problem. "We've seen very little value in traditional equity managers becoming hedge fund managers," the diplomatic Moriarty says. My translation: the bad money is driving out the good. With at least one notable exception -- George Soros. Even in the professors' study, the legendary speculator stood out as the shining exception to efficient-market mediocrity. Soros's funds boast compound annual returns of 30% for two decades, trouncing the S&P 500, the study reports. Like Peter Lynch and Warren Buffett, Soros stands out as almost a force of nature, a rare investment genius who consistently beats the odds. "George Soros is virtually in a category by himself," the professors write, with obvious amazement. Now just try getting into one of his funds. For more on hedge funds, see "Bucking the Trend," Barron's, February 9th. Howard R. Gold is editor of Barron's Online. You can e-mail him at "Fighting the Tape" appears monthly, usually on Thursday.

Footprints in the Global Sands"

James Picerno

Table 1
Global equity Market Performance
Annual Compound Returns
Country Period Real
North America
U.S.Jan. ∆21 - Dec. ∆954.73%7.37%
CanadaJan. ∆21 - Dec. ∆952.775.07
AustriaJan. ∆25 - Dec ∆951.525.04
BelgiumJan. ∆21 - Dec. ∆95-0.543.30
DenmarkJan. ∆26 - Dec. ∆951.494.94
FinlandJan. ∆31 - Dec. ∆951.946.21
FranceJan. ∆21 - Dec. ∆950.333.81
Germany +1924-19954.468.49
  GermanyJan. ∆24 - Jul. ∆441.653.40
  GermanyJan. ∆50 - Dec. ∆955.7410.84
IrelandJan. ∆34 - Dec. ∆951.134.81
ItalyJan. ∆28 - Dec. ∆95-0.013.01
NetherlandsJan. ∆21 - Dec. ∆951.985.44
NorwayJan. ∆28 - Dec. ∆952.606.02
Portugal +1930-19952.256.55
  PortugalDec. ∆30 - Apr. ∆741.164.96
  PortugalJan. ∆82 - Dec. ∆955.7211.65
SpainJan. ∆21 - Dec. ∆95-2.231.56
SwedenJan. ∆21 - Dec. ∆953.716.56
SwitzerlandJan. ∆26 - Dec. ∆953.036.95
UKJan. ∆21 - Dec. ∆952.281.97
Eastern Europe
CzechoslovakiaJan. ∆21 - Jun. ∆434.39N/A
GreeceJul. ∆29 - Sept. ∆40-5.50-8.08
HungaryJan. ∆25 - Jun. ∆442.80N/A
PolandJan. ∆21 - Jun. ∆39-2.97-3.77
RomaniaDec. ∆37 - Jun. ∆41-28.06-14.64
AustraliaJan. ∆31 - Dec. ∆951.506.38
New ZealandJan. ∆25 - Dec. ∆95-0.473.63
Japan +1921-19953.696.88
  JapanJan. ∆21 -May ∆44-0.34-1.83
  JapanApr. ∆49 - Dec. ∆955.7911.57
IndiaJan. ∆40 - Dec. ∆95-2.011.09
PakistanJul. ∆60 - Dec. ∆95-1.621.97
PhilippinesJul. ∆54 - Dec. ∆950.96-0.72
South America
Argentina +1947-1995-5.36-2.03
  ArgentinaSept. ∆47 - Jul. ∆65-25.09-23.64
  ArgentinaDec. ∆75 - Dec. ∆9516.8122.61
BrazilFeb. ∆61 - Dec. ∆95-0.904.02
MexicoDec. ∆34 - Dec. ∆952.405.96
Chile +1927-1995-2.130.64
  ChileJan. ∆27 -Mar. ∆71-5.37-4.23
  ChileDec. ∆73 - Dec. ∆954.6111.01
ColombiaDec. ∆36 - Dec. ∆95-4.32-1.05
Peru +1941-1995-3.715.06
  PeruMar. ∆41 - Jan. ∆53-11.692.19
  PeruJan. ∆57 - Dec. ∆77-9.71-7.24
  PeruDec. ∆88 - Dec. ∆9535.5060.06
UruguayDec. ∆36 - Nov. ∆442.41N/A
VenezuelaDec. ∆37 - Dec. ∆95-2.60-0.13
Middle East and Africa
EgyptJul. ∆50 - Sept. ∆62-2.82-1.62
IsraelJan. ∆57 - Dec. ∆953.467.59
South AfricaJan. ∆47 - Dec. ∆95 -1.622.02

All 39 countries
14 countries with continuous histories into the 1920s.
Note: + indicates a discontinuity in the series.
Where do you go if you want to rub elbows with the movers and shakers of modern finance? One place is the annual Western Finance Association (WFA) meeting. This year, it was held at the Lowe∆s Coronado Bay Resort in San Diego. A great spot! But with more than 100 papers on finance and economics on tap, finding time to enjoy the locale was a tall order.

An equally tall order was deciding which papers to focus on. So many papers, so little space. But after reflecting on what I heardýmuch of it destined to appear in leading academic and professional journalsýone theme resonated. Global asset allocation strategies look convincing on paper. But what about the real world?

Two papers in particular shed light on that subject. The first examines historical equity premiums in stock markets around the world, utilizing performance data going back to 1921. A key finding: Historical equity premiums (excess returns in stocks over so-called riskless securities, such as Treasury bonds) look far less attractive on a global basis compared to the more encouraging numbers derived by examining a U.S.-only sample.

The second paper should persuade international investors committed to a buy-and-hold strategy to at least take a second look at momentum investing active management. Based on 15 years of data from overseas stock markets, the report found that trading in foreign markets every six months on a top-down basis can add value. Overall, the paper suggests that gains from momentum investing are both significant and recurring.

Equity Premium Puzzle

Perhaps the most pressing challenge in asset allocation is determining the relevance, if any, of historical performance when projecting future returns. The stakes are high. The case for buying stocks at the expense of bonds is easily justified, of course, if investors expect a continuation of the 7.3% equity premium (U.S. large-cap stock returns minus long-term T-bond returns) posted during 1926 to 1996.

According to data from Chicago-based Ibbotson Associates, of the 52 holding periods of 20-year duration during the aforementioned time period, there∆s just one instance (1929 to 1948) when large company stock returns lagged those of long-term government bonds. Though bonds did edge out stocks a bit more often when the data was sliced into 10-year holding periods, stocks nonetheless remained the superior performer by far on both an absolute and a frequency basis over that span.

What does the data tell us? Stocks always bounce back, at least eventually. Yes, there will be losing periods, perhaps years at a stretch, but patience and a generous allocation to stocks pays off over time.

This conclusion jibes ever so nicely with modern portfolio theory, which advises that higher return comes via higher riskýunsystematic risk, to be precise. After plugging historical performance numbers of stocks and bonds into the quantitative framework of the Capital Asset Pricing Model (CAPM), the resulting asset allocation is likely to be one of heavy equity weighting and low bond exposure for a long-term investment horizon.

There∆s at least one conundrum, however. If stocks appear safer than bonds over timeýbased on the fact that equities outperform bonds over the long haulýwhy do investors require a risk premium for investing in stocks? Shouldn∆t it be the other way around? Puzzling!

We∆re not the only ones who find it puzzling, either. Rajnish Mehra and Edward Prescott are puzzled, as well, or so they wrote more than a decade ago. In their paper, "The Equity Premium: A Puzzle" (The Journal of Monetary Economics, 1985), the pair noted the historical premium generated by stocks over bonds looked unjustified based on reasonable assumptions of investors∆ risk aversion.

Solutions to the puzzle have since been offered, though no single explanation has become widely accepted. Some say flaws in CAPM are to blame. Others argue the puzzle is the logical consequence of a market dominated by investors fixated on short-term performance. Still others say what seems a large equity premium is justified by low-probability events with potentially large impacts, such as a stock market crash.

Two professors with a slightly different take on this subject presented their thoughts at the recent WFA gathering. In an as-yet unpublished paper ("A Century of Global Stock Markets"), Will Goetzmann of the Yale School of Management and Philippe Jorion of the University of California at Irvine, sound a cautionary note. Goetzmann and Jorion stress that what iinvestors expect in terms of a risk premium relies heavily on data from the U.S. equity market. That∆s a risky assumption to make, they add. Simply stated, the exceptionally positive history of U.S. capital markets isn∆t a random sample and, therefore, may cast an undeserved bullish aura on global equity markets.

"We find striking evidence in support of the survival explanation for the [U.S.] equity risk premium," Goetzmann and Jorion write. Reflecting on their study of foreign markets in the 20th century, they report the "United States had by far the highest uninterrupted real rate of appreciation, at about 5% annually. For most other countries, the median real appreciation rate was around 1.5%. This strongly suggests that estimates of equity premia obtained solely from the U.S. market are either biased upward by survivorship or reflect fundamentally different investor expectations about risk across markets."

