Finance is unlike other professions; the practicing doctor, attorney, or engineer must absorb a mountain of textbooks, academic literature, and case studies in order to achieve even passable competence. Moreover, doctors, lawyers, and engineers need to keep up with their peer-reviewed literature; those who stop reading it soon become stale.
Not so with finance; the money manager who hasn’t cracked open the Journal of Finance, Journal of Financial Economics, Journal of Portfolio Management, or Financial Analysts Journal for the past few years probably hasn’t lost any steps.
Financial practitioners, of course, need to master the basics, but it turns out that these essentials are more than a generation old, namely, the groundbreaking empirical and theoretical groundwork laid down roughly between 1930 and 1980. These include Williams and Fisher’s discounted earnings models; Cowles’ deconstruction of professional market timers and stock analysts; Markowitz and Sharpe’s basics of portfolio theory; Fama’s efficient market hypothesis, subsequently confirmed by decades of empirical work on professional money managers; and, finally, the Black-Scholes model of options pricing. In addition, no compendium of financial basics would be complete without Kahneman and Tversky’s work on Prospect Theory and “bounded rationality” (a four-bit way of describing how dumb investors at all levels can be.)
Stanford University’s Darrell Duffie put it succinctly in the preface to his asset pricing textbook: “Theoretical developments in the period since 1979, with relatively few exceptions, have been a mopping-up operation.”
Worthwhile literature from the past 50 years
Accordingly, I’m going to concentrate on the work built on top of those solid foundations since the late 1970s. For example, off the top of my head, I can only come up with three academic pieces over the last decade of practical significance:
- Hendrick Bessembinder’s “Do stocks outperform Treasury bills?” (Journal of Financial Economics, 2017): Just four percent of listed equities supply the entire equity risk premium; compared to T-bills, the rest are kitty litter.
- Rogoff, Rossi, and Schmelzing’s “Long-Run Trends in Long-Maturity Real Rates, 1311–2022” (American Economic Review, 2024): As societies get richer, the return on capital falls. In ancient Mesopotamia, for example, the statutory loan rate was 20 percent on silver and 33 percent on grain, a veritable wealth machine for that era’s few “capitalists,” most likely temple priests and successful farmers. (Those high returns were also a debt trap so swift and vicious that rulers had to declare regular debt amnesties – “jubilees.”) But who in their right mind would trade even the most humble life in a modern Western society for that of the richest in a world teeming with deadly pathogens without antibiotics, nearly absent communications and transport, and streets infested with thieves?
- Edward F. McQuarrie’s “Stocks for the Long Run? Sometimes Yes, Sometimes No” (Financial Analysts Journal, 2024): While the twentieth and (so far) the twenty-first centuries have been barn burners for stocks, nineteenth century stock investors could have slept better, and done just as well, with debentures. So in the long run, we’re not only dead, but we may – just may – be taking too much risk.
Your list of the past decade’s biggest hits will certainly be different, but likely not much longer. And even so, the above three articles are of mainly rhetorical value, lending authoritative heft to the knowledge that the experienced money manager and reader of financial history should already have.
A panel of experts weighs in
But what do I know? So I queried the heaviest financial practitioner hitters who will answer my emails about their list of the most influential academic research: in alphabetical order, Rob Arnott, Cliff Asness, Antti Ilmanen, Ed McQuarrie, John Rekenthaler, Bart Waring, and, never last except alphabetically, Jason Zweig.
Nearly all of them mentioned the groundbreaking work done between 1930 and 1980 noted above before mentioning more recent research; you’ll notice that a few of these recent articles were authored by members of the above panel, but all of those were recommended by other panel members; I also added a few more of my own.
Here, in approximately chronological order, is their list:
The 1990s saw four articles that examined the behavior of value and growth stocks: Fuller, Huberts, and Levinson’s “Returns to E/P Strategies, Higgledy-Piggledy Growth, Analysts’ Forecast Errors, and Omitted Risk Factors” (Journal of Portfolio Management, 1993); Lakonoshok, Schleifer, and Vishny’s “Contrarian Investment, Extrapolation, and Risk” (The Journal of Finance, 1994); and Fama and French’s “Book-to-Market Factors in Earnings and Returns” (The Journal of Finance, 1995) all pointed out that that investors overpaid for earnings growth, which decayed back to that of value stocks with great alacrity. (This last paper is a follow-on to the pair’s better known “The Cross-Section of Expected Stock Returns” (The Journal of Finance, 1992), which identified the small and value factors in equity returns.)
In addition, Dreman and Berry’s “Overreaction, Underreaction, and the Low-P/E Effect” (Financial Analysts Journal, 1995) put the icing on the value cake by observing the disproportionate damage done when growth stocks’ earnings disappointed, an effect that was almost absent with value stocks.
