Forty years ago, Eugene Fama and Kenneth French revolutionised Finance by casting doubt on the CAPM theory: “They wrote a series of papers that cast doubt on the validity of the Capital Asset Pricing Model (CAPM), which posits that a stock’s beta alone should explain its average return. These papers describe two factors above and beyond a stock’s market beta which can explain differences in stock returns: market capitalization and “value”. They also offer evidence that a variety of patterns in average returns, often labeled as “anomalies” in past work, can be explained with their Fama–French three-factor model.” (Source:
As if that weren’t enough, the two Finance legends played a key role in the creation of one the world’s largest quantitative asset management firms, Dimensional Fund Advisors (DFA) which has US$750 bn of assets under management.
In this piece written for DFA’s clients, Kenneth French makes several profound points which gave us months of thinking material!
Firstly, Prof French points out that most people, including Finance professionals, profoundly misunderstand ‘risk’ and confuse it with things like beta, standard deviation and loss of capital: “I define risk as uncertainty about lifetime consumption broadly defined. People invest because they want to use their wealth in the future. Some might plan to spend all the money on themselves for things like food, shelter, travel, recreation, and medical care. Others may plan to spend some of their wealth on political contributions, charitable donations, or gifts and bequests to their children. My definition of lifetime consumption includes all these and any other anticipated uses of wealth. Investors like a high expected return because it increases the expected wealth that will be available to spend or give away. And everything else the same, risk averse investors prefer less uncertainty about their future wealth.
If people don’t like uncertainty about future wealth, shouldn’t we measure each investment’s risk by its potential for losses or the volatility of its returns? No. Those definitions miss important interactions within an investor’s portfolio and, even more important, between the portfolio return and the investor’s other sources or uses of future wealth.”
What Prof. French is saying here actually has significant implications for almost everyone reading this sentence. For example, suppose I have financial requirements/obligations over the next 30 years which require me to compound my savings at an annual rate of, say, 15% per annum (failing which I will not be able to meet my requirements/obligations). I should therefore choose a fund which gives me the highest probability of meeting this return threshold as consistently as possible OVER THE 30 YEARS. Almost any other fund, including funds which have historical given and will in the future give higher returns than 15%, is sub-optimal for me. Therefore risk & return are specific to me and my needs/requirements/obligations.
Secondly, Prof French points out – in the most erudite manner possible – that the way most people allocate their wealth across various asset classes (using a mumbo jumbo mixture of grandmother’s tales, current fads and their own prejudices) does not make sense. Here is how he says it should be done: “I use a top-down approach when designing my investment portfolio….I start with the fact that all investors must collectively hold the global market portfolio of all stocks, bonds, and other financial assets. Simple arithmetic then says the average dollar invested holds the global market portfolio. And if we weight by investment wealth, so Bill Gates gets more weight than I do, the average investor also holds the global market. As a result, the average investor and the global market portfolio provide useful reference points for my portfolio.
My pro rata slice of the global market portfolio would probably be a fine choice for my portfolio if my preferences and circumstances matched those of the global average investor. But they don’t. The differences help me think about how my portfolio should differ from the global market portfolio. I illustrate this framework with a few examples of how I differ and the implications of the differences for my portfolio.
I live in the United States, almost everything I buy will be denominated in US dollars, and I may not be treated as well as local investors in foreign markets. All three facts lead me to overweight US investments. First, economists talk about something we call “keeping up with the Joneses” and younger readers know as FOMO, fear of missing out. If your neighbors overweight US investments, you can reduce your risk of suffering while they prosper by also overweighting US investments. Second, since the things I expect to consume are priced in dollars, investments denominated in other currencies have an extra risk; the dollar payoff from a foreign investment will be smaller if the foreign currency depreciates. Third, local investors have an advantage over foreigners in some markets. Foreigners sometimes pay higher effective tax rates than locals, and in some countries capital controls make it difficult for foreigners to repatriate their wealth. Argentina, for example, instituted restrictions on the flow of capital in 2019 that continue to challenge foreign investors. These and similar factors push me and other US investors to overweight US investments and underweight foreign investments. And this seems to be a universal result. As a group, locals overweight the investments in their home market.
Let’s look at another factor. I am substantially older than the average investor, even after weighting people by their investment wealth. When I was young, most of my wealth was anticipated income, so the volatility of my investment returns contributed little to the uncertainty of my lifetime consumption. The return on my investment portfolio had almost no effect on my anticipated wealth or lifetime consumption. I also had a lifetime of real options ahead of me. If my investments did poorly after I had accumulated some retirement savings, I could adjust, perhaps by deferring the purchase of a vacation home or by moving to a higher paying but less attractive job. At my current age, the return on my investment portfolio pretty much determines the wealth I will have available to spend or give away. As a result, my age pushes toward less risk, with a bigger allocation to fixed income and a smaller allocation to equities than the global market portfolio.
A third factor is my risk aversion. I think I’m less risk averse than the average investor. While my age pushes toward more fixed income, my low risk aversion pushes toward equity. Low risk aversion is winning for now, so I hold more equity and less fixed income than the global market portfolio.
The top-down global-market approach draws attention to many of the issues that are important when designing an investment portfolio. In addition to domicile, age, and risk aversion, one should consider how personal financial circumstances, including anticipated and potential sources and uses of wealth, tend to vary with the components of the global market portfolio….
The top-down approach helps me think about the direction I should move away from the global Value Weighted market – should I overweight value stocks and underweight growth stocks or vice versa. It also gives me a general sense of how much each of my portfolio allocations should differ from the global market’s. The approach does not tell me, however, exactly how much to deviate unless I am trying to match a specific liability, such as locking in a big down payment. Someone clever may be able to determine my “ideal” portfolio, but I would not trust a precise analytical solution to a problem as complicated and poorly defined as this.”
Thirdly – and this is the most powerful part of the article – none of us should get too carried away by historical returns because it is highly likely that they are deceiving us by playing on our psychological biases: “Perhaps because the evolutionary cost of false negatives – failing to see real patterns – was high relative to the cost of false positives, people seem hardwired to identify patterns, whether they are real or not (e.g., Shermer 2008). Who hasn’t seen a ship in the clouds or human figures in a dirty window…
Given the importance of financial markets and the human inclination to identify patterns, it is not surprising that researchers and investors have found patterns in asset prices and returns for centuries and continue to do so now. It is also not surprising that a nontrivial fraction of the patterns are false positives.
We can split an asset’s return into its expected return, which is our best guess of what will happen based on all the information currently available, and its unexpected return, which is the surprise – the difference between what actually does happen and what was expected,

R = E(R) + U.                                                                                 

The goal of most who study stock returns is to predict the future, not describe the past. In the context of equation (1), researchers are trying to identify persistent differences in expected return across assets or asset classes. Differences in the cross-section of expected returns, however, are usually small relative to the volatility of unexpected returns, so realized returns are mostly the result of chance. Over reasonable investment horizons – three, five, ten, even 20 years – realized returns are typically dominated by the unexpected component and inferences from realized returns are often false positives.
The performance of FAANG stocks…over the decade from 2012 to 2021 illustrates the importance of unexpected returns….The 2012-2021 average annual return on a value weighted portfolio of these five large stocks is 30.09% and the cumulative ten-year return is 1166%….Should we expect the portfolio to deliver 1166% over the next decade? No. Strong unexpected returns are a better explanation for the great return and, by definition, the expected value of future unexpected returns must be zero.”

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