Overall, the pair advises that the higher real rate of return in U.S. stocks relative to the other markets studied is "the exception rather than the rule."

Reassembling History

During his presentation to a standing-room-only crowd at the WFA meeting, Goetzmann recalled the many challenges associated with reassembling long-term performance data for 39 markets based on monthly data going back, in some instances, to 1921. The findings cited in "A Century of Global Stock Markets" were "painstakingly" collected from an array of international sources, many with erratic reporting histories, Goetzmann said.

The biggest challenge was reconstructing performance histories from markets that closed, if not collapsed. The authors wrote that overall, the process is akin to "financial archaeology." It was well worth the effort, they state, because their findings provide "the first comprehensive long-run estimates of return on equity capital across a broad range of markets."

The paper expands on an earlier study co-written by Goetzmann, Stephen Brown of New York University, and Stephen Ross of the Yale School of Management. That paper, "Survival," was published in the July 1995 issue of The Journal of Finance. In it, the three professors suggest the true equity premium may be closer to zero when correcting for survival bias. A market∆s survival, as in the case of the United States, they explain, "will induce a substantial spurious equity premium."

What∆s beyond doubt is that the equity premium for stocks on an international basis is far below the comparable U.S. level, based on data published in "A Century of Global Stock Markets." The annualized, compound real (inflation-adjusted) return for the United States is 7.37% between January 1921 and the end of 1996, the paper reports. That∆s far above the negative 0.28% mean, annualized return for the comparable period for all 39 countries analyzed (including the U.S.), and the 1.51% for the 14 countries with continuous histories from the 1920s onward (see Table 1).

Goetzmann and Jorion warn in "Century" that "if we fail to account for the ślosers∆ as well as the świnners∆ in global equity markets, we are providing a biased view of history which ignores important information about actual investment risk."

If so, then there∆s a lot of bias going on in the real world, at least from Goetzmann∆s point of view. During a recent phone interview for this article, he stressed that he knows of no asset manager who takes into account the survival bias in U.S. data when making asset allocation decisions.

Stocks Have Drubbed Bonds Historically, But Not All Investors Have Caught On

Getting Going, by Jonathan Clements

So why has the stock market done so well? Forget about the dazzling performance over the past year or even the past 15 years. For many academics, the real curiosity is why stocks have done so much better than bonds in the 20th century "Given the differences in volatility, stocks shouldn't beat bonds by more than a couple of percentage points a year," notes William Reichenstein, an investments professor at Baylor University. Yet the gap has been far bigger. Since year-end 1925, for instance, Standard & Poor's 500-stock index has soared 10.7% a year, while intermediate-term government bonds have shuffled along at 5.2% and annual inflation has run at 3.1%, according to Ibbotson Associates, the Chicago research firm. So what explains the so-called equity-premium puzzle? Two intriguing answers have been offered recently. One answer suggests the data are flawed. When Wall Street touts the wonderful returns from stock-market investing, it usually cites the performance of U.S. stocks and neglects to mention foreign markets. University of California at Irvine's Philippe Jorion and Yale School of Management's William Goetzmann address that oversight in an unpublished paper titled "A Century of Global Stock Markets." The two finance pro~ fessors tracked the performance of 39 markets, including 21 with histories going back to the 1920s. Their findings? Of these initial 21 markets, eight had temporarily suspended trading during the 76 years analyzed and seven others had suffered a long-term closing. Much of the disruption occurred during World War II, when markets like Germany and Japan lost most of their value. Clearly, stock-market investing is a dicey business. But does this mean that stocks have done far worse than the returns for the U.S. market indicate? Some commentators certainly think so, dismissing the "gospel" of stock-market investing as "history, as written by the winners." But the Jorion-Goetzmann study doesn't justify such scorn. Yes, if you ignore dividends, you find that 18 of the 39 markets failed tc generate an inflation-beating rate of return. But most of these laggards turn out to be small, speculative emerging markets. Indeed, after weighting each market by the size of its national economy, the two professors found that their index of all stock markets lagged behind the U.S. market by just 0.28% a year- a modest number, given the huge margin by which stocks have outpaced not only bonds, but also inflation. "There is some evidence that there's a survival effect that explains part of the equity premium," Mr. Goetzmann says. "We don't think we've explained all of it." In fact, Mr. Goetzmann says he finds his study "somewhat comforting." He notes that most of the markets closed at times of political turmoil. "You can usually see political turmoil coming. If you see war coming, you will have a chance to change your allocation." When a crisis is looming, your best bet is to get your money out of the country, r ather than merely swap out of the troubled country's stocks and into its bonds. "When theres a big crisis, bond markets are no safe haven," Mr. Goetzmann says. The Jorion-Goetzmann stody is fascinating. But it doesn't explain the equity-premium puzzle. So what does? If the fault doesn't lie with the data, then maybe it lies with investors. Why haven't folks been willing to buy stocks, given the attractive returns available? That question was tackled by Schiomo Benartzi of the University of California at Los Angeles and Richard Thaler of the University of Chicago in a February 1995 article in the Quarterly Journal of Economics. Their answer relies on two insights into investor behavior. First, they point out that investors are especially sensitive to investment losses, because they feel the pain of losses far greater than the pleasure of gains. Second, they note that investors usually evaluate their portfolio performance frequently, even when their investment goal is far away. The resulting "myopic loss aversion" causes investors to steer clear of stocks, despite the potential for handsome long-run returns. "You can never prove that a theory is right," Mr. Thaler says. 'But we've done some experiments that lend support to the theory." In one experiment, university employees were given charts displaying the returns employees shown how stocks and

Rornan Scott for stocks and bonds. The bonds have performed each year put 40% of their money into stocks. But employees who were shown 30-year returns plunked 90% into stocks. So all you have to do is overcome your myopic loss ~version and reap the reward of the extraordinary equity premium? Not quite. It's a good idea to buy stocks and invest for the long haul. But that doesn't mean you will outpace bonds by the hefty margin that history suggests. "Today, there's a lot of talk that myopic loss av~rsion is disappearing," notes Jeremy Siegel, a finance professor at the University of Pennsylvania's Wharton School. "If people are recognizing the long-term benefits of stock investing and have bid them up as a consequence, this will narrow the spread in performance between stocks and bonds in the future."

For Many Investors, to Deny That You Err Is Human

Aline Sullivan

Investors don rose-tinted glasses when reviewing the performance of their mutual funds, according to William Goetzmann, a professor of finance at the Yale School of Management. Instead of switching funds, he found, investors often adjust their beliefs to support their decisions. In other words, they stay in poorly performing funds rather than admit they were wrong. Mr. Goetzmann discussed his research on investor psychology with Aline Sullivan.

Q.What evidence do you have that shows investors believe their mutual funds performed better than they actually did?
A.We asked two groups of investors about the past performance of their mutual funds. One study focused on a state chapter of the American Association of Individual Investors, a group that we expected to be knowledgeable. The other was based on a group of professional architects who have a profit-sharing plan and invest in mutual funds, who we did not expect to follow year-to-year performance. Both groups thought that their investments performed much better than they actually did

Q. Did the more sophisticated investors have less tolerance for poor performance?
A. They were more realistic in appraising their actual returns: They overestimated the actual fund return by 3.40 percentage points, compared with 6.22 percentage points for the architects. But they were not necessarily the ones who made the better choices. It was interesting to note that the more control investors in both groups had in selecting a fund manager, the better he or she perceived the fund's performance to be.

Q. You found evidence of the endowment effect people are more likely to believe something they own is better than something they do not and the cognitive-dissonance effect people revise their beliefs to match their actions. Which has the greater impact on investor behavior?
A. The dissonance factor has more impact. Investors receive tons of information about mutual funds, investment managers and stock markets. They are bombarded with information. But when they consider how that information impacts their choice of mutual funds, they put on blinders. They want to focus on the positive.

Q. But even when the evidence is incontrovertible, your research shows that investors are reluctant to abandon poorly performing funds. Are switching costs a factor or is it simply inertia?
A. It is very hard for people to admit that they made a mistake in an investment choice. Instead they maintain a hope that the fund's management will turn around. Also, if you have to admit that your first choice was ineffective, how do you make another? It is a hassle to cash out of one fund and open another, but the psychological factor is much greater.

Q. You observe that while investors appear overly optimistic about their past investment choices, cognitive dissonance is not a major problem in the mutual-fund industry as a whole. For example, there are not large pools of wealth invested in obviously underperforming funds. Why should there be a discrepancy between the behavior of individuals and the industry?
A. We wanted to find out if the mutual-fund industry was taking advantage of people based on this cognitive dissonance. If, for example, there was a large section of mutual funds with high fees and regular poor performance and therefore a need for industry regulation. But we only found a small group of underperformers and these didn't have much money. Instead, we found very clear evidence the poorly performing funds were shut down or merged into better funds. It became very obvious that the mutual-fund companies are disciplining themselves to at least some extent.

