THE NEW FINANCE
by Robert A. Haugen (1995)
Book review by Franklin Neubauer © 
October 1997
Until about the 1980's, the consensus among
academics who study U.S. capital markets was that they are efficient markets.
Then more researchers began finding exceptions to the rule, so called
"market anomalies" where stock prices appeared to conflict with the
efficient market hypothesis. One anomaly called the January effect surprisingly
showed that small company stock prices rise during January. In this book,
professor and financial consultant Robert Haugen, known for writing The
Incredible January Effect, argues that the evidence against efficient
markets requires that we rethink established theories. In The New Finance -
The Case Against Efficient Markets, Haugen summarizes and interprets a wide
range of statistical studies. He concludes that patterns of market inefficiency
provide investors with a Golden Opportunity to earn consistently above average
returns on their investments.
This opportunity lets investors in value stocks profit from swings in
inefficient markets that overreact to information about companies' future
prospects. More specifically, markets initially underreact to new earnings
information and some months or years later markets overreact after developing
unrealistic expectations about future earnings. Haugen writes persuasively,
using his knowledge of relevant research, flair for vivid expressions, and
irreverence towards old theories that conflict with new research results.
Haugen observes that stock prices exhibit inertia in the short-term and often
have reversals in the long-term. This behavior is driven by the tendency for
companies in competitive industries to revert to the mean, so yesterday's
winning performers become tomorrow's average performers or losers, while
yesterday's losers are likely to improve. The market is slow to recognize the
occurrence of these reversals.
Haugen reviews evidence on how designated winners' and losers' stocks perform
in the months after their status as winners and losers is established. He also
presents a somewhat slanted view of the performance of value stocks versus
growth stocks. He devotes one chapter to the predictability of future earnings.
Haugen contends today's investors count too much on future earnings growth, as
investors did in the late 1920's. Investors generally expect too much from
growth stocks, driving up their prices and resulting in disappointments later.
In attacking the belief in market efficiency, which Haugen calls The Fantasy,
he hits related targets, notably the Capital Asset Pricing Model (CAPM), which
he calls The Theory. In describing the origins of CAPM and some assumptions
behind it, Haugen provides one of the clearest explanations of CAPM I have
seen. CAPM describes the relationship between risk and expected return, which
as every MBA knows is positive and measured by beta. Haugen draws heavily on a
well known 1992 study by Fama and French to identify factors that are superior
to beta in predicting expected return. Fama and French found little statistical
support for beta in that study, but Haugen carries the argument further. He
identifies a common bias in the statistical approach researchers use to show
that CAPM is valid. If Fama and French found the
relationship between beta and return is almost flat, but this measurement is
biased upwards, their data supports what seems an implausible conclusion. In
today's investment environment, Haugen concludes high risk stocks have low
expected returns, while low risk stocks have high expected returns. So Haugen
has turned CAPM upside down.
Some conclusions rely on performance for hypothetical portfolios instead of performance
statistics from actual investment managers who charge management fees and incur
brokerage costs. This is an unfortunate omission, because true believers in
market efficiency have long held that market inefficiencies are not large
enough or reliable enough to justify these costs of undertaking an active
investment strategy. Critics of Haugen would argue that investors are better
off buying and holding a market index fund.
Contrary to the book cover's description, Haugen's review of existing research
is not comprehensive. However, the book is well organized and provides an
excellent starting point for readers interested in either the debate on market
efficiency or in evidence on value investing. This book is part of the Level
III curriculum for Chartered Financial Analysts.
Read about economic policy and political promoters. See the review of economist Paul Krugman's Peddling Prosperity.
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