Investment Evolution

I have spent the last two weeks doing a lot of reading.  I will soon be entering a new professional environment with new philosophies on investing, and I made it a priority to educate myself on the broad governing concepts that form the investment style of this new firm.  In the readings that I have done I have come across information that I already knew, information that I did not know, and new implications of concepts that I already understood.  Below is a summary of my thought process as I gained an understanding of three-factor asset class investing:

The Efficient Markets Hypothesis (Fama, 1966) asserts that current securities prices reflect all available information and expectations.   Based on this theory, stock mispricing should be considered a rare condition that appears with randomness, and active management strategies cannot consistently achieve alpha

The Efficient Markets Hypothesis states that investors may be best served through passive, structured portfolios using asset class diversification to manage uncertainty and position for long term growth

Diversification helps reduce uncertainty and control risk

Diversification across asset classes allows for efficient portfolio management and flexible trading

Global diversification of overall investment strategies (conservative, moderate, aggressive etc.) created by combining asset classes can minimize the volatility caused by the inherent randomness of returns

A globally diversified portfolio should include asset classes that are exposed to different macro risk factors, with different dimensions of risk and return across the globe

Using the size of a country’s stock market relative to the world’s total market value rather than economic data (population, GDP, consumption etc.) to assign asset classification removes emotional distortions caused by economic statistics

Severe negative volatility (7% or greater decline in monthly value) has, historically, been experienced simultaneously by domestic large cap, domestic small cap, international developed markets, and emerging markets equities only 3.4% of the time between 1988 and 2009.  This negative correlation shows the importance of global diversification

In any given year, a small subset of stocks may contribute a large portion to the market’s overall return; with the CRSP 1-10 Index from 1926 to 2012 as a sample, removing the top performing decile of stocks reduces the total return from 9.6% to 6.3%.  Because it is impossible to consistently pick winners before the fact, it is logical that the optimal portfolio will maintain broad diversification

The three dimensions of stock returns are the equity market (complete value weighted universe of stocks), the company size (market cap.), and company price (BtM)

Returns of the CRSP 1-10 Index show that the smallest capitalization stocks produce both superior returns, and also the highest standard deviation in returns

The size effect of superior returns has been established over the longest available time period (1926-2012), but over shorter periods returns of small caps have been significantly above, and below the S&P 500