Q. What are you working on now?
A. We are looking at hedge funds because the absence of indexing should show whether there is any real management skill in the fund industry. But we have not found any evidence that hedge fund managers who have done well in the past continue to do well. This is disappointing because some mutual fund managers maintain their performance.

History, as Written by the Winners

Phillip E. Ross

IT HAS COME to be taken as gospel: Stocks are a can't-lose investment. They have bad years, but they win out in the end. If you are young and can afford to sit through the inevitable corrections, you ought to have all your savings in stocks.

Need some money in the interim? You just borrow against stocks. Hang in for at least 30 years and you can't lose money.

How do we know this? From the statistics. In every 30-year period since 1871, stocks have handily beaten every other financial asset, including cash. Since 1926, stocks, with dividends included, have made money in every 20-year period.

The gospel is preached these days by just about every financial planner, financial columnist and stockbroker you run into. The problem with it is that it may be based on a faulty interpretation of history.

Listen to Paul Samuelson, the distinguished Nobel-winning economist and also an astute investor: "Most people have been encouraged to become long-term stock investors by a line of reasoning that is incorrect," he says. "That doesn't mean I can tell someone not to be a long-term investor in equities, only that the current bull market is being fed by a misunderstanding of the law of large numbers."

The misunderstanding he is referring to has to do with survivorship bias. When the pundits say stocks always win, they turn for proof not just to any nation with a history of stock returns but to a particular one: the U.S. The record is long and wonderfully positive. If you had held U.S. stocks since 1816, you would have averaged a terrific 6.7% compound return, above and beyond inflation. Considering that money doubles every 12 years at 6%, you'd need a lot of zeroes to show how much you would have if you had invested $100 in stocks in 1816. You'd need a computer to tell you.

But is this country typical? In the early 19th century the U.S. was just beginning a two-century-long expansion into a resource-rich continent, unpunctuated by a revolution or invasion. Not coincidentally, long continuous records are lacking for countries that have had periods of acute discomfort for owners of equity capital—countries like Germany, Russia, Poland and Japan. Probably there weren't any stocks in Russia in the very early 19th century, but if there had been, we're not at all sure they would have been a great investment. Maybe stocks are not the sure winners they are cracked up to be.

The New York Stock Exchange has maintained continuous trading since its inception in 1792. Tack on the London exchange, and the unbroken ticker tape stretches all the way back to 1773. More importantly, the two big Anglo-Saxon exchanges kept going through the 1930s and 1940s, when their less fortunate cousins either suffered big breaks in trading or simply winked out.

Financial historians depend on Anglo-Saxon data because they need long data series to draw conclusions about long-term risk. The trouble is they have picked two big winners. Great Britain was the preeminent economic power in the 19th century and into the 20th; the U.S. has been for most of the 20th. How good, though, is triumphalist history, written from the winner's point of view?

"Economists commonly take historical data from the winning countries and extrapolate that into the future," warns William Goetzmann, a professor of finance at the Yale School of Management. "If you take data from the losing countries, you get a different picture."

Since 1993 Goetzmann and Philippe Jorion, of the University of California at Irvine, have been doing just that, collecting data from countries where economists have lacked stock market data because of breaks in trading. What happens when stock trading stops? You could suffer a temporary inconvenience, as Swiss shareholders did when their exchange closed during a general mobilization in 1940 against a feared German invasion. Or you could lose everything, as did those who invested in the St. Petersburg exchange before the Russian Revolution of 1917. The chart, Survivors rule, gives the benefit of the doubt to markets like Tokyo's where there was a prolonged disruption: It simply ignores missing years. But Goetzmann speculates that half of equity value vanishes in such years.

So what are some of the really bad things that might happen to our stock market? Take a look at another seemingly secure country: Britain in the 1970s.

"In the early 1970s the U.K. went through an incredible period of turmoil," says Goetzmann. "When we looked at the pages of The Economist, we found articles questioning whether capitalism would survive in Britain at all.

"In a slightly different world the U.S. exchanges might have met their end in the 1930s," he goes on. "Had the Senate investigation into the stock market crash discovered one more scandal, it might have tipped the balance in favor of those who wanted to end equities trading for good. It seems hard to imagine, but then, no one who comes off a long period of stable finance is likely to see that kind of disaster looming until it's too late.

"After the Russian Revolution, the British press was really skeptical that the mining shares on the St. Petersburg exchange would be really worthless," says Goetzmann. "They figured they [the mines] were too productive for the Bolsheviks to be so foolish as to kick out management. So the Bolsheviks took over the mines, and then they said, 'Okay, but they'll still need foreign capital.' Then the foreign capital was expropriated. There was denial all down the way, until the shares were really worthless."

Goetzmann doesn't disagree that most stock markets have done well most of the time. He simply finds enough disturbing exceptions to the rule to give him pause. Looking only at price returns, since dividend data is extremely scanty in most of the world, he and Jorion plotted average annual inflation-adjusted returns for 39 countries. A sampling is shown in the chart on page 206.

For a number of countries, including Belgium, Spain, New Zealand and Italy, the number is negative. In this context the U.S. stock market is a bit of a freak, combining a long uninterrupted data series with a very positive return.

What would you get with dividends added back in? No one knows for a lot of these countries, but dividends would probably be high enough to put just about all of the 39 into the positive column for real total return. In Spain, though, the return would be pretty meager—in the vicinity of 1% or 2% over stretches covering at least half a century.

Japan is an interesting case. During the period 1921-44, the professors calculate, stock prices in Tokyo did not keep up with inflation. During 1949-95 they raced ahead. What happened to stockholders between 1944 and 1949? Good question. We know that some controlling owners of companies—for example, Kononsuke Matsushita of Matsushita Electric Industrial Co.—were able to retain their property after the war. But just what happened to public holders of shares traded on the Tokyo exchange remains a mystery.

Those who bought Japanese equities in late 1989, when the Nikkei was at 39,000, have lost nearly half their money after eight years. It's impossible to lose money in stocks if you hold them for 30 years? Maybe, maybe not. Remember this: From 1966 to 1982, the U.S. stock market, as measured by the Dow industrials, went nowhere. It has since more than made up for that, but this didn't help someone who bought in 1966 and died in 1976.

It has long been a mystery among academics why stocks have done so much better than bonds throughout U.S. history. Goetzmann and Jorion think they have part of the answer: It's a rational response on investors' part to the risk that something catastrophic will happen someday to the New York Stock Exchange.

Not everyone agrees with them. Jeremy Siegel, a professor at Wharton and an authority on financial history, thinks that stocks have done well because savers have been too foolish to want them. Had people been rational, that is, they would have accepted smaller returns on stocks and insisted on better returns on bonds, pushing the two asset classes closer to equality (see chart, Stocks beat bonds).

"People have an irrational fear of short-term risk," Siegel says. If he's right, and if you have no such fears, you can improve your lot by dumping your Treasurys and buying stocks. He denies that investor jitters reflect a rational fear that what happened to foreign exchanges might one day happen to ours. Reason: Bonds are equally vulnerable to political disaster.

Paul Samuelson is not a bear, but he agrees with Professor Goetzmann that people who are not 100% in stocks are not necessarily stupid.

"There is a survival bias," Samuelson says. "My hunch is that if you were able to eradicate all of that bias, you would remove part of the demonstrated superiority of equities in the last 150 years over alternative investments, such as bonds, money market funds and bank accounts.

"It is in terms of that rational calculation that you should determine whether you are a 10% equities investor, or 50% or 100%," says Samuelson.

He adds, a bit sadly: "I have students of mine—Ph.D.s—going around the country telling people it's a sure thing to be 100% invested in equities, if only you will sit out the temporary declines. It makes me cringe." ROGER IBBOTSON, Yale economist and vendor of financial databases, has almost all of his liquid investments in common stocks. He thinks stocks always have been, and always will be, much better than bonds in long-term performance. He has a lot of company (see story).

What sets Ibbotson apart is the passion with which he preaches the equities gospel. His view: You ain't seen nothing yet. By year-end 2001 the Dow Jones industrial average will hit the magic 10,000. By 2015 it will clear 34,000. In 2020 look for the average to hit 53,000.

Let's see. I put $100,000 in stocks today, I'll have $757,000 in 23 years without even counting dividends.

Ibbotson will turn 77 that year. If he's right, he's going to be one rich professor. He's already doing quite well, as principal owner of Chicago-based Ibbotson Associates, which sells software and data that money managers use for statistical analysis.

