Phil DeMuth's 'Affluent Investor' Highlights Hindsight Bias

by: Eric Falkenstein

I received a copy of Phil DeMuth's Affluent Investor, which at around $11 is a bargain. Alas, advice books like these, for the layman, are kind of futile, as good advice is ignored by those who need it precisely because those who need it would never seek it. So, it's best as a gift. If there's a 10% chance they can learn, it's worth $11.

For example, DeMuth nicely informs the reader what investment advisers think is wealthy: $100k to $1 million is 'affluent', $1MM to $10MM is 'high net worth', above that is 'ultra high net worth'. From a practical perspective, one should target getting 25 times one's income when one retires, probably a good definition of 'comfortable.'

He makes the interesting point that gambling is fun and savings is hard. But savings, investing, and gambling, are all different shades of grey, and highlights that something may seem the same at one level (not spending) is very different at another (buying T-bills vs. lottery tickets). Another good point is that some stocks, like utilities, have generated profits and dividends for decades, and some like Facebook (NASDAQ:FB) are predicated on something unconventional, monetizing something novel. These should be thought of as totally different, yet, these are both 'stocks', and classed the same.

He seems to be plugged in to the big names in finance, and so co-authored several books with Ben Stein, a well-know author and commentator (and son of famous economist Herb Stein), and seems to know the Peter Bernstein crowd (eg, Black, Scholes) pretty well.

Interestingly, DeMuth's book mentions low-beta investing in a couple of pages, and even includes this blog as charitable reference, which I greatly appreciate. Alas, I don't agree with his portrayal of the low-beta phenomenon. He promotes an alternative history, one consistent with Frazzini and Pedersen's betting-against-beta theory. The basic idea is that low beta stocks outperform high beta stocks on a risk adjusted (but not absolute) basis, and this is because of borrowing constraints.

DeMuth mentions Myron Scholes, Peter Bernstein, Perry Mehrling and others, in creating his narrative, that these guys were big early believers in the Frazzini and Pedersen model (before these guys were born), but were thwarted by regulation. That is, all the big players knew low beta stocks outperformed since 1969, and actively advocated levering up low-beta stocks. In practice, however, this aggressive leveraging is hardly, if ever, observed, as a result of which the volatility effect can persist, because people are leverage averse. That is, the big players knew about the low volatility investing anomaly all along (just ask them!).

True, Black did show early on why the Security Market Line (SML) is too flat because of borrowing constraints (see Brennan (1971) and Black (1972)) . Facts are important, and Black missed the big one here, which is the SML is flat--not insufficiently upward sloping--but flat (at best). A flat SML doesn't generate a rational reach for high beta that underlies the Frazzini and Pedersen (and Black, Scholes, Mehrling, etc.) model, because you don't prefer the higher returning 1.5 beta stocks if, actually, those stocks don't generate higher returns.

That is, 1.5 beta stocks don't outperform 1.0 beta stocks, so saying investors prefer them because they have higher returns means their beliefs are irrational. It's like normal form game where everyone is wrong about the other guy. This is general not considered an equilibrium, and so, back in my day, non-publishable. Times change. I suppose this is the mainstream academic's (eg, Fama, Campbell) favored explanation.

The low volatility (aka low beta) anomaly is not merely that low beta (vol) stocks have higher than expected returns, it's that their returns are higher than average. Just look at the performance of Acadian, Robeco, or Analytic, which have been running low vol funds since 2006ish.

If borrowing constraints were key, we would see a risk premium where they are not applicable, such as futures, but we don't. We also see the opposite in options, where the negative risk premium seems simply related to volatility. Saying this is consistent because investors believe they are amplifying positive returns, while in fact they lose something like 20% per expiration, implies an insane dichotomy between expectations and reality. For this reason I think Frazzini and Pedersen or Scholes are wrong to say this all fits in their theory, because their theory is based on everyone acting on a different model than they assume: maximizing returns personally, while assuming everyone else is maximizing variance-adjusted returns. Usually, the dichotomy is someone thinks everyone else is acting irrational, here, the agents act irrational and assume everyone else is rational.

In sum, I don't think it's a good explanation now, and historically, Scholes or his colleagues didn't ever discuss the low volatility anomaly for 35 years or so, which makes me think it wasn't something they thought was important, relative to their other ideas over that period. For them to now insinuate they documented the low volatility anomaly back in the 1970's is typical post hoc rationalization you find in regular people.