Foundations of Financial Economics

Introduction to Investment Philosophy

Information isn’t knowledge …

Because we read the daily financial newspapers and monthly business magazines, watch finance and business programmes on television, talk with our accountant and swap opinions with friends and colleagues, it is easy to believe we are accumulating valuable knowledge that will make us successful investors. Unfortunately, the harsh reality is that all we are accumulating is information.

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And, as the saying goes, information isn’t knowledge and knowledge isn’t wisdom …

Most people understand that they are not going to learn enough from the relevant popular media to be able to successfully practice medicine or law, for example. It is accepted that it takes years of formal education, training and experience to develop the knowledge and wisdom to become competent in these fields. If you have a major medical or legal issue to deal with, you seek the advice of a doctor or lawyer who has demonstrated that they are at the forefront of research in their specialty and are highly regarded by their peers.

But when it comes to the not insignificant task of managing their life savings, very few see the parallel. They don’t understand that in the financial services’ market someone often becomes perceived as an “expert” not as a result of their extensive education, knowledge and relevant experience, but simply by “putting their hand up” and claiming they are an “expert”. In fact, many “experts” believe that by putting up both hands, they qualify for “guru” status. Most people are simply not aware that there is almost 60 years of valuable investment research done by real “experts” - the world’s leading academic financial economists.

Encouraged by the ready availability of vast amounts of investment related information – we call it “noise”- many normally rational, intelligent people will strike out on their own confident that they can successfully manage their life savings themselves or they can effectively identify someone who will do it for them. And there is a huge financial services industry with a strong vested interest in keeping these folks blissfully ignorant that they are deluding themselves.

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60 Years of modern portfolio theory ...

We believe you have a right to know what the world’s leading academic financial economists have to say about investment. And to understand the implications of what is now a vast body of research in the area known as modern portfolio theory, that has its roots in a 1952 paper by Professor Harry M Markowitz called “Portfolio Selection”.

In 1990, Markowitz won The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel – the “Nobel Prize in economics”- “for ... pioneering work in the theory of financial economics”. He is one of a number of preeminent financial economists and behavioural scientists whose contributions to the development of how investment markets work have been recognised with the Nobel Prize.

In summary, many counterintuitive ideas have emerged from the field of modern portfolio theory. The key messages for investment practice to take from the research are quite straightforward, even boring. They don’t change greatly over time, they don’t provide a source of constant babble for the financial media and they don’t support the notion that there are brilliant fund managers out there that can reliably outperform markets and they will do it for you!

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Four key philosophies...

In fact, most in the financial services’ industry would prefer you ignore (or aren’t told about) the findings of the smartest people in finance because universal adoption of their wisdom would result in many highly remunerated people looking for new jobs. The acceptance of four key philosophies that derive from modern portfolio theory will change forever the way you think about investment and make investment decisions.

In the following articles, we describe these philosophies and their investment decision implications under the following headings:

  • Markets work – rather than trying to outguess the market (i.e. investment markets), let it work for you;
  • Risk and return are related - Only take risks that research has shown to have been reliably rewarded in the past and can expect to be rewarded in the future;
  • Diversification is key - Invest in broad based asset portfolios of every asset class where risk is rewarded over the long term in a strong and reliable manner; and
  • Structure explains performance - Asset allocation is the key determinant of the variation in investment portfolio returns – the rest is "noise".

A guaranteed payoff from accepting and implementing these philosophies is that the next time you see one of those finance "talking heads" on television you can change channels without fear that you are missing anything worth hearing. Of course, you may wish to keep watching because you appreciate the entertainment value!

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