What makes him so confident? Not fundamentals. Stocks, after all, are trading at historically steep multiples of their earnings, dividends and book value. No, his market calls are predicated on just one thing: past performance. What was, will be.

Along the way, there are corrections, of course, but intrepid investors just ride them out. With one exception, market dips have never lasted more than two years. That exception was a doozy, a 90% decline in stock prices between 1929 and 1932. So the professor doesn't say that prolonged crashes can't happen, only that they are unusual. The corrections of 1987 and 1990 were much shorter and are mere blips in a long-term chart. "Over the past 71 years, stock prices have moved up in two of every three years," says Ibbotson.

He goes on: "There's been no 20-year period where you lost money in the stock market, and only two periods of ten years, 1929-38 and 1930-39, when stocks lost ground." He is putting stocks in their best light: including dividends but not adjusting for inflation.

What if you look at price changes only and adjust for inflation (as in the international scatter chart, Survivors rule)? Then you see more bearish stretches, including, in the U.S., the decade of 1965-74.

Given that recent performance has been well ahead of the long-run average, don't stocks have to take a bit of a breather?

Nonsense, says Ibbotson: "There's no evidence to support the idea that after a period of high returns we get a period of low returns. We don't have to offset the high returns. It's possible we'll mark time. It's possible, but not likely."

So why isn't everyone 100% invested in stocks? "There's a one-in-three chance that stocks will go down in any year. Most people aren't willing to take that risk. Risk causes prices to be lower and makes the returns higher," he maintains. Ibbotson makes it sound too easy.

How now, Dow?

Mark Hulbert

The venerable Dow Theory currently is on a buy signal. Should you be paying any attention to the Dow Theory, this 100-year-old market-timing model? I think so. It has an impressive track record that--believe it or not--even a few pioneering finance professors are beginning to recognize.

The Dow Theory began with a series of William Peter Hamilton editorials in the Wall Street Journal between 1902 and 1929. Many of those editorials focused on how to distinguish the beginning of a bear market from a mere correction. That's the question on everyone's mind today.

Here's the theory: If the market comes back strongly after a correction and both the Dow industrial and Dow transport averages surpass their precorrection highs, then it's not a bear market. But if the postcorrection rally fails to take either one or both the Dow averages back to their previous highs and if both averages then proceed to fall below their correction lows, a Dow Theory sell signal will be generated.

The Dow Theory has some very impressive calls to its credit. Several were from Richard Russell, who has been editing his Dow Theory Letter since l158--longer than any other advisory letter editor publishing today. Russell used the Dow Theory to generate a buy signal in January 1975, within a few weeks of the bottom of the great 1973-74 bear market--in which he had been predominantly bearish. He used it again in August 1987 to get out of stocks two months prior to the 1987 crash.

Academics have traditionally dismissed the Dow Theory, starting with a seminal 1934 study that appeared in a prestigious academic journal. The study found that followers of the Dow Theory lagged a buy-and-hold between 1902 and 1929. It was a watershed article, which in many ways became the father of the Efficient Market Hypothesis.

The study turns out to have been fatally flawed, however. According to William Goetzmann, a professor at Yale's School of Management, the Dow Theory substantially reduces the risks involved in buying and holding. Once this risk reduction is taken into account, Hamilton's application of the Dow Theory beat the market by an impressive margin.

Now to the burning question: Is the Dow Theory calling for a bear market now? After one of the biggest market retreats since 1990, it is not surprising that people are worried.

What does the Dow Theory say? The Dow transportation index has already surpassed its precorrection high, so let's turn to the Dow Industrial index. Will it eclipse its precorrection high of 7085? If it does, the bull market will be deemed intact. If it doesn't, and if both Dow averages then drop below their correction lows of 6477 and 2350, respectively, look out below!

What should you do while waiting for the market to resolve the matter? You could jump the gun and build up cash now in anticipation of an eventual bearish resolution. This is Russell's recommended course of action.

Not all Dow theorists agree with Russell, however. Their response is to stay invested until and unless a definite sell signal is generated. This is the approach that is being recommended by Dow Theory Forecasts, another long-lived letter whose market-timing (though not its stock selection) is based on the Dow Theory.

Dow Theory Forecasts recommends that investors "remain invested and use price pull-backs to add to portfolios." Here are the service's top picks for one- to three-year gains: Abbot Laboratories (recent price: 61), Air Products & Chemicals (71), American Business Products (24), Callaway Golf (30), ECI Telecom (22), Harcourt General (45), Hewlett-Packard (52), Merck (92), Pittston Brink's (32), Southwest Airlines (28), VeriFone (50), Vishay Intertechnology (23), (ECI Telecom trades o-t-c.)

The two Dow Theory letters agree the market is at a crucial point. They disagree as to where it will go from here.

Risk-Adjusted Investment for the Meek: Making a Case For the Dow Theory

Getting Going, by Jonathan Clements

Risk-Adjusted Investment for the Meek: Making a New Case for the Dow Theory

We were right. Sort of. At issue are the writings of The Wall Street Journal's William Peter Hamilton. Born in Scotland, Mr. Hamilton joined the newspaper in New York in 1899, after a stint as a reporter in London and Johannesburg. He went on to edit the Journal's editorial page from 1908 until his death on Dec. 9, 1929. Colleagues admired Will Hamilton for his concise writing and remarkable calm. But our man Hamilton had an unfortunate quirk: He thought he could predict the stock market. Anybody tempted to guess the direction of today's jittery market would be well advised to consider his record. In his editorials, Mr. Hamilton popularized and elaborated on the Dow Theory, which attempts to forecast the market by analyzing the Dow Jones Industrial Average and Dow Jones Transportation Average. The Dow Theory posits that, if the industrials and transports are together hitting new highs or new lows, that's the signal that stocks have entered a prolonged bull or bear market. Mr. Hamilton turned cautious in the years running up to the 1929 stock-market crash. He reiterated his bearishness in a famous Journal editorial headlined "A Turn in the Tide." The editorial, which was first published in Barron's and reprinted four days later in the Journal, appeared just ahead of the Oct. 28-29 market crash, which saw stocks tumble 23% in two trading sessions. "The twenty railroad stocks on Wednesday, October 23, confirmed a bearish indication given by the industrials two days before," noted the Journal, in reprinting the earlier Barron's editorial. "Together the averages gave the signal for a bear market in stocks." But no good deed, it seems, goes unpunished. Soon after Mr. Hamilton's death, gentleman scholar Alfred Cowles analyzed his market calls, by looking back through the editorials he wrote between 1933 and 1929. Result? Mr. Hamilton's market predictions would have generated a return of just 12% a year, far less than the market's 15.5% annual gain. At the time, many on Wall Street still believed it was possible to forecast the market and thereby earn superior returns. The Cowles study, which appeared in 1934, spurred the development of the efficient-market theory, the idea that prices of stocks and other securities reflect all prevailing public information and hence it's very difficult to earn long-run market-bearing results. The Cowles study also, no doubt, encouraged the Journal's editorial page to spend less time predicting the stock market, thus freeing up space that could be devoted to the foibles of Washington. But the shift from bulls and bears to donkeys and elephants was maybe a tad premature. Or so suggest finance professors William Goetzmann of Yale University's School of Management and Stephen Brown of New York University's Stern School of Business. Recently, they went back and re-examined Mr. Hamilton's track record. Yes, the professors concede, Mr. Hamilton did indeed lag behind the market averages. But in doing so, he took remarkably little risk. The two professors calculate that, if investors had followed Mr. Hamilton's advice, they would have spent 38% of their time in cash investments, 46% of the period invested in stocks, and 16% of their time short the market, meaning that investors sold borrowed stock in a bet that share prices would fall. As a result, investors earned slightly less than the market averages while suffering only about a third of the stock-market gyrations. "Adjustment for systematic risk appears to vindicate Hamilton as a market timer," the professors conclude. That's gratifying, to be sure. But should we care? Earning healthy risk-adjusted returns might be attractive to the faint of heart, who would otherwise avoid stocks. But as Wall Street wags will tell you, you can't eat risk-adjusted returns. Unless investors were willing to make leveraged bets when following Mr. Hamilton's advice, they would have ended up with more money by simply buying and holding stocks. I have no doubt that you can reduce the price swings in a portfolio by market timing. After all, if you jump in and out of stocks, you will spend at least part of the time sitting in sedate cash investments, like money-market funds and Treasury bills. But for long- term investors, the biggest worry shouldn't be short-term market fluctuations. Instead, the key concern is the long-term damage done by inflation and taxes. If that's the danger you're worried about, you shouldn't flit in and out of stocks. All you will do is crimp your returns, enrich your broker and realize your capital gains quickly, thereby fattening your tax bill. Instead, if you want to garner top-notch returns over time while beating back the threat from inflation and taxes, your best bet is to buy stocks-and stick with them. "Over the 26 years, you would have made more money by holding stocks," Mr. Goetzmann agrees. "While you should care about risk adjustment, a lot depends on how sensitive you are to risk. If you are insensitive to risk, you shouldn't worry. But if you are sensitive, the Hamilton theory may be for you."


