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David Livingston explores what academic theory can teach the sector about investing capital for charities
Academic research in the field of finance is a relatively new offshoot of economic theory, which in its modern form dates back to Adam Smith’s 1776 book the Wealth of Nations [1]. The American economist Irving Fisher was one of the first to try and explain the functioning of markets in the early 1900s and he developed theories to explain interest rates and capital and investment [2]. Since then, a significant amount of academic research has tried to understand how financial markets work, how to allocate capital most efficiently and how individual participants behave within them. There has been too much research to touch on all of these points and so I have focused on the most important question: ‘I have capital to invest; what lessons can I learn from academic research?’
This article covers the following points:
1) asset allocation drives investment returns;
2) diversification works;
3) passive investing outperforms active investing over the long term;
4) fund selection is hard – is it skill or luck; and
5) patience is a key virtue to investing.
Early research in financial theory focused on calculating the intrinsic value of stocks (Graham and Dodd 1934, John Burr Williams 1938) but more recently extensive empirical work has elucidated the most important decision for any capital allocator. This is the question of whether to be invested in financial markets at all, which asset classes and when – so called asset allocation. A study by Ibbotson and Kaplan in 2000 looked at how five asset classes (large-cap US equities, small-cap US equities, non-US equities, US bonds, and cash) explained 10 year returns of 94 balanced mutual funds. The results suggested that asset allocation explained virtually 100 per cent of the fund returns. Numerous academic papers before and since (Brinson, Hood and Beebower 1986) corroborate these findings and suggest that asset allocation explains at least 90 per cent of fund returns. The importance of asset allocation was best exemplified last year in 2008, when the only assets to own were cash or government bonds.
This academic research tells us that the main question for charity finance practitioners and their investment managers today is not which stocks to buy but the choice of asset allocation. It is of course an extremely difficult decision to make, especially over shorter periods, and there is no right answer for all investors. It depends on willingness and ability to take risk, time horizon, and expected withdrawals among other factors. Within asset allocation there is the longer term or strategic asset allocation and also the shorter term tactical asset allocation. What is important is the process of asset allocation decision making which can determine outcomes, such as how often you rebalance the portfolio.
Once we have made the difficult decision of the asset allocation of the capital then what does finance theory tell us about portfolio construction? Harry Markovitz’s seminal work at the University of California Berkeley in the 1950s identified how rational investors (who choose the lowest risk portfolio for a given level of return) should construct portfolios. His work identified the tradeoff between risk (as measured by standard deviation) and return. This was the birth of ‘modern portfolio theory’ (MPT) which shows that by investing in a portfolio of stocks, which are not correlated, an investor can reap the benefits of diversification. Much of his work is taken for granted in modern finance.
Implementation of MPT has shown the problems of the underlying assumptions. Long Term Capital Management, an infamous hedge fund run by Nobel laureates Scholes and Merton, used more complex models based on Markowitzian assumptions to invest capital. After several very successful years they collapsed in 1998 losing $4.6bn in less than four months. The positions went against them, even though this was ‘irrational’ and ‘improbable’. As the economist John Maynard Keynes said ‘the market can remain irrational longer than you can remain solvent’ (1946). Overall what we can take from Markovitz’s work is the simple idea of not keeping all your eggs in one basket, and ideally making sure that the various baskets are not too closely correlated.
Investors are always trying to gain a competitive edge when it comes to picking of individual stocks for portfolios. However academic research shows that this is an extremely
difficult game and fund managers fail to beat a relevant index over time.
William Sharpe, a Nobel Prize winner in 1990, and is famous as one of originators of the Capital Asset Pricing Model and also the Sharpe ratio (which measures risk-adjusted performance) suggested that index investing is a prosaic way to beat the average investor (2002). His argument is that given it is difficult to pick consistently outperforming active managers (see figure 1 below), he believes that an average of all active managers delivers an index return. However, when you include the higher fees on active managed funds this means that on average active managers deliver the index return minus fees.
To support the idea that picking the outperforming funds is extremely difficult below I use an example from Nassim Taleb’s Fooled by Randomness. Imagine that you have 10,000 people who toss a coin once a year. After five years you should have 313 people who have come up with heads every time. This highlights that even by chance some managers will outperform over a five-year period. It is extremely hard to tell luck from skill.
Active managers can and do generate alpha, i.e. outperform a relevant index, but consistency is a big problem. There is generally a high dispersion of returns, and this changes actively over time. Therefore there is quite a high likelihood that you will pick a future loser.
In comparison, an index fund or straightforward exchange traded funds (ETF) have had extremely low dispersion and so it is very reliable over time, as they own the market.
Thus research tells us that over the long term passive investing, i.e. buying the market, as opposed to using active managers, is generally the more profitable and less risky choice. Some skilled investors are well known; everybody knows Warren Buffet’s name but this is the exception that proves the rule. There are very few long-term investors who have beaten the markets.
Classical financial and economic theory has been severely tested in recent years, as a strand of thinking known as behavioural economics has returned to the forefront of finance theory. It was largely absent from the economic literature of the 19th century as economists focused on homo economicus; the idea that man is a rational and self-interested agent. Empirical studies, such as Kahmeman’s and Tvesky’s Prospect Theory have challenged this idea. For example the idea of herding or groupthink, indeed Nietzsche described the ‘herd instinct’ in human society has been suggested as a cause for exuberance and panic that leads to stock market booms and crashes. Therefore although it may minimise risk following or imitating others, be very aware of the potential consequences before proceeding.
Akerlof and Shiller’s fantastic 2009 book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism offers a very plausible explanation of the recent financial market crisis, and of market cycles in general, and gives suggestions for macroeconomic policy going forward. In my view, as financial markets are socially constructed we should not be surprised that human behaviour – especially fear and greed – is a crucial element to causing market cycles.
If you can be patient and invest on an ultra long-term time horizon then, if the last 109 years are anything to go by, you can hope to expect a real return (after inflation) of 4.9 per cent per annum from equities (Barclays Equity Gilt Study 2009). The real returns per annum for the various UK asset classes from 1900 to 2008 are 5.25 per cent for equities, 1.37 per cent for bonds and 1.04 per cent and cash (Dimson, Marsh and Staunton ABN AMRO/LBS Global Investment Returns Yearbook 2008, J.P. Morgan). Another way to highlight this is the following example:if you had invested $100 in US equities, bonds and cash at the end of 1925 (and reinvested the income gross) then you would have had $16,492, $832 and $173 respectively in 2009 (Barclays Equity Gilt Study 2009). Having said this, before you invest all the capital in equities today, the past 20 years have been an extremely poor time for equities and so to minimise your investment risk invest little and often and diversify across asset classes.
Overall if you are patient and can hold your nerve, which is easier said than done, then equity investing in the long term is your best bet for protecting and growing your wealth.
There has been significant and far reaching academic research since Irving Fisher’s work at the start of the 20th century. The most important messages to take away from this are that asset allocation is key, diversification works, passive investing is a better bet than active investing, fund selection is difficult and that patience is a key attribute to investing. Good luck.
[2] Ironically although we’d like to think that we have come a long way since Irving Fisher’s work; his theory on the vicious cycle of debt-deflation following the crash of 1929 seems to explain the recent economic crisis as well as any other.
Author: David Livingston
David Livingston is a portfolio manager at Thurleigh Investment Managers LLP and has an MSc in Management Research from the Saïd Business School. He began his city career with Albourne Partners, a hedge fund consultancy, as a due diligence analyst. David has represented Great Britain as an international rower and has written a sports book on rowing, Blood Over Water. He was voted the 2009 Financial Times New Breed Adviser Best Investment Adviser.
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