| The S&P isn’t a reasonable benchmark to PE in the first place. Your argument is like saying: “US Teasuries underperform the S&P by 8% every year, people and countries buying treasuries are stupid and just want to be part of some secret club.” There’s a couple of things wrong with this argument so let’s go over it: 1) Low or uncorrelated return streams are very valuable due to the central limit theorem. As you add these return streams together, they form an increasingly tighter normal distribution. This gives us two advantages: we can convert non-normal distributions into normal ones, and we reduce our standard deviation with every stream we add as long as the correlation is less than one. 2) Returns aren’t the defining factor of whether a strategy is worth it. Instead institutional investors measure investments by their Sharpe ratio: the slope of the line between return and risk (the axis is the risk-free rate). The reason for this is that since these kinds of investors can not just lend, but borrow at the risk-free rate, they can lever up their returns to anything they want. This is called risk-adjusted returns. 4) The biggest risk in investing is exposure to Beta, “the market,” which in the US is usually measured by the S&P 500. Reducing exposure to Beta is often goal #1 of institutional investors. Maybe not a 100%, you should definately not be exposed to a 1.0 Beta coefficient. This is especially important for endowments, pensions, and other funds that have monthly or yearly pay-outs. The auto-workers would be super pissed if the economy tanked and they no longer got their retirement pensions. After all, that’s one of the things that pensions are supposed to hedge against. Before I started working in finance, I definately had the same questions and theories as you. After all, the field is very baroque and complicated and the explanation of the industry being stupid is very simple and straightforward. Chesterson’s Fence is a good way to view a lot of things. Understanding is always a prerquisite for change. |