The subsequent underperformance of value stocks prompted John Rekenthaler to propose what became his eponymous rule: “If the bozos know about it, it doesn’t work anymore.” But there are alternative hypotheses: perhaps the digital age’s network externalities/flywheels have prevented the earnings deterioration of growth stocks that had previously savaged their returns or, alternatively, growth stocks have indeed become irrationally overvalued and are due for a bounce; and the fact that both in both foreign developed markets and emerging markets, the value premium has been alive and well has attracted little notice.
You pays your money and you takes your chances.
The value of discipline and optimism
Schleifer and Vishny’s “The Limits of Arbitrage” (The Journal of Finance, 1997) pointed out that both investors and their money managers tend to bail from worthwhile strategies during market panics, just when their expected returns are the highest; starved of investment capital, these profitable arbitrage opportunities go unexploited. As Charlie Ellis has observed, one wins on Wall Street by being smarter, harder working, or more disciplined than competitors.
The first two propositions, he points out, are nearly impossible; there’s always someone smarter and harder working than you. Schleifer and Vishny’s seminal paper holds out hope that the race is not to the swift or to the diligent, but rather to the disciplined, or, more accurately, to those with the most disciplined clients. Or, better yet, to the individual investor who is her own client.
Dimson, Marsh, and Staunton are best known for their ground-breaking monograph The Triumph of the Optimists; I’ve slipped them into this article because they also formulated the book’s premise in “Irrational Optimism” (Financial Analysts Journal, 2004). Don’t be fooled, they say, by the sure-thing equity risk premium served up by the U.S. stock market over the previous century; returns abroad often fell far short of that, and for very long stretches: “Investors or corporations who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational.”
In the same vein, one article mentioned by almost everyone is Peter (no relation) Bernstein and Rob Arnott’s “What Risk Premium is Normal?” (Financial Analysts Journal, 2002). This piece has received much attention, but not as much as it deserves, as it puts historical and theoretical meat on the strong bones of Dimson, Marsh, and Staunton.
The high twentieth century U.S. equity premium, the authors wrote, was due to four historical accidents: the 1940–1980 bond market bloodbath, the result in the decoupling of nominal from real returns borne on the shift to fiat currency; the rise in equity valuations; survivorship bias (see Argentina, China, and the USSR); and the introduction of strong financial regulation, which greatly reduced the “leakage” of per-share earnings growth that, for the first time, flowed to investors.
None of these four factors can be counted on in the future, which prompted the authors to predict a lower, and perhaps even negative, equity risk premium. Unlucky timing that, since the article was published near the 2002 market bottom. Nonetheless, given current market valuations it’s likely that its predictions may yet be borne out.
The perils of bad behavior
The classic descriptions of dysfunctional investor behavior are a pair of papers by Barber and Odean: “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” (The Journal of Finance, 2000); and “Boys will be Boys: Gender, Overconfidence, and Common Stock Investment” (The Quarterly Journal of Economics, 2001).
Simply put, the more you trade, the worse your returns will be, and testosterone sure doesn’t help. And while it’s easy for professionals to sniff at the peccadilloes of the little guy, it turns out that they’re no better; the most thorough study of lagging and non-persistent mutual fund performance by Carhart (“On Persistence in Mutual Fund Performance” [The Journal of Finance, 1997]) also showed a strong negative correlation of returns with turnover.
Also on the behavioral side, Benzarti and Thaler’s “Myopic Loss Aversion and the Equity Premium Puzzle” (The Quarterly Journal of Economics, 1993) applied Kahneman and Tversky’s Prospect Theory, a formal model of the commonplace that the pain of a given loss is far greater than the pleasure of the same gain, to determine that the risk horizon of the typical investor is about one year.
This would not surprise most evolutionary psychologists, who point out that for the past several millennia humans evolved in an environment of settled agriculture with an annual crop cycle. This served us well enough on the plains of the Fertile Crescent, but not so much in a modern postindustrial society with a financial horizon of more than half a century.
Most readers will quibble with at least a few of the above pieces, and nearly everyone will want to add substantially to this list; I look forward to readers’ additions and comments. With luck, the absorption of the above finance literature gems will prove salutary to returns – and if not, they should at least make the work more interesting.
William J. Bernstein is a neurologist, the co-founder of Efficient Frontier Advisors, an investment management firm, and a writer with several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from the CFA Institute.
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Finance is unlike other professions; the practicing doctor, attorney, or engineer must absorb a mountain of textbooks, academic literature, and case studies in order to achieve even passable competence. Moreover, doctors, lawyers, and engineers need to keep up with their peer-reviewed literature; those who stop reading it soon become stale.