Professor Brad Cornell: A Skeptic's Look at the Cross Section of Expected Returns (EP.151)

May 27, 2021

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INSIGHT

Characteristic ≠ Priced Risk Factor

A characteristic (e.g., high P/E) is not automatically a priced risk factor in asset pricing theory.
Treat characteristics as observed patterns, not proof of a permanent risk premium.

INSIGHT

Markets Often Change The Urn

Investing faces non-stationarity: the data-generating process changes over time.
Many historical regularities vanish or reverse when the 'urn' (environment) changes.

INSIGHT

Limited Knowledge Of Cross-Sectional Returns

We know very little about the true cross-section of expected returns.
Historical patterns can mislead because finance is not like physics with stable constants.

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There is an overarching investment philosophy that permeates most of what we do here at the Rational Reminder Podcast, and while some guests' positions might differ at times, it is rare that we have someone on the show whose approach is as strongly contrasted with ours, as Professor Brad Cornell. Professor Cornell's arguments are so well-founded and researched that they require a re-examination of positions that we feel have been a given for us for a long time. He is the author of about 150 referenced articles, four books, and has conducted hugely interesting work on the current state of value investing. His research with Aswath Damodaran, and insights into Tesla's valuation provide great food for thought, and we get into all of this on today's show! Our conversation also covers ways to go about picking a fund manager and a slightly different lens through which to view past performance. We feel truly grateful to have such a different, yet valid, perspective expressed so well here, and cannot wait to share this highly useful information with all of our listeners. Tune in to hear it all from Professor Brad Cornell!

Key Points From This Episode:

The difference between a stock characteristic and a stock risk factor loading. [0:03:30.2]
Some of the challenges in using characteristics to develop an investment strategy. [0:05:43.8]
The problem of non-stationary frameworks as a starting point for investing. [0:07:33.4]
How little we know about the cross-section of expected stock returns. [0:08:32.1]
Concentrated, characteristic-focused portfolios versus something more diversified. [0:11:12.7]
Unpacking the 'big market delusion' and the huge power of the narrative. [0:12:11.4]
Looking at the example of the electric car market and what it teaches us. [0:16:18.4]
Professor Cornell's thoughts on how to pick a fund manager. [0:21:23.0]
Assessing the issues with mean reverting performance. [00:25:58]
The most relevant ratio: price to a value estimat [00:30:35.2]
Some thoughts from Professor Cornell on the rise in ESG investment. [00:32:22.5]
Approaches to the expected equity risk premium for investors and planners. [00:39:45.0]
Bringing in historical context to the conversation about predictability. [0:45:16.1]
Professor Cornell's approach to calming down investors' reactivity to volatility. [0:47:56.5]
A great definition of success from Professor Cornell! [00:49:57.2]