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The Theory Behind Investing Investment TheoryIsn't investing really just about making money, so what does theory have to say about that? A lot, actually. Investing is all about making money, true, but there is a little four letter word risk that keeps getting in the way. Investment theory has a lot to tell us about why that happens and what to do about it. A nice introduction to modern investment theory is provided in The Real World Lessons From Investment Theory from The American Association of Individual Investors. For an academic, yet readable, review of the current state of modern finance and its implications for investing, read John H. Cochrane's New Facts in Finance and Portfolio Advice for a Multi-Factor World. Active vs. Passive Investing One of the most profound, heated and far reaching debates among investors is that over active versus passive investing. Do actively managed investment funds provide value over and above their index fund counterparts? The case for the practice of passive investing that has taken root, particularly in institutional investing, over the last few decades comes down to the old saying, "If you can't lick 'em, join 'em." Study after study of investment performance has reached the same conclusion: After deducting costs, actively managed funds have not as a group fared as well as a passive participation in the indexes to which those funds were benchmarked. Now, however, an award winning article, "Passive Investing: The Emperor Exposed?," suggests that those studies were based on improperly weighted data, and that when the performance data is weighted to more accurately reflect the experience of actual investors, the results are quite different. Asset Allocation Written in early 1999, at a time when asset allocation had just about been forgotten at the end of the greatest bull market in stocks, Roger Gibson made a clear and prescient case for the practice in The Rewards of Multiple Asset Class Investing. A good illustration of the reason for asset allocation can be found in this chart of asset class returns 1996 - 2005. Asset allocation is not without its controversy, dating back to the 1986 seminal article Determinants of Portfolio Performance, which is as often misinterpreted as it is widely quoted. Vocal critics include: Ibbotson & Kaplan and Kritzman & Page. A recent interview with one of the authors, Gary Brinson, helps to clarify some of the confusion that developed over the past twenty years. Like it or not, investing always has been and will always continue to be something of a crap shoot. Every risky investment is a bet on an unknown outcome. Gamblers and investors have always been closely linked, and each has something to learn from the other. A colorful recital of the way the mathematics of betting has been successfully used in both arenas, gambling and investing, is found in the recently published, Fortune's Formula, an interesting review of which you can read. Yes, it does have a lot to do with asset allocation. Diversification "Let every man divide his money into three
parts, and invest a third in land, "Don't keep all of your eggs in one
basket." "Uncertainty is the only certainty there
is,
Because life is unavoidably
uncertain, diversification works. Always has. Always will. It is simply the
common sense notion of dividing your investments up and spreading out your risk
in such a way as to at least blunt the blows that financial markets always
deliver from time to time and when least expected, and it has worked for about
as long as man has been able to acquire and hold any wealth at all.
Unfortunately, belief in diversification requires disbelief in prophesy - at
least as practiced in the financial world! Listen as the colorful author of
Fooled By Randomness
Investor Behavior As the cartoon character Pogo said, "We have met the enemy and they are us." Pogo would have been a wise investor, because nowhere is his recognition of human fallibility more true than in the realm of investing. Risk The financial markets, like life itself, are wrapped in uncertainty. A wise man, who never played the market or studied probability, yet understood the meaning of both, said 'Uncertainty is the only certainty there is, and knowing how to live with insecurity is the only security.' Risk is the most important four letter word in finance. No risk, no return. It's that simple. Risk has to be taken, with the only real questions being how much and to what end. To make the equations work, modern finance has had to greatly simplify the concept of risk, some researchers say far too much some researchers say far too much as pointed out in How the Finance Gurus Get Risk All Wrong. The Web site of the authors, Benoit Mandelbrot and Nassim Nicholas Taleb, offer considerable elaboration of their provocative claims. A new approach to risk measurement comes under the heading of Post-Modern Portfolio Theory. |
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,
Does
risk change over time? If so, how so? We have all seen the charts that show how
the risk of investing in stocks diminishes over time. Trouble is, "It ain't
necessarily so." What is often labeled "time diversification" actually presents
a paradox. As time passes, one form of risk indeed diminishes. Unfortunately,
another grows over time. 