Date: May 18, 2009
Why Save? Cause My Granny Told My Mother Who Told Me…
Before dabbling into investing, we must answer this important question – why invest? But to answer this question, we must first answer another related question – why do we save? One main reason for saving is to prepare for that rainy day; such as a sudden fall income due to economic downturn or some unfortunate event. This is known as precautionary saving. Another reason for saving is to improve future living standard – which is also known as deferred spending.
Since precautionary saving is a form of self insurance, the level of risk that one could take on this category of savings must be low, savings for deferred spending, on the other hand, could handle a higher level of risk as its is money budgeted for the future. It is therefore the latter that investors should be using for risky investment rather than the former.
However, the risk level that investors can take on deferred spending is also dependent on the fund’s objective. More essential objectives – such as for retirement and child education – may have long investment period but may not able withstand any value fluctuation while less essential objectives – such as buying a new car or bigger house – may be able to withstand wider value fluctuation.
We will focus from here on savings for deferred spending rather than precautionary savings itself.
Time is Money.
We often hear that there are two ways to earn returns – invest over a longer period and take more risk. Because the objective of deferred spending is to improve future living standards, returns are the motivation behind deferred spending. Therefore, time is the first component of returns in investing. This return is required even in the absence of risk and should not be confused with returns required from taking risk.
Compensation for risk-free savings is however low. For example, one month US Treasury bills between 2001 and 2009 averages around 2.4% per annum compared to 4.9% average returns for US 20 year bond. Why is there a difference between the returns of 1 month bills and the 20 year government bonds? There must be compensation for investors to take risk.
Entering the Tiger’s Den for Tiger’s Cubs – Risk and Return
Risk is the chance that an investment does not deliver what is expected. For example, liquidity risk is the chance that the asset cannot be converted into cash within certain timeframe; counterparty risk is the chance that the contracted party cannot deliver the agreed compensation; and market risk is the chance that the investment returns do not meet expectations.
Because risk introduces uncertainty, most investors would avoid it – unless they are sufficiently compensated above the risk free rate for undertaking it. While an investment with high potential returns may not necessarily come with high risk, a high risk investment must provide potentially returns to in order to attract investors. The higher the risk, the higher will be the required returns.
We therefore form this simple general rule in investing, returns is made up of two parts – a risk free time rate and a required returns for undertaking risk. If an investor chooses to not take risk, then he must be very patient or thrifty to grow his future wealth. However, by taking more risk, there is a chance that he can improve his wealth level within a shorter period and with less funds.
No Rewards For Removable Risk
In 1952, Nobel Prize Laureate Professor Harry Markowitz delivered the financial world a great finding. He found that certain investment risk can be simply and cost effectively removed through diversification. He showed that by combining different assets together and varying its weights, a myriad of portfolios with certain risk-return characteristics can be created. Most importantly, he found that a certain set of portfolios can provide investors the best returns given a certain level of risk. He named this set of portfolios the efficient frontier and the removal risk as non-systematic (or diversifiable) risk.
In 1967, another Nobel Prize Laureate, Professor William Sharpe, added that the efficient frontier can be further improved by adding a zero-correlated asset (usually risk free) and this set of efficient portfolio can cater a variety of investors with different risk appetite and budget.
The findings also had another important conclusion; since investors could simply diversify non-systematic risk, investors will only be compensated for the systematic risk that they undertake. This principle has been followed by most fund managers and analysts when valuing investments.
The principle of compensating only systematic risk is also the basis of risk management. Investor must ensure that their portfolio is well diversified to remove non-systematic risk and set systematic risk close to the risk level that they can undertake through selecting a proper asset allocation model. This is the accepted road to Rome and has been the mainstream knowledge thought in all universities.
Roads to Rome
We can now discuss the roads to Rome. Generally, we can divide investment strategies into three categories – asset allocation, market timing, and stock picking. By and large, all three strategies aim to optimize the risk-return level. However, market timers and stock pickers claim that their methods can outperform asset allocation method.
Asset allocators basically follow the ideas developed by Markowitz. They would study statistical parameters and correlation between different assets and then run models to create the most efficient portfolios. Asset allocators are mainly quantitative “nerds” who believe that statistical methods are more reliable for investment strategies in the long term. Their methods however are extremely quantitative in nature and can be hard to understand – even to many financial professionals.
