October 22, 2009
A LITTLE CONTEXT GOES A LONG WAY
Twenty-first-century investing is all about predicting. But developing intuition about markets, asset classes and how they interact is too often overlooked if not ignored outright. That's a mistake for strategic-minded investing, albeit a mistake that's understandable in the crowd's rush for quick and easy profits.
It's hard to miss all the self-proclaimed seers running around espousing magic formulas and the three most-important investment gauges that insure big gains. Rarely do you hear of the dark side of these easy rules, such as the possibility that maybe, just possibly they're byproducts of data snooping, survivorship bias and other gremlins that harass seemingly flawless assumptions.
It's no surprise that limitations, blemishes and in some cases blatant fallacies are minimized/ignored in the three-minute talking-head interview or the personal finance column at your favorite financial publication. To be fair, some of this is simply an issue of time. Journalists and investment strategists can't deliver a full accounting of prudent investing practices and concepts every time they opine on the subject du jour. As such, it's easy to get a distorted view of investing by looking at any one post from, say, the CapitalSpectator.com and embracing it in isolation to my broader asset allocation analysis as outlined in my book and in my monthly newsletter.
The point is that investing requires (demands) constant vigilance on the critical issue of maintaining strategic perspective. It's tempting to cherry pick a few tidbits of the analytical pie in the belief that a few simple rules and/or market metrics will dispense triumph. Too often they lead to something less.
Investing, after all, is complicated. Financial economics has uncovered many insights into the inner workings of the black box known as asset pricing, but we're still a long way from fully understanding the process. There are some tantalizing clues, however. But in order to take full advantage of the lessons distilled by way of studying economic cycles, asset class relationships and asset pricing, we need to develop some intuition and context about the capital and commodity markets and how they compare with one another and the larger economy through time.
As a quick example, investors need to develop informed expectations about return and risk for each of the major asset classes, or at the very least domestic stocks, domestic bonds, and the aggregate equivalents for foreign markets. That begins by studying history and incorporating what we know about the behavior of prices relative to risk.
Take a simple dynamic like stock market return relative to stock market volatility. How should we think about this relationship? It's temping to extrapolate a raw reading of history and call this a forecast, but that's naïve. The relationship isn't stable. By looking at, say, three-year snapshots of this relationship, however, we can develop a deeper understanding of risk and return. In turn, this can help us formulate an enlightened view of the future.
But we can't stop there. We should also apply an overlay of current valuation, for instance. Another variable is integrating these signals with the business cycle. And if we're strategically oriented in our investing decisions, we'll apply a similar analysis of other asset classes and combine the insights for designing asset allocation. Even so, this only scratches the surfac of the necessary work.
If you're looking for rules of thumb, here's one: Forecasting returns directly is short sighted. A more durable approach is inferring equilibrium-based risk premiums via studying volatility, correlation and other risk parameters and then comparing that with our tactical expectations. This takes time and effort, of course, which is why such topics aren't popular fodder for the three-minute interview.
The bottom line: be wary of easy solutions that purport to offer investment success for little or no effort. If it was really that easy, middling investment results (and worse) wouldn't be so common.
Posted by jp at October 22, 2009 9:51 AM
Okay, okay, so I ordered your book. Happy? :)
Posted by: Anonymous at October 23, 2009 2:00 PM