This is the presentation I gave to a group of CPAs and estate planning attorneys to give them a headup of what the 2013 Nobel Prize Economics winners have to say about investing.

1. Investment Insight
of
Nobel Prize Winners
Michael Zhuang
The Investment Scientist
MZ Capital Management

2. 2013 Nobel Prize in Econ
• Eugene Fama
– RISK based explanation of the market
• Robert Shiller
– BEHAVIOR based explanation of the market
• Lars Peter Hansen
– General Method of Moment or GMM
– High power mathematical tool to measure the
market

3. Eugene Fama
• Efficient Market Hypothesis (EMH)
– In a competitive capital market participated by
millions of people out to make an extra dime,
there will not be any advantageous information
left unused.
• Risk factors of the market
– There are three factors of risk

4. Efficient Market Hypothesis (EMH)
• Weak form EMH
– Past stock prices have no predictive power of future
stock prices.
– Implication: technical analysis useless
• Semi-strong form EMH
– All public information has no predictive power of
future stock prices
– Implication: watching Jim Cramer waste of time
• Strong from EMH
– Private information has no predictive power

5. More on Strong Form EMH
• There are evidences that Strong Form EMH is
rejected
• Insider information: CEO, COO, CFO, 5%
Owners, Directors
• Law markers
• My experience trading insider information
after Sarbane Oxley Act.

6. Stock Prices are Predictable …
• By company size
17.64%
14.65% 14.64% 14.26%
14.88%
13.80%
12.84% 12.96%
11.40%
10.68%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
Smallest 2 3 4 5 6 7 8 9 Largest
Annual Returns Relative to Size

7. Stock Prices are Predictable …
• By P/B ratio
19.56%
18%
16.80% 16.68%
15.12% 14.88%
14.04%
12.72%
11.76%
7.68%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
Annual Returns Relative to P/B

8. Contradiction to EMH?
• Isn’t this contradictory to Fama’s own Efficient
Market Hypothesis?
• Alas Fama has a risk based explanation
– Smaller stocks are riskier than larger
stocks, therefore investors in those stocks are
compensated more by the market
– Value (non-growing) stocks are risker than growth
stocks, therefore investors in those stocks are
compensated more by the market

9. Fama French Three Factor Model
• Stock expected returns are determined by
three risk factors
– Beta, or correlation with the broad market.
– Size, and
– Valuation

10. Fama French Five Factor Model
• Unified pricing model for stocks and bonds
• Stock/Bond expected returns are determined
by five factors
– Beta
– Size
– Valuation
– Duration
– Credit

11. Risks That Pay
• Beta risk
• Size risk or small cap risk
• Value risk
• Duration risk
• Credit risk

12. Risks That Don’t Pay
• Idiosyncratic risk, or individual stock risk
– Individual stocks risk can be diversified away
costlessly, therefore it’s not compensated by capital
market
• Agency risk
– Risk that your agent don’t work for your best interest.
Example: Lloyd Blankfein Goldman CEO Congressional
Testimony
• Information asymmetric risk
– No hedge funds for my clients.

13. Can Money Managers Pick Stocks
• S&P Active vs Passive Study: No!
• Academic research
– 25% of money managers outright lost money
picking stocks
– 75% of money managers make some money but
not enough to overcome their costs
– Only 0.24% of money managers make money
picking stocks, they may not repeat.

14. Can Analyst Predict Stocks?
• Overwhelming evidences say NO!
• Analysts’ “buy” “sell” “upgrade” “downgrade”
calls have very little advantageous
information.
• Analysts earning forecasts five years out are
negatively correlated to actuals. (La Porta)
Thus those companies forecasted to have the
strongest growth to have the worst returns.

15. How I Apply Fama’s Insight
• Construct well-diversified portfolio to seek
broad exposure to all five risk factors with a
tilt towards small cap and value.
• Shun actively managed funds, use DFA or
Vanguard instead.
• Rebalance to maintain risk exposure

16. Robert Shiller
• “Eugene Fama is like a good friend who
believe in a different religion.”
• “The market is not so much driven by risk
factors but by animal spirits.”
• Author of two “Irrational Exuberance”
books, called the tech bubble and housing
bubble.
• Co-creator of Case-Shiller Real Estate Index

17. Stock Prices Too Volatile

18. Robert Shiller’s Explanation
• Price volatility shouldn’t be 13x dividend
volatitility
• People are basically irrationally
• Stock prices are driven by fear and greed;
stock prices are alternating between
underpriced and overpriced.

19. PE10 Can Predict LT Market Ret

20. How I Apply Shiller’s Insight
• Another Great Depression when stocks drop
85% is nothing to fear
• Not that I can predict it …
• But I know how to deal with it after the fact …

21. Dividend to Rescue

22. Rebalance Periodically
• Not just as a mean of maintaining risk
exposure
• But also can earn additional 50 bps in return a
year.

23. Trading Is Hazardous
17.64%
16.93%
16.33%
15.22%
12.11%
17.90%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
Lowest 2 3 4 Highest Index
Portfolio Returns vs Turnover
(1991-1996)

24. Investment Do and Don’t
• Do diversify
• Do tilt toward small cap and value
• Do rebalance
• Don’t pick stocks
• Don’t pick active fund managers
• Don’t time market
• Don’t trade frequently