Chris Farrell
With the collapse of communism and the embrace of freer markets by much of the developing world, a growing number of U.S. investors are looking to put some money into the emerging markets of Latin America, Asia, and the former East bloc. Stock exchanges are flourishing from Shanghai to Buenos Aeries, and over the past decade emerging stock markets have expanded from a nearly 4% share of world market capitalization to more than 10%. Of course, these are volatile investments. Over the past year or so, the onetime stars of the emerging market world have languished, including Singapore, South Korea and Thailand, while the Russian, Hungarian, Czech, and other stock markets from the former Soviet empire have soared. Still, investors going abroad into the world's frontier economies are seeking high long-run rates of return, largely reflecting widespread expectations that the long-term economic growth rates of the developing world will be at least twice the growth rates of the industrial countries. What rate of return, after adjusting for inflation, should investors anticipate? Double-digit? Triple digit? Chill. The recent extraordinary performance of many emerging markets may not be sustainable, caution two National Bureau of Economic Research papers, authored by William Goetzmann of Yale University and Philippe Jorion of the University of California at Irvine. Many of today's emerging markets were around a century or so ago=97and they were hot back then, too. But war, hyperinflation, and expropriation shut down a few markets and sent many into hibernation for long-periods of time. Instead of emerging markets they became "submerged" markets. The economists collected data on 39 markets going back to the 1920s. The U.S. had the highest long-run rate of return, after adjusting for inflation, should investors anticipate? Double-digit? Triple digit? Chill. The recent extraordinary performance of many emerging markets may not be sustainable, caution two National Bureau of Economic Research papers, authored by William Goetzmann of Yale University and Philippe Jorion of the University of California at Irvine. Many of today's emerging markets were around a century or so ago and they were hot back then, too. But war, hyperinflation, and expropriation shut down a few markets and sent many into hibernation for long-periods of time. Instead of emerging markets they became "submerged" markets. The economists collected data on 39 markets going back to the 1920s. The U.S. had the highest long-run rate of return of about 5% a year, after adjusting for inflation. For other countries, the comparable figure was a median real rate of 1.5%.=20 Turns out returns sizzle when a submerged market re-emerges on to the world capital market, perhaps because investment opportunities are particularly good. Long-run performance lags, say the authors, after taking into account severe economic and political disruptions. Take the Argentine stock market. It dates back to 1872. It has been considered an emerging market since 1975, and the market has surged by an average of 23% a year since then, in dollar terms. Yet from 1947 to 1965, the era of Evita and a time when the Argentine stock market was submerged, returns averaged a minus -24%. Investing overseas makes sense, both to branch out and to participate in some the world's fastest growing regions. But investors are largely making a bet on politics, not economics. Which countries will enjoy political stability and the rule of law in the year 2010 and which ones will have descended into chaos and banditry by then? China? Malaysia? Brazil? Venezuela? Diversify for the long-haul, and keep investment expectations reasonable.
Reuters 2/20/97

"Bad Data May Mislead Emerging Market Investors"

Aaron Pressman
Stock prices in the so-called emerging markets have sky-rocketed over the past decade, but those high returns may be a temporary phenomenon, according to an academic study released on Thursday... That data, ,from the International Finance Corporation, ignored the performance of such markets before they "emerged," warned Philippe Jorion, professor of Finance at the University of California.

Jorion and a colleague conducted what he termed "financial archaelogy," sifting through stock market data from earlier periods collected by the International Monetary Fund, the United Nations and even its precursor, the League of Nations. They sought "the data that no one wants anymore," he said at a conference sponsored by the Federal Reserve Bank of Atlanta.

Looking at stock markets before they "emerged" or even cases where markets emerged then submerged and re-emerged later, Jorion and Professor William Goetzmann of Yale University found sharply lower returns.

The average returns on markets that have emerged are temporarily high," he said. Looking only at the later data "provides an overly optimistic picture of future investment performance. Therefore, basing investment decisions on the past performance of emerging markets is likely to lead to disappointing results."

Markets are classified as emerging typically when economic growth and some measure of political stability push stock market capitalizations over $100 million, Jorion said. Wars, coups or economic chaos can push emerging markets underwater and out of view of global investors.

For example, Portugal's stock market has been around since 1901 but has been interrupted by political upheaval. The IFC has only tracked Portugal since 1986, reporting an average annual return of almost 30% since then.

But, when the market initially dropped in the 1970's and was disrupted for three years, prices dropped 80%, Jorion found.

"When these markets are interrupted, typically there is a big drop," he said. That means that looking only at "emerged" markets ignores the returns of those same countries' stock markets when times were bad, he said. Emerging stock markets seem to do best just after they are classified as "emerging" and then taper off, he warned.

Looking at 25 countries in the IFC data, Jorion found countries posted an average return of almost 31% in the first five years after emerging, dropping to 16% in the following five years. The results were even more dramatic looking at just the first three years, with a return of 37%, compared to a return of 13% for the second three years.

The Christian Science Monitor 2/3/97

"Ivy League Graduates Manage Money Better"

David R. Francis
In 1994...William Goetzmann, now at Yale University, and Roger Ibbotson, president of Ibbotson Associates a Chicago firm providing various services to financial institutions, looked at the performance of 728 funds from 1976 through 1988. Their industry pleasing finding was that fund money manager winners on average remain winners. So past returns and relative rankings of funds are useful in predicting returns and rankings"

U.S. News and World Report, 2/3/97

"First, Pop the Hood: A fund's name may tell you nothing about how it acts"

Gregory Millman
" analysis of mutual fund styles by Stephen Brown of New york University's Stern School of Business and William N. Goetzmann of Yale did find some evidence of "moral hazard" in the industry. During the late '70's and early 80's, Brown [and Goetzmann] found numerous examples of funds that changed their names after performing poorly. Presto! Relative to their new benchmarks, the funds' track records "improved" by an average of 9.8%"

The Wall Street Journal 5/28/96(2),

"Going Global"

Michael Sesit
...In many ways, today's mutual-fund investors and pension-fund managers are still playing catch-up with their globe-trotting British predecessors. "People now are crazy about international investing," says William Goetzmann, associate professor of finance at Yale University's School of Management in New Haven, Conn. "But U.S. investment in overseas equities is nothing compared to what British investors were doing."

Back in 1900, Baring Brothers and Co.'s non-government-bond investment portfolio -- a mix of corporate stocks and bonds -- was only 37% invested in the U.K. The U.S. accounted for 27%, Chile for 12% and Argentina for 6%. The rest was spead among Austro-Hungary, France, Mexico, Australia, Russia, India, China, Roumanina and South Africa...

U.S. Investors did venture abroad from time to time, but they often lost their shirts -- especially in the Latin American and Weimar Republic bond defaults in the 1930's. World War II didn't help. "Borders were slammed shut and you couldn't get your money out," says IntersSec's Mr. McCain. "In many cases assets were literally destroyed."

It wasn't much easier after the war, when U.S. laws restricted Americans' investment abroad. Moreover, "the U.S. is so huge that people felt they could diversify sufficiently within the U.S. economy," Says Prof. Goetzmann of Yale.

The Wall Street Journal 5/28/96(1),

Different Drummers

Matthew Rose

There's a saying in the investment community that when the Dow sneezes, the rest of the world catches cold...'Just because a market is more integrated with the world capital market, it does not mean that it is more correlated with other equity markets says Prof. Harvey...Will Goetzmann, associate professor of finance at Yale University's School of Management, concurs. Reactions to moves in the Dow "can fool the market for a few weeks," he says, "but not for much longer than that."

USA Today (Magazine), January, 1996

Has your mutual fund changed its personality?

Longstaff, John S.

Most people probably have met someone who, at first impression, displayed a certain type of personality - only to discover later that person was quite different. Mutual funds can be like that; some appear to be one thing when, in fact, they're something else, or their personality changes over time.

Unlike people, however, mutual funds do not have good or bad personalities. What is important for investors is to select the funds whose "personalities" match their individual goals, objectives, tax situation, and tolerance for investment risk. For instance, if you're young and investing for retirement well down the road, you may prefer the dynamic personality of an aggressive growth fund that primarily seeks to increase its share price by buying fast-rising new

companies. If you're a more conservative investor or a retiree seeking primarily current income, you may want the button-down personality of a growth-and-income fund or a government bond fund.

