When Eugene Fama couldn’t explain why beta didn’t cover all of the stock market’s various twists and turns he started to explain the market’s “efficiencies” by adding various “factors” to his model. He expanded it to the 3 Factor model and then a 5 Factor model and today we seem to have an endlessly growing list of “factors” that explain the market’s moves.
What’s really going on here is a series of backtested studies that have been extrapolated into the future to try to explain why the market might move in a certain way. And the inevitable result is a series of research reports trying to explain why and how the market moves using a rear view mirror approach. And then investors take these “factors” as if they are the rule of law, apply them to their portfolios and expect the future to look like the past. And then when these “factors” fall out of favor for long periods, as we’ve seen with value and growth for instance, then the fad shifts and investors come up with some new reasoning for why the market might perform in a certain way.
It’s all a great irony in that Fama’s work has been used to promote the idea of “passive indexing” which supposedly doesn’t require forecasting the future and is very critical of people who chase performance. But what we find with all of the research that’s used to justify “passive indexing” is that it’s all based on extrapolative expectations where researchers study the past and then expect the future to look like the past. And then when they can’t explain the future moves (because their original research was wrong) then they add in different factors (which also will end up being wrong at points).
The result of all of this is that you end up with is a bunch of investors who don’t think they’re predicting the future, don’t think they’re investing in fads and don’t realize that they’ve been sold a great big pile of academic mumbo jumbo.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.