4min chapter

Prof. John Y. Campbell: Financial Decisions for Long-term Investors (EP.250)

The Rational Reminder Podcast

notes

CHAPTER

The Shortfalls of Mean Variance Optimization

Financial markets are subject to extreme events while things can happen like the stock market crash of 1987 when stocks fell 20% in one day. The problem is if you use historical variances and covariances to combine risky assets along with historical mean returns, that procedure can go disastrously wrong. If you're looking at too many assets with not enough historical data, what you'll tend to do is find a portfolio just by chance which happens to be almost riskless. It's probably better done in the context of a personal relationship with a financial advisor than just filling in a form for a mutual fund company.

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Transcript

Episode notes

Navigating the world of finance and investing is undeniably complicated, sometimes unnecessarily so. And all too often the people who end up making the most costly financial mistakes are those who can least afford to do so. But what exactly needs to change in order for more people to make wise and well-informed financial decisions? And how do we go about implementing those changes? Joining us today to help us unpack this topic and the many decisions involved in the world of investing is John Y. Campbell, a British-American economist, professor of economics at Harvard, and founding partner at Arrowstreet Capital, a systematic asset management firm based in Boston. John has published over a hundred of articles on a range of topics including fixed income, equality valuation, portfolio choices, and household finance, all of which we explore in today’s expansive conversation. We kick things off by discussing utility theory, why it’s so important to the study of finance, and what it can teach us about risk aversion, before delving into portfolio structure, asset allocation, and hedging. John also expands on the study of household finance, the mistakes that households typically make, why household behaviour tends to differ from theoretical predictions, and how to bring theory and behaviour into alignment. We wrap things up by discussing how financial literacy, education, and regulation can improve outcomes for households before hearing John’s advice on selecting an optimal mortgage contract along with an overview of the type of risk that mortgage contracts expose you to. Today’s episode is jam-packed with information and insights from a profoundly knowledgeable figure in academia.

Key Points From This Episode:

• An overview of asset pricing theory; unpacking the utility function in finance, what it teaches us about being risk averse, and how it is used to determine the value we place on any amount of money. (0:04:01)

• The implications of using the Capital Asset Pricing Model (CAPM) for portfolio choice. (0:13:58)

• The difference between arbitrage pricing theory and the Intertemporal Capital Asset Pricing Model (ICAPM). (0:18:15)

• How predictability in stock returns affects portfolio advice for long-term investors and why John prefers the cyclically adjusted price-to-earnings (CAPE) ratio. (0:23:40)

• Why a long-term inflation index bond is the ideal risk-free asset for a long-term investor, and how portfolio advice, concerning bonds, changes when inflation index bonds are not available. (0:28:32)

• The impact that labour income should have on optimal portfolio choice and the relationship between human capital and financial assets as you age. (0:35:31)

• Learn about John’s 2004 paper entitled ‘Bad Beta, Good Beta’ and how intertemporal asset pricing explains differences in returns between value and growth stocks. (0:38:33)

• The benefits and drawbacks of value investing: why historically they do well on average, but extremely poorly over certain periods. (0:41:12)

• A breakdown of stochastic volatility and how it affects portfolio choice for long-term investors. (0:47:16)

• How long-term equity investors should approach foreign currency hedging in their portfolios, and how fixed-income investors should deal with foreign currency exposure. (0:50:07)

• The study of household finance, what it aims to answer, and the major challenges in this area of study. (0:53:54)

• An overview of the mistakes that households typically make, how costly they can be, and why household behaviour tends to differ from theoretical predictions. (0:59:57)

• Suggestions on how household behaviour and theoretical predictions can be brought into alignment and the methods that have the most potential to improve outcomes for households. (01:04:47)

• What households should take into account when selecting an optimal mortgage contract and the different types of risk that mortgage contracts expose people to.[01:10:18]

• How John’s definition of success has shifted over the years, the joy of academia, and why he is especially grateful for the opportunity to connect with students on their educational journey. (01:16:04)

Participate in our Community Discussion about this Episode:

https://community.rationalreminder.ca/t/episode-250-prof-john-y-campbell-financial-decisions-for-long-term-investors-discussion-thread/23202

Links From Today’s Episode:

Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582. Rational Reminder Website — https://rationalreminder.ca/

Shop Merch — https://shop.rationalreminder.ca/

Join the Community — https://community.rationalreminder.ca/

Benjamin on Twitter — https://twitter.com/benjaminwfelix

Cameron on Twitter — https://twitter.com/CameronPassmore

John Y. Campbell — https://scholar.harvard.edu/campbell/home

'Who Should Buy Long-Term Bonds' — https://www.nber.org/system/files/working_papers/w6801/w6801.pdf

'Inflation Bets or Deflation Hedges? The Changing Risks of Nominal Bonds' — https://scholar.harvard.edu/files/campbell/files/campbellsunderamviceira_20160523.pdf

'Growth or Glamour? Fundamentals and Systematic Risk in Stock Returns' — https://scholar.harvard.edu/sites/scholar.harvard.edu/files/campbell/files/gorg20090319_copyedited.pdf