The challenge today is that independent studies, and a few headlines, have shown that many mutual finds are not always what investors perceive them to be. One example that made news recently involved a well-known institutional government income fund. To its shareholders, "government income" implied a conservative, safe fund owning primarily U.S. Treasury securities. In reality, the fund was invested heavily in a more speculative class of mortgage-backed securities. When interest rates rose during 1994, the fund lost more than 20% of its net-asset value within a few months. Two major components define the personalities of mutual funds. First, what objective does the fund's prospectus say the fund is trying to achieve for its investors? Generally, this means one of three things: current income from interest or dividends, growth through long-term gains in share price, or a combination of income and growth. Second, how does the fund intend to achieve its stated objective? If seeking income, does it invest primarily in bonds and, if so, what type of bonds? Or will it invest mostly in the stock of companies that pay out high dividends? If looking for growth, does the fund emphasize the stock of small, medium-sized, or large companies? Will it invest mostly overseas, in real estate, in gold and silver? Will the fund try closely to track a broad index such as the Standard & Poor's 500 or focus on a specific sector of the economy such as technology or financial services? Or does the fund have a wide latitude to invest in whatever it sees fit as long as this achieves the stated objective?

Based on its objective and policies for reaching that objective, each fund is placed into one of about 20 categories - such as aggressive growth, growth-and-income, international, index, fixed-income, and money market. A fund's name also may suggest what type it is. This is where things may get sticky for investors. A rose may be a rose by any other name, but a mutual fund by a different name or classification can be misleading. A study by a Harvard University student, Erick Witkowski, now with Northfield Information Services, found that 56% of the mutual funds he analyzed were miscategorized. Economists Stephen Brown of New York University and William Goetzmann of Yale University found that just 35% of 282 funds listed as growth funds by a mutual fund rating service actually should have been listed in that category. They argued that 17% of those funds belonged in a higher-risk category of small-company funds.

Having a "misleading" personality doesn't necessarily mean a fund will perform poorly. One top-performing fund characterized as a growth-and-income fund - Oppenheimer Main Street Income and Growth Fund - returned 24.3% annually the past five years. However, the fund appeared to have achieved that success by emphasizing growth, not income. Its income was a mere 2.1% - low for conservative investors who bought the fund primarily for steady income. So how can you identify the real personality of a mutual fund, or whether its personality has changed since you bought it? * Never invest in a fund based solely on its last year's performance. * Never pick a fund based only on its name or categorization. * Read the prospectus carefully. It may state the minimum and maximum percentages of a particular type of asset the fund will invest in, or the guidelines may allow a lot of leeway. The wider the latitude, the greater the potential that returns and risk may deviate from your expectations and needs. * Pay particular attention to the actual investment holdings listed in the annual and semi-annual fund reports. Two funds investing in 60% stocks and 40% bonds might be classified as "balanced" funds. Yet, while one focuses on conservative blue chips and high-quality bonds, the other may bet on more speculative small companies and higher-risk junk bonds. * If returns are unusually higher or lower than the average returns for its peer group, that may be a sign the fund belongs in another category. Experts caution that some funds intentionally misstate their category in order to stand out among their more conservative peers. * Follow a fund carefully if it changes managers. The new regime may bring a different style of implementing policies and achieving objectives, especially if the fund gives the manager enough latitude. * Watch the fund size. For instance, new investment money may pour into a particularly successful fund that focuses on small, high-growth companies. The flood of money may force the fund to invest in larger companies or hold larger amounts of cash, thereby changing its original personality.

Businessweek 5/6/96

Fixing Fidelity

By Geoffrey Smith and Jeffrey Laderman

It was a battle of money-management titans. In one corner stood the reigning champion, Fidelity Investments. In the other, five pesky rivals vying to break Fidelity's dominance of the fastest-growing segment of the financial services industry -- the $675 billion 401(k) market. The clash was over the management of the retirement assets for the employees of Toto, Inc., the Minneapolis-based manufacturers of lawn mowers...Fidelity lost out to the smaller Putnam funds because its funds were too erratic and unfocussed.

Inconsistent? Undisciplined? That's hardly a description befitting the world's most famous investment machine. Fidelity's considerable stock picking prowess has produced the most remarkable growth streak in the annals of finance...How Fidelity manages its spectacular growth will have major consequences for the company's customers -- and the $3 trillion mutual fund industry as well. "Fidelity and Magellan are in a special position of representing the mutual-fund industry," says William Goetzmann, at Yale University's School of Organization and Management.

Forbes, 3/11/96

Absolutely No Guarantees

BY Doris Atheneos

Aside from its value in enriching your life and enhancing your prestige, is art a good investment?

Yale School of Management economist William Goetzmann has spent a decade crunching 280 years' worth of auction prices. Sitting in his bare-walled (sic) office, he says "You can double or half your money with an art market portfolio" He does think a diversified portfolio of good art can beat the stock market with an average annual return of 17%.

William D. Grampp, a retired University of Illinois economist, and author of Pricing the Prticeless: Art, Artists, and Economics Basic Books, $19.95),thinks Goetzmann is being overly simplistic..."statistical analysis doesn't take into account the large amount of art that becomes worthless."

...Art prices are often seen as trailing indicators of the world's stock markets. New highs in stocks take from two to four years to translate into the art market, according to Goetzmann. "If the trend established in the 20th century continues, then 1997, 1998 and 199 should be boom years in the art market," he predicts, based on the U.S. stock market's recent huge gains.

Forbes, 12/18/95

Auctions on the Internet?

BY Robert La Franco

...Next year Art Net will take a step into the unknown when it unveils the Art Market Analysis, a program written by Yale School of Management professor William N. Goetzmann. The Program will offer a way to evaluate an artist's work as an invest ment by entering an artist's name, the size of the work and some other defining details.

Once the information is entered, the program will spit out an estimated value of the work based on past auction prices. The program will also offer price indices of the works of individual artists as well as an index of the 500 most heavily traded artist s since at least 1987....

Forbes, 11/20/95

Annual Reality Check

BY Shelby White

...The memory can play funny tricks. Sometimes I don't really remember what I paid for something and in my imagination, my profits are greater than they are in fact. Professor William Goetzmann of the Yale School of Management interviewed two groups of investors and asked them to recall how their investments fared. It turned uot that memories were rosier than reality. No doubt we also kid ourselves about our losses...

Money 10/95

Why mutual fund investors need a truth-in-labeling Law

by Penelope Wang

Talk about confusing. Fund tracking firms like Lipper Analytical, Value Line and Morningstar (MONEY's data source) employ some 40 labels to categorize America's 6,700 stock and bond funds. What's worse is that some funds may be deliberately taking advantage of the labeling confusion to mislead investors.

Here's how. When a fund goes public, the fund tracking outfits assign it to one ot their proprietary categories based on the fund's objective and investment policies as described in its prospectus. Then the fun begins. After that initial assignment, fund execs can (and sometimes do) lobby the raters to get the fund switched to a category that, in theory at least, better reflects the fund's true nature.

Guess what? When the funds prevail, according to a study by finance professors Stephen Brown of New York University and William Goetzmann of Yale, the category switchers usually perform better vs. their new peers than they did against their old ones. (The professors examined 237 stock funds that switched categories between 1976 and 1992.) "Our test does not prove funds switched purely to improve their relative returns," notes Goetzmann, "but the results certainly suggest that may be the case."

Furthermore, the researchers found that fund labels don't tell you much about the way a portfolio is likely to behave. When Brown and Goetzmann analyzed the performance of 2,283 stock funds, they found, for example, that fewer than two-thirds of the 391 funds classified as "growth and income" selections actually performed in a manner consistent with an investing style that emphasizes buying the shares of large dividend-paying companies.

To avoid being tripped up by a mislabeled fund, check out your fund's true investing style. Morningstar's and Value Line's main fund publications (available at most major libraries) provide style analyses that show whether a fund primarily buys large, small or medium-size companies and if it takes a growth, value-oriented or blended approach. Only by going beyond the label and examining how your fund invests can you know that your chart topper isn't mopping up against a misdefined field of bogus competitors.


Researchers Brown and Goetzmann say that suprisingly high percentages of funds categorized one way actually invest another.

