CHAPTER 1

QUESTIONING THE CURRENT INVESTMENT PARADIGM

The past 10 years have proved challenging for the asset management industry. Toput it very simply, traditional portfolio-construction procedures have notproduced results capable of consistently outperforming a naive portfolio inwhich all risky assets are equally weighted.

In addition, the claim that in the long term, risky assets and in particularequities should revert to a stable, positive risk premium has been questionedover the last 10 years, a period during which three major troughs have occurred:the technology/Internet crisis between March 2000 and September 2002, which ledto a 45 percent fall in global equity prices, the credit crisis between October2007 and February 2009, which led to a 54 percent drop and the sovereign debtcrisis in 2011. Overall, the period has not been characterized by the benefit ofany long-term positive equity return but rather by extreme spikes of volatility.Investment professionals have lost a lot of respect from their clients, and,more fundamentally, the capability of these professionals to articulate credibleinvestment solutions in response to the crises has been close to nonexistent.

In the opening chapters of this book we will sharpen our diagnosis byidentifying the many weaknesses of the well-established modern portfolio theory(MPT) paradigm, and it is surprising how many flaws and simplisticapproximations it is possible to spot. A positive take on this would be to claimthat a lot of knowledge has been acquired over the past 50 years since MPT, thecapital asset pricing model (CAPM), and the efficient market hypothesis (EMH)were first expounded—now we have to work out how best to apply what wehave learned.

This book is not intended to be a blow-by-blow discussion of technical issues.Instead, we want to take a more fundamental look at the principles of portfoliomanagement, particularly in the light of what has been learned over the past 10years, and to suggest, as a result of our analysis, some possible ways forward.

We believe that any reformulation of portfolio-construction techniques shouldmeet the following four requirements:

1. A clear understanding of the behavior of investors

2. A realistic representation of the dynamics of investment returns

3. A sound and sophisticated blending of these two positions

4. A robust empirical testing framework

In this chapter, and in the three that follow it, we are not going to provide aready-made solution but rather will focus our attention on reasons why thetraditional approaches have not delivered. In Chapters 5 through9 we set out the details of our proposed new approach.

We start here by articulating the link between investors and investments. Wethen focus more specifically on investors and subsequently on investments.

It is important to accompany any theoretical approach to portfolio constructionwith an understanding of what goes on in the real world and of what purposefinancial assets actually serve. In practice, the savings of individuals andinstitutions are invested in a great variety of assets, including both realassets (such as real estate) and financial assets (such as equities and bonds)for the purpose of storing and increasing their stock of wealth. Financialintermediaries reallocate idle resources from savers to those in need ofinvestment to fund profitable projects by transforming, repacking, andredistributing the cash flows generated by the producers, issuing liabilities inexchange. The interaction of many optimizing agents theoretically allowsfinancial markets to reach equilibrium, setting the prices of financial assets.

In terms of understanding the behavior of investors, things are not as simple asthey look. Consider first a specific problem—how we establish a linkbetween the decision-making process of any individual investor and the processby which the community of investors behaves as a whole. The essential insightfrom the discussion of this problem below is that the concept of arepresentative investor (much used in the current financial literature)is largely flawed. This has major implications because it means that slavish useof the MPT/CAPM (see Chapter 2) will produce suboptimal results forindividual investors. This is an unresolved (and usually unremarked) problemthat lies right at the heart of current approaches to investment.

Our third area of focus, which is more of a tour d'horizon related tothe dynamics of investments, highlights the necessity of incorporating differenttime horizons and combining different academic disciplines. We review long-,medium-, and short-term time horizons and outline what economics, MPT, andquantitative analytics, respectively, can tell us about each. All disciplineshave notable weaknesses specific to each of them. We claim that it is essentialto combine the disciplines to form a more realistic picture of the situation.

Investors and Investments

In this section we introduce the main agents in the economy, together with theirtypical portfolios and the assets and liabilities commonly held in their balancesheets. The main agents in an economy can be broadly classified in six groups:

1. Households

2. Corporations

3. Government

4. Retail and commercial banks

5. Other financial intermediaries

6. Central banks

Households

The objective of households is to maximize their consumption and wealth alongtheir life span (and possibly beyond in the case of bequests). Their currentconsumption typically is financed by an annual income together with mortgage andconsumer credit agreements that sit on the liability side of their balancesheets (Table 1.1).

Households store wealth to allow for future consumption by means of a variety ofreal and financial assets. The main real asset is usually property (realestate), but this category may include other valuables, such as cars, jewelry,and art.

Of the financial assets, cash is the safest and most liquid and includescurrency (paper money and coins) and non- (or low-) interest-bearing instant-access deposits at banks (checkable accounts). A broader notion...