PDF Question:
What should you do if you think the US dollar is doomed to failure?
Mark’s Response:
Eugene Fama recently stated that currencies follow a random walk and exchange rates embed all current information and the forecasts of future information (just like every other traded asset in free markets), therefore there is no expected return from hedging or speculation of any kind. In fact, due to the costs, expected returns are negative. I just saw the new Wall Street and Gordon Gekko said with apparent personal knowledge that, “The Mother of all evil is speculation.”
Willing buyers and willing sellers converge on a fair price (the essence of the Efficient Market Hypothesis).
Fair prices imply that future outcomes are equally likely to be above or below the expected return (calculated from a future price) for the risk of the investment. See the chart below, then click the button near the bottom left corner that says “To View the Percentages Above or Below the Average.”
Think of a fair price as being somewhat similar to a fair coin, where future prices are equally likely to be higher or lower than the future price that will earn a return appropriate for the risk.
When a fair coin is flipped once, the probability that the outcome will be heads is equal to 1/2. Therefore, according to the law of large numbers, the proportion of heads in a large number of coin flips should be roughly 1/2.
The Probability Machine in our front lobby is a fair price simulator, because every time a bead hits a peg, it is equally likely to bounce left as right. As we approach a large number of beads, half are to the left of average and half are to the right and the further from average (or the larger the initial price error), the less likely the outcome. Every time we let all the beads drop, they end up looking similar to the histogram of 600 monthly returns of Index Portfolio 100. This is because at the beginning of each month over that 50 year period, the market arrived at an estimate of a fair price that would lead to a 1% return over the next month based on the news and the participants estimates of the impact of future economic uncertainty. The 5 out of 600 times that the return ended up being in the area beyond –15% or +15% represent the large error in prices that the market estimated at the beginning of the month. Please remember that when there are errors, they are equally likely to be positive as negative. But most of the time, the market gets it pretty close, earning 1% plus or minus 4.5% two thirds of the time and a average of 1% over the 600 months.
If you flip a coin 20 times, how often will get 10 heads, which is the expected outcome, or do you get 3 heads or 17 heads, which are rare occurrences. Look how similar the distribution of heads out of 20 coin tosses looks to the distribution of monthly returns, where the expected outcome is 1%, with -15% or + 15% being the rare occurrences. Lastly, the beads hitting a peg, with a 50/50 probability of bouncing left or right look like the fair coin flip or the fair market price.
A good way to think about this is to realize that somebody has to take the other side his trade on a currency. How confident are you that you know more than the thousands, if not millions, of individuals that combined all of their information and embedded it into the current exchange rate or price of anything traded in a free market. This is the primary reason that capitalism works.
Remember, not only the traders impact the price, but also those who have looked at the price and decided it was a good estimate of future uncertainty and decided not to trade. Like all of our clients at IFA. If we thought prices were wrong, we would trade. But we realize markets set prices so investors are rewarded for the risk they take. So from every price, we have the same positive expected return, which is tied to the a long term documented history of reward for that risk.
See the Hebner Model below. The newly minted Director of Research at DFA, Gerard O’Reilly ( http://www.dfaus.com/library/bios/gerard_oreilly/ ), said that he likes this diagram as an explanation as to how markets work.
Free markets are the best way to price future uncertainty. As seen below, the news and their implications are all ready in the price.
A few questions to ask yourself are:
1. Why wouldn’t this information already be embedded in the price?
2. Is this inside information or well known to all the existing traders?
3. Why wouldn’t prices be fair?
The answer to his risk aversion concerning the dollar is to diversify in the cash flows and capital gains generated from bonds and stocks from 43 countries all over the world, taking advantage the the Law of Large Numbers (LLN) for companies, governments and time.
Once we have agreed upon an initial risk level, Index Portfolio 50 for example, then we accept global diversification as the best antidote to risk. The 50 or 80 year data already includes lots of currency uncertainty, so the variance of returns from such a large data set should give us the best estimate of how well markets estimate future uncertainty and embed it in prices.