                         % of funds that actually

use these investing styles

Growth Small

and growth

Growth income stocks Value Other


Growth 39.9 26.5 10.4 15.8 7.4

Growth and income 8.7 63.2 0.0 5.4 22.8

Small company 5.9 0.0 42.4 48.7 3.0

n1 Morningstar category

Source: Brown and Goetzmann

The Wall Street Journal 10/13/95

Investors Stick With Duds to Keep Illusion

BY By Ellen E. Schultz

Staff Reporter of The Wall Street Journal
PG C25
Why do investors stick with funds that are duds? It's no secret that money flows quickly into winning funds, yet dribbles slowly out of the losers. How come? Research has offered a number of explanations, including transaction costs and investor inertia-and one study even cites the "failure of investor probability heuristics." (In other words, investors are lazy.) Now comes a new theory in a working paper by a researcher at the Yale School of Management, which suggests that investors stick with losers for the same reason they love their lemon cars: They can't admit to themselves that they made a mistake. Regardless of the funds' performance, mutual-fund investors "believe they had higher returns than they actually did, and often believe their funds outperformed the benchmarks, when they didn't," says William * Goetzmann, a professor at Yale who specializes in investment research. Psychologists call this "cognitive dissonance," which in layman's terms means that the gap between hope and reality is filled with fiction. To test whether mutual-fund investors are cognitively impaired, * Professor Goetzmann asked members of a Connecticut chapter of the American Association of Individual Investors to estimate the previous year's returns on their funds, and whether the funds beat or lagged behind the appropriate benchmarks. When he compared the answers to the actual returns on the funds, as calculated by Morningstar Inc., he discovered that the investors overestimated their earnings by an average of 3.4 percentage points. The AAII members, who tend to be sophisticated amateur investors, also inflated the amount by which their funds had beat the benchmarks for their categories, by an average of 5.11 percentage points. Unsophisticated investors were even more likely to puff up their * investing acumen, Prof. Goetzmann found. He surveyed a group of architects, who overestimated the returns on their funds by 8.58 percentage points. This inflation is nothing other than cognitive dissonance, the professor says. "They just didn't want to believe they had chosen badly." Significantly, the architects weren't nearly as inclined to inflate the returns on the mutual funds in their profit-sharing plan, which they hadn't chosen themselves. They overestimated the funds returns by only 2.36 percentage points. The architects also said they were relatively unhappy with the managers of the funds they had no choice in selecting, but were relatively satisfied with the managers of funds they chose themselves. * Professor Goetzmann concludes, among other things, that it may not make much sense to require funds to provide more performance information, since investors don't pay much attention to data they already have. But he does suggest that fund marketers might want to run ads telling shareholders that they "made a wise investment choice" -- because these investors probably believe they did.

The Economist 9/95

Taking stock of history.

(accounting for the equity premium)(Column)
PG 68
THESE are profitable times for punters on the world's stockmarkets. On Wall SDow Jones Industrial Average is 24% higher than it was at the end of last year. In London the FT-SE 100 index is up by 16%. And such gains are hardly unusual. Even if a correction occurs in the autumn, it will not change the fact that shares have been marvellous investments over the past 200 years (see chart). Or so says the conventional wisdom. Is it a fact that equities have done so well? The received view is to be found in popular books on investing such as "One Up On Wall Street" by Peter Lynch, a veteran investment guru, and in more academic tomes such as "Stocks for the Long Run", published last year by Jeremy Siegel, an economist at the Wharton School in Philadelphia. Mr Siegel says that between 1926 and 1992 the real total return (capital gain plus dividends) on American equities exceeded that on short-term Treasury bills by an average of 6.1 percentage points a year. Severe inflation caused Treasury bills to perform particularly badly in the 1970s. But this does not explain the so-called equity premium, which existed in earlier periods too. For instance, it averaged 1.9 percentage points a year between 1816 and 1871, and 2.8 points between 1871 and 1926. British equities produced comparable premiums. Moreover, shares in both countries have consistently outperformed investments other than Treasury bills, such as long-dated government bonds and property. One of the tenets of financial economics is that investors can earn a higher return only by accepting greater risk. Thus economists have long explained the equity premium by emphasising that returns on shares are far more volatile--that is, they jump up and down more--than those on bonds. In any short period an equity investment is more likely to do badly than one in bonds; so investors require the long-run average return on equities to be higher to compensate for this risk. Some economists, however, find this risk-return explanation unconvincing. They point out that, although shares are riskier in the short-run, over almost any period of more than a few years they are arguably safer (ie, less volatile) investments than either government bonds or Treasury bills. If this is so, bonds, not equities, may deserve to earn a premium. Many attempts have been made to solve the equity-premium puzzle. Richard Thaler, an economist at the University of Chicago, has shown that it might be due to a kind of short-termism. If investors measure the performance of their assets over relatively short periods, such as a year, and dislike big losses more than they like big gains, then they would demand greater compensation for holding volatile assets, such as equities, than conventional economic theory suggests. Living to tell the tale A quite different tack is taken in a new paper by Stephen Brown, of * New York University, and William Goetzmann and Stephen Ross, both of the Yale School of Management*. This argues that the equity premium on American and British shares reflects not short-sighted behaviour, but the fact that the British and American stockmarkets are historically odd. They are odd because they have survived. The New York Stock Exchange began trading in 1792. At that time investors could also buy shares in the financial markets of Britain, Holland, France, Germany and Austria. But of these six markets, only America's and Britain's have operated continuously since that time. Moreover, of the 36 stock exchanges operating at the start of this century, more than half have suffered at least one significant break in trading, through war or nationalisation of large quoted companies. So any economist attempting to study long-term returns from equities has no choice but to analyse the American and British markets. The snag is that their very survival makes these markets unrepresentative: they give a deceptively good impression of the rewards from investing in equities. This raises an intriguing possibility. Perhaps the apparently inexplicable part of the equity premium is compensation for the risk that the markets may break down. * Messrs Brown, Goetzmann and Ross estimated how much extra return investors would require from equities to compensate them for the risk that the market might not survive. To do this, they assumed that a stockmarket cannot survive when prices fall below a certain level. They also assumed that the true equity premium is zero--ie, that when averaged across all stockmarkets, including the casualties as well as the survivors, the average long-term real return on equities is the same as on Treasury bills. They found that, on these assumptions, investors would expect surviving shares to yield roughly the premium that they produced over the years in America and Britain if they gave markets a 50% probability of survival. That is roughly markets' survival rate over the last 100 years. However, few economists would expect the true equity premium to be zero, given, say, the extra short-run volatility of shares. Assuming that such explanations account for around half of the premium on British and American equities, the other half would be consistent with investors assuming an 80% survival rate for markets. Although that is well above the historical average, it is more in tune with today's more stable capitalist systems. All this suggests that investors should not make sweeping judgments about the superiority of shares--particularly as they pile into emerging markets, where the risk of interruption is much greater than in more established ones. There may be plenty of good reasons for buying equities, but history is not one of them. ART illustration graph

The Economist 7/95

A question of style: mutual funds.

(gauging the investment styles of mutual funds)
INVESTORS are a varied bunch. They have different investment horizons, tax rates and risk appetites. On the face of it, the mutual-fund industry for all of their preferences. "Growth" funds, for example, try to make returns from capital gains (increases in the prices of individual shares), rather than from high dividends or interest payments. " opposite. In theory, an investor need only choose the style that suits him best, and pick a mutual fund that pursues it. There is, unfortunately, a huge snag with using such labels to pick funds: they are larg Some of the reasons for this are well known. Sweeping definitions ignore the fact that, even if funds fall under the same broad heading, their managers might invest in different industries and in firms of different sizes. probably also adjust their portfolios in different ways. But there are more alarming reasons for investors to tread carefully when looking for a fund that matches their needs. A recent study* by Stephen Brown, an economist at New York University, * and William Goetzmann, an economist at Yale University, suggests that some funds deliberately mislead their clients about the strategy they pursue. By switching categories at the end of the year, a fund can choose the benchmark that portrays it in the best light. Messrs Brown * and Goetzmann examined the performance of 48 American mutual funds that changed their stated investment styles. In each case, they compared a fund's performance in the year before the switch with the average return in its old category and the average performance in its new one. On average, the switch made their benchmark-adjusted returns look almost a full percentage point better. None of this would matter if the research firms that track funds' performance had a reliable technique for classifying funds. But they do not. That hurts investors and good fund-management companies, who need a credible way to distinguish themselves from their competition. Moreover, an objective benchmark would also help firms to assess the performance of their own in-house managers. That is why all concerned are scrambling to find a better way funds' * investment styles. Messrs Brown and Goetzmann reckon that they have one. The two eschew the traditional approach, which specifies a number of styles and then tries to find ways of fitting funds into them. Instead, they suggest turning the process on its head. First, they pick out clusters of funds that have followed similar performance patterns in the past; only after forming these "natural groupings" do they try to attach labels to the different styles. Using data from Morningstar, a financial research firm, Messrs Brown * and Goetzmann looked at the monthly returns of 276 American mutual funds from 1976 to 1988. They grouped these funds into eight clusters, according to how closely their returns matched. Then they tried to tease out each group's salient features by examining how the returns of the funds responded to changes in major stock indices and other economic indicators. At first glance, their results differ little from the traditional approach: many of the style definitions that they generate, such as "growth", "income" and "small-cap", are similar. However, Messrs Brown * and Goetzmann put many funds in a different category to the one in Morningstar places them. Take two of Morningstar's 13 categories: growth funds and international ones. As the table shows, only about 57% of the funds in the "growth" categories conform to the economists' notion of a growth fund: 17.4% of are more like small-cap funds, which invest mainly in the shares of small companies; another 12.4% are more like value funds, which invest primarily in firms with low share prices relative to historical earnings; and over 6% turn out to be market timers-- funds that move in and out of markets frequently, trying to cash in on bull and bear runs.

