There is an abundance of noise that surrounds investing; whether it is the noise of pundits who make empty promises about where the market will go or what the next hot sector will be—all this chatter creates an environment of complexity and confusion. Very few investors realize that there is a better way.
The last fifty years have seen the evolution of financial investment science in terms of portfolio construction and asset allocation. Many investors are unaware that there have been significant changes to the way portfolios are constructed, and that these changes have led to more efficient portfolios and reduced risk.
The field has shifted from a focus on historical returns to an emphasis on expected returns. This shift has led to an increased awareness of risk management and risk-adjusted performance benchmarks. The result is better investment strategies that are less influenced by market cycles and more focused on long-term goals for clients. In this article we will discuss how we use “Financial Investment Science” in creating prudent portfolios that are not subject to forecasting or predicting the future. This academic approach to investing is used by the largest pension funds in the world; this methodology captures global market returns by engineering portfolios with specific risk and return characteristics.
Let’s dig in and explore the various components of Financial Investment Science, so you can be confident that your portfolio is set up to provide for you the retirement of your dreams.
The Belief In the Concept of Free Markets – A Primer in the Efficient Market Hypothesis
The Efficient Market Hypothesis is an important concept in financial economics. EMH theory was derived from a theory first developed by the French mathematician, Louis Bachelier. Bachelier wrote about the mathematical properties of random variables and their probability distributions. Bachelier’s 1900 doctoral thesis, “The Theory of Speculation” laid out a mathematical model for understanding how prices of financial instruments change over time. This work became known as Brownian motion, or random walk theory—the idea that prices move from one moment to another randomly and independently of one another. Bachelier used his research to develop a theory that the price of stocks changes in response to new information and reflects all publicly available information. It was from Bachelier that the Efficient Market Hypothesis (EMH) developed.
The Efficient Market Hypothesis (EMH) is a theory that assumes that financial markets are efficient, meaning they act in a way that reflects all available information. In other words, the price of a stock reflects all information about the company and its prospects. The Efficient Market Hypothesis (EMH) is one of the most significant hypotheses in finance. Because financial markets are “informationally efficient” prices reflect all publicly available information. As such, it is very difficult for investors to beat the market because they cannot take advantage of any mispricing or inefficiencies. EMH was developed by Eugene Fama in the 1960s. Fama is a well-known American economist, who has been awarded with the Nobel Prize in Economic Sciences. He is best known for his work on EMH, as well as his contributions to the theory of portfolio management. EMH has since been popularized by other investment academics such as Burton Malkiel and Kenneth French.
EMH in Practice
The Efficient Market Hypothesis (EMH) is a theory that states that securities prices fully reflect all available information. EMH implies that it is impossible to “beat the market” on a consistent basis, as this would require one to have more and better information than all other market participants.
In other words, if you were able to consistently beat the market, you would be able to profit off of your knowledge and increase your wealth at a rate faster than those who are not privy to your information. This would mean that eventually everyone will know about this information, which means it cannot continue to provide you with an advantage over others.
The implication for investors is that a portfolio should be composed of funds that own all the available stocks in all available asset classes (ex: small company stocks, large company stocks, value stocks, microcap stocks, etc.). This broad asset allocation market approach is counter to stock picking and trying to find the next hot fund or sector; this method also lowers the portfolio’s overall cost due to transaction and turnover costs.
The Application of Financial Science to Portfolios
Modern Portfolio Theory
Modern portfolio theory is a way of managing risk that was developed in the 1950s by Nobel Prize winner Harry Markowitz. It says that there are two types of risks: market risk and company-specific risk.
Market risk is the risk that the entire stock market will go down. Company-specific risk is the risk that your own specific investment will go down, regardless of whether or not the market as a whole goes up or down.
The key to managing these risks is diversification—which means spreading your money out among different types of investments so that if one goes down, you’re covered by others. You can also use leverage (borrowing money) and other techniques to lower your exposure to market risk while still being able to take advantage of company-specific opportunities when they arise.
Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a model used to calculate the required rate of return for an investment based on the riskiness of that investment.
The model assumes that investors prefer safer investments with lower expected returns, and that investors dislike risk and will demand compensation in the form of higher expected returns for assuming more risk. In other words, the CAPM says that investors will demand a higher rate of return on risky investments than they will on safe ones.
The CAPM also assumes that investors have rational expectations, which means they’re able to understand what’s going on with their investments and are therefore able to make decisions based on knowledge rather than emotion or fear.
The Power of Global Diversification
Though the US Stock market is the biggest in the world, investors need to be reminded that global stocks are critical in building a diversified and prudent portfolio. The global market represents about 40% of all available stocks in the world and offers great return premiums when allocated in a portfolio.
Financial Investment Science is used in determining the appropriate allocation to global stocks. The use of what is called “Factor Premiums” can target specific dimensions of returns and risk. The “Factor Premiums” of small stocks, value stocks and momentum stocks can be allocated in a manner that offers the highest probability of return premiums without increasing the overall risk of the portfolio.
Behavioral finance is a field of study that looks at how the way we think and behave can affect our investment decisions. It’s an important area of study because it can help us understand why we make some of the mistakes we do, and how to avoid them.
For example, one common behavior that affects our investment choices is overconfidence. We tend to believe that we’re better at things than we really are, and this tends to lead us to overestimate our ability to predict the future and make good decisions about investing.
Another common behavior that affects our investment decisions is Loss Aversion: when faced with a choice between two possible outcomes, we’ll often choose the less risky one even if it seems unlikely to pay off in the long term. This bias means that when choosing between different investments or strategies, people often pick ones that will protect them from loss rather than increase their gains over time.
Behavioral finance helps us understand why these behaviors happen so we can avoid making them ourselves—and maybe even use them as an advantage!
The Dalbar Studies
The Dalbar Study is a long-term quantitative analysis of the US stock market, which looks at how individual investor behavior affects the overall market. It’s conducted on a quarterly basis, and it’s considered one of the most comprehensive studies of its kind in the world.
The Dalbar Studies consistently show that the average investor earns less – in many cases, much less – than mutual fund performance reports would suggest. Investors notoriously sell at the wrong time (sell low) and buy at the wrong time (buy high).
In closing, it’s important to remember that there are no guarantees in investing. However, by using the components of investment science you can greatly reduce your portfolio risk and increase the probability of investment success. Investing does not have to rely on guessing, predicting or even speculating with your hard earned money. By targeting specific dimensions of return, you can build a portfolio that captures global market returns.
You should also remember that the most important thing you can do as an investor is to work with a trusted financial advisor and develop a solid financial plan for your future. A financial plan is an essential part of investing, because it allows you to see how much money you will need in retirement, how much money you’ll have available for other goals, and how much risk is involved in achieving those goals.
A good financial planner will help you develop this plan by asking questions about your lifestyle and goals—and then giving you the tools to help you reach them!