Efficient Frontier
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William J. Bernstein

The Investment Entertainment Pricing Theory (INEPT)

Stocks, Bonds, Bills, and Lottery Tickets

The interplay between return and risk is the heart and soul of the financial markets. You want high returns? Fine, prepare to have your bells seriously rung every now and then. You want safety of capital? OK, but forget about retiring to La Jolla or Provence.

And once you've decided to embrace risk in search of higher returns, it can't be just any old risk, it has to be systematic risk—the risk of the market as a whole, which cannot be diversified away. As Bill Sharpe is fond of pointing out, you're not rewarded simply for going to Las Vegas, or for taking the risk of investing all your assets in a nondiversified portfolio of stocks.

It's worth probing the good professor's bon mot. Consider a simple lottery ticket: Your one dollar purchase at the local convenience store is in reality a marketable security with a one week expected return of about minus fifty percent and a standard deviation in excess of one hundred percent. Clearly, a miserable asset class if ever there was one. Even its zero correlation with the rest of your portfolio does not redeem it. In Professor Sharpe's argot, it has a hideously low alpha.

And yet, folks buy these things. Why? Because a lottery ticket's return is only partly financial. What it lacks in strictly fiscal terms it makes up for in entertainment value. In other words, the low return is supplemented by the heady but short-lived fun of dreaming about spending the rest of your life on Maui. Taking this line of reasoning to its logical extreme, we can view a theater ticket as an investment with a return of minus one hundred percent, a standard deviation of zero, and very high entertainment value.

Does this model tell us something about investing? I think so. Even a cursory look at asset-class behavior provides some rich parallels. Initial public offerings (IPOs) come most readily to mind. There is a wealth of data demonstrating that IPOs in the aggregate return considerably less annually than the market and certainly with much greater risk. To quote Ben Graham's exasperated summary of unseasoned offerings, "Why do folks buy this junk?" In my opinion, here’s why: Because it’s so much more fun taking a chance on finding the next Amazon.com or Iomega than owning Federal Screw Works or Caterpillar. In short, IPOs are the investment equivalent of a lottery ticket—one is in effect trading return for entertainment.

An even meatier example is seen in one entire corner of the market. Eugene Fama and Kenneth French (F/F) have shown that one can explain almost all of the returns of equity portfolios based on only three factors: market exposure, market capitalization (size), and price-to-book (value). According to F/F, all three factors are proxies for risk. While there is serious debate as to whether the higher return of value stocks is related to their inherent riskiness and whether in fact there even is a premium for small stocks, the fact remains that F/F's "three-factor model" does a crackerjack job of explaining domestic portfolio returns, with R-squareds of about 0.95 anywhere you want to look. There is one exception, though—small growth stocks—which seem to have had returns much lower than predicted by the model. How much lower? I've plotted the growth of one dollar of the four style-corner portfolios since 1927:

The returns of small growth stocks are ridiculously low—just 2.18 percent per year since 1927 (versus 17.47 percent for small value, 10.06 percent for large growth, and 13.99 percent for large value). It should be noted that the above returns are for hypothetical portfolios: the returns of real portfolios using the above methodology are lower still, particularly for small stocks, because of little things like commissions, bid/ask spreads, and market impact.

In fact, the F/F model successfully predicts the returns of stock portfolios of a given size and value status with one significant exception: small-cap growth stocks. In this one case, portfolios of small-cap growth stocks have had annual returns several percent per year lower than predicted. Since these are your best shot at a Peter Lynch ten- or hundred-bagger stock, they are not simply securities, but also lottery tickets. It’s not unreasonable to suppose that because of their entertainment value, their expected returns are lower.

The burgeoning world of mutual funds is rich with examples as well. Go with Heikko (of the notoriously volatile American Heritage Fund) and you will be well entertained, but likely not well compensated. Rumble with the "Tough Guys" (of the Kaufmann Fund) and fulfill your investment Rambo fantasies… and again, most likely, you will pay the piper on the bottom line. (A small personal confession: For years I've been mildly amused by Ralph Wanger's well-written Acorn Fund quarterly reports, and over the past decade I too have paid the price.)

The Fourth Factor

To recap, F/F decompose portfolio returns into three factors: market exposure ("Mrk"), size (small minus big, or "SmB"), and value (high book-to-market minus low book-to-market, or "HmL"). I propose a fourth factor for the excess returns offered by dull stocks. Using F/F's nomenclature, I designate this factor "dull minus boffo," or "DumB." DumB differs from the three classic factors in that it carries no discernible financial risk. Unfortunately, however, in finance there are no free lunches: Seek the excess return of DumB stocks and you suffer a major tedium penalty, forgo bragging rights, scintillating cocktail party chatter, and the pleasure of having Dan Dorfman plug your holdings.

Where do you find DumB? With disciplined, low-key managers. With low portfolio turnover. And, of course, with that mother lode of dullness—index investing, preferably in out-of-favor asset classes.

I propose to name this concept the "investment entertainment pricing theory," or "INEPT." Over short time periods, small growth stocks and IPOs can do very well, but in the end, investing in DumB stocks is the safest way to avoid becoming an INEPT investor.

Editor's Note: Four weeks after this article was written, the Chairman of the Federal Reserve Board appeared before the Senate Budget Committee, and explained the excessive valuations of internet stocks in terms of a "lottery premium." EF's Internal Affairs Division swung into action, and the source of the leak was swiftly pinpointed. Prompt and merciless punishment was administered—the perpetrator's rations of tiramisu and chianti were drastically curatiled. EF assumes no liability for market or economic dislocations caused by the unauthorized use of its intellectual property by Central Bankers, foreign or domestic.

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copyright (c) 1999, William J. Bernstein