Risky business

This should worry investors because the so-called growth category not only embodies many different styles, but also different levels of risk. For example, although the income fund is the safest of the economists' categories, the small-cap fund is the riskiest. Investors hoping to diversify by buying international funds should also tread classified as international by Morningstar, fewer than two-thirds appear to be international according to the economists' categories. * Critics could say that Messrs Brown and Goetzmann's categories are just as arbitrary as those already in use. However, their approach appears to do a better job of predicting performance. After classifying the funds, they examined each one's future returns and found that their scheme explains more of the differences in these than traditional ones. of room for fine-tuning their approach by, for example, including firm size and other measures as well as looking at past returns. Nevertheless, any attempt to improve truth-in-packaging in the mutual-fund industry would be a welcome change. * "Mutual Fund Styles". * By Stephen Brown and William Goetzmann. Western Finance Association, June 1995 ART illustration table

New York Times 3/95

Funds watch: History repeats


PG 10
A study by Roger G. Ibbotson and William N. Goetzmann, professors of finance at Columbia University (sic!) and Yale University, respectively, has found that highly successful fund managers do repeat their winning performances, despite mutual fund disclaimers about past performance vs future performance. RF Avail: UMIACH/60001.01 ISSN: 0362-4331

The Wall Street Journal 1/94

Your Money Matters: Savvy Mutual-Fund Investors Can Be a Bane to Some Brokers

BY By Ellen E. Schultz

CR Staff Reporter of The Wall Street Journal
LP Some brokers think investors are becoming just a little too smart for their own good. The brokers' good, that is. Individuals nowadays receive a wealth of information and advice about finances from newspapers, magazines, cable television, investment newsletters and on-line data services. The explosive growth of mutual funds, meanwhile, makes it easy for small investors to hire experts to manage their money. And to comparison shop among those experts, individuals can easily peruse the managers' track records in statistics published by such organizations as Morningstar Inc. and Lipper Analytical Services Inc. Not surprisingly, these trends alarm brokers, because the more individual investors learn to think for themselves, the less they need their brokers. Data on managers' track records, in particular, "render the salesman superfluous," warns Nick Murray, a popular industry speaker and columnist for Investment Advisor, a trade publication that includes tips for brokers on how to sell more effectively. Performance numbers also make the costs of broker-sold mutual funds obvious to investors. In contrast to no-load funds, broker-sold funds typically come with hefty "loads," or sales charges, as well as surrender fees. What's more, "all the academic research I've ever seen shows that there's no difference in performance between load and no-load funds -- until you add in the sales loads," says John Markese, president of the American Association of Individual Investors. Once loads are accounted for, the broker-sold funds tend to lag. "The more your presentations make track record a critical . . . variable, the more clearly you tell the investor to just go buy Money magazine's top-performing no-load fund," Mr. Murray tells brokers. To sell their funds in the face of such evidence, brokers often resort to telling clients to ignore the bottom line. "You can't argue with performance numbers, so it's easier for the broker to say: `Don't look at performance. Trust me to help you choose a fund,'" says Mr. Markese. Sometimes, the brokers even fight back with a few statistics of their own. Take a recent study from Dalbar Financial Services, a company that produces mutual-fund marketing information and research for organizations that rely on brokers and other salespeople to distribute their funds. The Dalbar study purports to show that "no-load fund investors underperform load investors." However, it doesn't actually compare performance. Rather, it measures "retention rates," or how long investors hold on to their mutual funds -- although it doesn't specify how those rates are measured. According to Dalbar, load-fund investors hold onto their mutual funds for an average of 48.84 months, compared with an average 21.84 months for no-load investors. The results are based on Dalbar's proprietary data base of funds for the nearly 10-year period between Jan. 1, 1984, and Sept. 30, 1993. Based on these retention rates, the study concludes that investors who buy mutual funds from brokers were in the market longer, and therefore enjoyed higher returns. In contrast, direct buyers were more likely to "churn" their accounts, which resulted in lower returns, the study says. But that doesn't wash with Martin J. Gruber, chairman of the finance department at the Stern School of Business at New York University. "They're making an unwarranted conclusion," he says. For one thing, the study assumes that people with no-load funds got out of the market, he notes. In reality, they may have moved into other stock funds. Further, says Mr. Gruber, it's not surprising that the average dollar remained invested longer in load funds. But this may be more a function of surrender charges that penalize investors for taking their money out of such funds than a reflection of prudent hand-holding on the part of the broker. * Will Goetzmann, a finance professor at Columbia University Business School who specializes in mutual-fund performance and asset flows, says it's "impossible to track individual investors" using Dalbar's methods. * Mr. Goetzmann says that current research on cash flows in and out of mutual funds shows that while money pours quickly into funds with winning records, it oozes rather slowly out of losing funds. He likens it to a "roach motel" effect. "Investors who buy load funds may be less knowledgeable, and more prone to stay in losing funds longer," he says. Still, Jerry Tuccille, senior financial analyst at Dalbar, defends the study. Assuming load-fund investors did tend to stay put longer, thus enjoying more of the benefits of the past decade's bull market, they would have reaped returns of 6.82% a year, on a compound annual basis. Meanwhile, the restlessness Dalbar sees among no-load fund investors would have reduced their returns to just 5.61%, compounded annually, the study shows. Actual performance figures reverse those standings, however. According to Morningstar, the average compounded annual return for no-load funds was 12.38% for the 10 years ended Dec. 31, 1993 -- a notch above the 12.16% average for broker-sold funds. Those results don't account for loads, which would make the broker-sold funds look even worse. Incidentally, both groups did extremely poorly relative to someone who just bought and held a fund that tracked the Standard & Poor's 500 index. This low-cost investment strategy would have produced compound annual returns of 15.07% in the 1984-93 period. Investors who rely on performance data to pick and choose among mutual funds should be careful not to read more into those numbers than is warranted, however. For instance, to avoid the apples-to-oranges problem, only judge "performance relative to similar investments," says Mr. Markese. And to check the integrity of the data, experts say investors should make sure the numbers are supplied by a third party, such as Morningstar or Lipper; cover a meaningful stretch of time, preferably five years or longer, and have been adjusted for all fees, expenses and potential loads. It's also useful to find out how a fund does in both bull and bear markets. A good broker will be happy to supply this information, and will welcome an investor's desire to better educate himself, says Jennifer Strickland, a consultant at Morningstar. "A lot of financial planners and brokers have told me that their best customers are the best-educated customers," she says. (See related letter: "Letters to the Editor: Take Their Eyes Off The Rearview Mirror" -- WSJ Feb. 4, 1994) 940120-0063 YY94 MM02

Museums Take Their Art Works to Cyberspace

BY By Farhan Memnon
...The Internet is a modern-day toool for achieving our goal of making museum-quality exhibitions available to as vast an international audience as possible," siad Aaron Schindler, Director of Photo Perspectives.

Yale University art expert William Goetzmann agrees and believes that with the Internet curators will be able to enhance their work.

"Very often it's impossible to gather all the material you need for and exhibit in one place. Some museums don't want to lend their art or sometimes its been destroyed. Using the Internet, exhibits can be put on without such encumbrances. The images may not be of great quality, but the underlying message of the show still comes through," Goetzmann said....

The Mutual Fund Shell Game

By Gary Hector

...In another study of mutual funds, two finance professors, Stephen Brown of New York University and William Goetzmann of Yale School of Management, analyzed mutual fund returns between 1977 and 1988 to see if the funds fell naturally into classes or categories. Like Witkowski, Brown and Goetzmann focussed on monthly returns over time rather than portfolio composition.

After analyzing thereturns on 758 funds, they found they fell into eight distinct clusters: growth and income, income. growth, value, small company, market timers, hedgers and international. Most of these categories sound familiar, but their composition diverges greatly from the older classifications. For example, Morningstar's growth category, with 282 funds, splintered into five different groups. Only 99 remained in Brown and Goetzmann's growth category. The remainder shifted into growth and income, value, small cap and income. Funds from Mornigstar's growth nad income category fell into fourdistinct groups with barely half staying in the growth and income area. Brown and Goetzmann found their share of wolves. In Morningstar's grow th category, 49 funds turned out to be more volatile small-company funds. Morningstar's growth and income group included 26 funds that belonged to the new growth or value groups. Their study also identified two new gropus -- funds that attempt to time market, switching from cash to stocks and back, and hedge funds that invest primarily in precious metals....