Should We Take a Gamble on the Equity Risk Premium Forum: Is There a Risk of a Bubble?

Every 10 years since 2001, a group of leading investors, finance experts, and academics has gathered for a free-flowing discussion of the equity risk premium. This forum, held under the auspices of the CFA Institute Research Foundation and chaired by Laurence B. Siegel, has featured renowned individuals such as Rob Arnott, Cliff Asness, Mary Ida Compton, William Goetzmann, Roger G. Ibbotson, Martin Leibowitz, and Rajnish Mehra, among others. In their latest talk, the participants explored the concept of bubbles and the momentum factor in finance.

Defining and recognizing a bubble is a challenging task in finance. While it is easy to identify bubbles in hindsight, pinpointing them in real-time is much more difficult. Bubbles often occur when asset prices become detached from their underlying fundamentals. However, it is important to note that some bubbles have been justified by the success of a single company within an industry.

Momentum is a powerful force in short-term factor studies, but its efficacy and sustainability are debated. Momentum investing involves buying stocks that have historically performed well and expecting them to continue performing well in the short term. However, this strategy has a short half-life, with stocks typically losing their momentum within a few months. To be successful in momentum investing, one must have a disciplined sell discipline to avoid losses.

Combining momentum with value investing can yield better results. While value investing focuses on buying undervalued stocks, momentum investing focuses on buying stocks with positive price trends. These two strategies can complement each other, with value investing playing out in the long term and momentum investing working in the short term.

There are two main explanations for the momentum factor in finance: overreaction and underreaction. Overreaction occurs when investors buy stocks simply because their prices have gone up, while underreaction occurs when investors fail to react adequately to changes in fundamentals. Both these explanations can coexist and dominate at different points in time.

The efficiency of markets is questioned if momentum trading can consistently generate profits. Efficient market theory suggests that it should be impossible to consistently earn excess returns in efficient markets. However, momentum investing has been shown to generate profits, indicating that markets may not always be fully efficient.

Bubbles can occur in any industry, and it can be challenging to pick the winning company within that industry. History has shown that industries with a multitude of companies often experience bubbles, with only a few companies ultimately surviving and prospering. Therefore, holding an index of an industry during a bubble may not yield favorable results.

Defining a bubble involves making implausible assumptions about valuation models. By analyzing valuation models, such as discounted cash flow models, and assessing whether current prices can be justified, one can gauge the likelihood of a bubble. However, this method has limitations and may not be applicable to certain assets, such as bitcoin.

To navigate bubbles, portfolio diversification and a long-term perspective are key. Investing in a diversified portfolio can help mitigate the risks associated with bubbles, as it reduces exposure to individual companies or industries. Additionally, taking a long-term view allows investors to weather short-term fluctuations and focus on the fundamental value of their investments.