Academic Finance Beach Reads

Every summer, we teach a class on financial markets and equity investing to our summer interns. We start by having them read what we consider to be the most important papers for equity investors, drawn from the work of Nobel Prize winners like Eugene Fama, Robert Shiller, and Daniel Kahneman and other star academics like Philip Tetlock, Andrei Shleifer, Mordecai Kurz, Charles Lee, and Joseph Piotroski.

This week, we have compiled five of the greatest hits from our syllabus, linking to the original books and papers as well as some of our commentary from our weekly research archives. We love re-reading these each summer, and we hope you might find some good summer reading in these selections from academia.

Philip Tetlock, Expert Political Judgment: How Good Is It? How Can We Know?
Philip Tetlock assembled a group of 284 experts from a variety of fields and had them make over 82,000 measurable, testable forecasts from 1988 to 2003. He found that the experts were worse than dart-throwing monkeys, even in fields they’d spent their lives studying. In fact, Tetlock found that expertise is a negative for forecasting, because it increases confidence without increasing accuracy.

Tetlock’s work has major implications for investing, most of which is predicated on forecasts. If expertise in a topic area across professions does not improve forecast accuracy, then many of the conventional approaches of active managers may suffer from a fatal flaw. How can we make meaningful investment forecasts, and how should investors change their behavior in light of Tetlock’s work? We explore this subject in depth in our piece “Why Most Active Managers Fail.”

Louis Chan, Jason Karceski, and Josef Lakonishok, “The Level and Persistence of Growth Rates”
Most active investors spend a disproportionate amount of their time forecasting growth rates for the companies they invest in to pick stocks. But what if predicting growth rates is a fool’s errand? These three economists show that there is no persistence in long-term earnings growth beyond chance. We explore the implications of the unpredictability of growth in this piece.

Robert Shiller, “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?”
Robert Shiller took historical earnings, interest rates, and stock prices, and calculated the true value of the stock market with the benefit of perfect hindsight. He found that doing this could explain less than 20 percent of the variance in stock prices. He concluded that changes in dividends and discount rates could “not remotely justify stock price movements.” Stock prices depend far more on investor sentiment than on the fundamentals of a company’s financial performance.

What causes this excess volatility? And how should investors respond? We explored this subject in our piece “How Forecasting Errors Lead to Excess Volatility.”

Eugene Fama and Ken French, “The Cross-Section of Expected Stock Returns”
In a world where forecasting corporate fundamentals is near impossible and where shifting investor sentiment makes such forecasts questionably valuable, what does predict stock returns? Nobel Prize winner Eugene Fama and his research partner Ken French essentially founded the field of modern academic finance. They showed that some types of stocks performed better than others and that those types of stocks could be identified ex ante by investors.

Their seminal 1992 paper introduced the “three-factor model,” which found that small stocks outperform large stocks and value stocks outperform expensive stocks. Our paper on leveraged small value stocks argues that they perform even better than the unleveraged small value stocks identified by Fama and French.

Joseph Piotroski and Eric So, “Identifying Expectation Errors in Value/Glamour Strategies: A Fundamental Analysis Approach”
Car buyers know the problem of lemons well: you think you’re getting a great deal on a car, only to learn later that it’s defective. This is a common problem in financial markets as well. If a small-cap stock is cheap, how do you know it’s not cheap for a reason?

Stanford professor Joseph Piotroski has taken up this question as it applies to value stocks. He shows that investors can reduce their risk of buying a lemon by looking at the historical financial statements. He argues that investors can improve their approach to buying small value stocks by eliminating those stocks with poor-quality financials. We explore Piotroski’s work in greater depth in our piece “The Piotroski Synthesis.”

Maybe these aren’t exactly beach reads, but we hope you enjoy reading some of our favorite papers nonetheless.