Market timers believe that investors should spot trends and momentum to profit from investments. Market timers usually study charts to find such trends and act when they figure that the timing is right rather then what the asset really is about. They believe that all available information is reflected in price and therefore believe that profits can be made from identifying market trends. In the book “A Random Walk Down Wall Street” Burton Malkiel wrote “A true chartist doesn’t care to know what business or industry a company is in, as long as he or she can study its stock chart. A chart shaped in the form of an ‘inverted bowl’… means the same for Microsoft as it does for Coca-Cola. Fundamental information on earnings and dividends is considered to be useless – and at worst a positive distraction.
Stock picker or security analyst, on the other hand, believe that stock prices can deviate from the stock’s intrinsic or fundamental value and over time prices and value will eventually converge. As Malkiel put it “forecasting earnings is the security analysts’ raison d’être”. After making their forecast, the analyst will then apply a combination of methods – including the require rate of return based on asset allocation method – to determine a firm’s intrinsic value and decide if there is abnormal returns to be made from the value-price differentials. Malkiel however pointed out that security analysis has its flaws, “First, the information and analysis may be incorrect. Second, the security analysts’ estimate of value may be faulty. Third, the market may not correct its “mistake” and the stock price might not converge to its value estimate.”
The tussles between the three “prophets” seem never ending. Security analysts claim that by carefully analyzing stocks, they can select a set of stocks that can beat the asset allocators. They claim that meeting companies, staring at ratios, and forecasting numbers is definitely more superior then calculating statistics and building models at the desk. Market timer claim that fundamental analysis can be crushed by trends and by the time prices converge to intrinsic value, they would have made a lot more from the price movements. Asset allocators claim that fundamental analysts cannot beat the market over the long term because they focus only on equities and therefore their portfolio risk will be too focused. Furthermore, while both fundamental and technical analysts may be able to tell you what to invest, they are unable to tell you how to mix their recommendation.
Creating Value by Harmonizing the Strategies, Not by Arguing which is Better.
I believe that all three strategies have its value and a good mix of the strategies will create synergy.
The power of asset allocation is in its ability to help mix assets together to get the lowest risk for a given return. It therefore solves the investor’s long term investment objective. Asset allocation models are created from mixing different types of assets together – and not just focusing on equities – and identifying the most efficient sets of portfolios. Investors can then choose from the different portfolios that best fit their risk appetite and budget. However, because asset allocation is based mainly on statistics and models, the realization of its benefits can only be felt in the long term.
That is where market timing methods can enhance the asset allocation strategy. Since asset allocation is done at asset class level – bonds, equities, properties, and commodities – not all asset classes can be fundamentally analyzed. Technical analysis methods can be incorporated to help adjust the components in the long-term portfolio in the interim to take advantage of market movements.
Security Analysis can finally be deployed to enhance investors’ excess funds. Excess funds are funds left over after the long term objectives are met by asset allocation strategy. There are three reasons why stock picking should only be deployed for excess funds and not the main investment funds. Firstly, like Malkiel mentioned, the analysis may be wrong and therefore each stock selection has a risk of not meeting expectations. Secondly, because security analysis assumes that stock prices are wrong, there is no reasonable basis to allocate such investments according to asset allocation methods. Therefore, equal weighting is the only way to allocate funds to these selected stocks and as such, we cannot determine the risk-return efficiency of such allocation. Finally, while security analyst can identify companies that are undervalued, they are unable to determine the period for prices to converge to their value. This means that the investment period is really unknown. It will therefore be very risky for investors to use funds, other than excess funds, for such investments.
The best road to Rome is a properly planned path. I would prefer to ignore the arguing over which is more superior and focus on what is best for the investor – regardless of whether investors appreciate it.
by Roger Tan, SIAS Research
Investing is a “mystical” activity; no one can really say they can fully comprehend it. While we know it is an activity we need to undertake to better our lives, we are skeptical over the ways to approach it. With the numerous strategies available, which is the right approach? Will all roads lead to Rome or is there only one true path?
