Investment Science
The Science and Art of Investing
The field of investing has evolved into a rigorous and rational discipline based on the collection and analysis of data by researchers and practitioners, the testing of hypotheses, and the formulation of models that explain the performance of portfolios.
Simultaneously, the field of behavioral finance has evolved to demonstrate and explain why investors do not always make financial decisions that are rational. Therefore, we must focus on details of the rational, analytical approach to investing, including the efficiency of markets, the factors of risk in markets, and the leading models used in the design of portfolios. Moreover, we must thoroughly examine the most important behavioral biases that prevent investors from making smart decision about their money.
Capitalism
There is a misconception that investing requires predicting the future. To the contrary, most investors are harmed through perceived future predictions. These predictions are little more than speculating, which is entirely different from investing. Investing is the responsible and methodical act of deploying capital to markets across specific areas of risk. This should then result in expected benefits from the value that is to be created by that capital.
Modern Portfolio Theory
In 1990, Harry Markowitz, William Sharpe, and Merton Miller, three highly acclaimed financial economists, won the Nobel Prize for Economics for their work in the development of Modern Portfolio Theory (MPT). MPT has been widely adopted by institutions and individuals for portfolio design, despite the fact that MPT contradicts many larger Wall Street institutions, which preach stock selection as a key to success. Modern Portfolio Theory consists of four elements that we subscribe to:
1) Investors inherently avoid risk. By nature, one would not be willing to bet a large sum of money on the flip of a coin, despite the fact that the reward of the outcome, doubling one's money, provides measured reward for the risk. Rational investors expect a level of return that appropriately compensates them for taking risk.
2) Securities markets are efficient (Efficient-Market Hypothesis). This is often the most misunderstood concept of MPT. Simply put, it states the prices on traded assets, such as a stock, reflect all known information. Therefore, it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Of course, this theory contradicts the long-established business models of many Wall Street firms, who often refute the efficient-market hypothesis. Research from the top financial institutions, however, continuously illustrates that it is impossible to accurately predict which stocks will outperform others with similar size and growth/value characteristics.
3) Structure dictates market returns. Many highly-regarded follow-on studies have illustrated that as much as 96% of a portfolio's returns are dictated by the overall structure, not by individual securities owned. In fact, more often than not individual stock selection has proven to have a negative impact on a portfolio's performance.
4) Risk and reward are related. There is a maximum reward any investor should expect for their corresponding level of risk. The less risk, the less expected return. The Efficient Frontier represents the range of portfolios with optimal expected returns for any given level of risk. The goal for investors should be to have a portfolio that lies on the appropriate point of the Efficient Frontier for their risk level.
Behavioral Finance
Researchers in the field of finance have expanded their tool kit and integrated human characteristics into their overall understanding of risk. The emerging field of behavioral finance suggests several reasons why understanding risk involves much more than simply assigning investors to categories of portfolios (aggressive, conservative, etc.) based on questionnaires. Here are some interesting observations:
- An investor does not react to loss in the opposite way as he reacts to gains. Gains and losses are not mirror images of each other;
- An investor's utility (material happiness) increases, but at a slower and slower rate, as gains become larger and larger;
- An investor's utility (material happiness) decreases, but at a faster and faster rate, as losses become larger and larger;
- Suppose investment outcomes gradually shift from good outcomes to bad outcomes (for instance, returns gradually reduce over time); the investor's utility (material happiness) does not also gradually reduce, but rather takes a sharp drop precisely at the point that the investor considers the boundary between good and bad outcomes;
- Risk is an individual concept that depends upon one's particular goals and preferences; and
- Goals generally come in a range of acceptable outcomes, ranging from a minimum acceptable outcome to a lofty ("tickled pink") outcome.
Dimensions of Risk
Most finance academics and investment professionals acknowledge that there are three primary factors influencing equity portfolio returns:
1. Exposure to the overall market (beta).
2. The percentage invested in large company stocks versus small company stocks. Over time, small company stocks have higher expected returns than large company stocks. This is because stocks of small companies are riskier than those of large companies and investors demand a premium for this risk. In a more technical perspective, it is hypothesized that due to smaller companies having higher "costs of capital" (for example, they must borrow money at a higher interest rate than larger companies), they must embark on projects that yield a higher return. Of course, this also increases the likelihood of failure. This risk is mitigated, however, by investing in a large enough group of small companies so that the rewards from successful companies net of failures will provide an expected benefit over larger companies.
3. The percentage invested in growth stocks versus value stocks. It is counter-intuitive, but over time, value stocks have higher expected returns than growth stocks. Value stocks are those that sell at lower prices relative to their earnings and book values. They are perceived by investors to be riskier than growth stocks and investors demand a premium for this risk as well. Like their small company counterparts, value companies tend to have a higher cost of capital.
