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Short term trading has no place in modern portfolio theory

The miserably low returns achieved by equity investors over the decades to the end of 2009 and 2010 have led to a major shift in the methods of many professional investors and advisers. But they are not owning up to the importance of this and its implications for the investors they advise and manage money for.

The academic evidence that “timing the market” does not work is deep and solid. Scores of studies have shown that selling before a fall and buying before a rise requires far better-timed correct judgments than any investor can hope to achieve with any consistency. Anyone can be lucky with a few such decisions. Nobody, say the academics, can use market timing to generate consistent market-beating returns.

That conclusion is based on evidence, so it is independent of portfolio theory, which provides an explanatory framework. But many people are using the evident failures of portfolio theory as justification for moving the goalposts.

In particular, if you look back five years you will struggle to find many references to “tactical asset allocation” in fund manager or adviser reports. An asset allocation framework based on expected returns and volatility delivered the division of capital between the major asset classes, and this was subject only to periodic strategic reviews. This methodology was theoretically validated by portfolio theory, but it also conformed to the traditional practice of dull and grey inv-estment advisers of the 1950s.

Today, in contrast, both fund managers and advisers talk about tactical asset allocation. Whether or not they use “overlay strategies” (a fancy name for punting with derivatives), these involve short-term market timing – putting a bit more or less into Japan, or resources, or bonds, than the strategic asset allocation model calls for. What they are really doing is short-term trading. It has no place in portfolio theory.

Being pragmatic, fund managers and advisers know they need to generate returns well above cash to keep hold of clients’ money, so, of course, they try to do so. But pragmatism without any basis in methodology or theory is just the old boy stockbroker method all over again. “The backroom chaps say the Japanese economy should recover quickly from the tsunami, so let’s have a punt.”

Value investing and small-cap investing remain the only two proven methods of generating long-term market-beating returns. Both require discipline and stockpicking skills. Both are essentially long-only methods and do not need any derivatives, overlays or stochastics. The evidence also shows that momentum investing has worked in the US and the UK but the academics reckon the costs will usually eat up all the returns.

Momentum investing works for its inventors – hedge funds – because of the huge gearing they apply. Without gearing, it is a sure way of generating lots of trading costs with a low probability of gener- ating extra returns.

I find it depressing that almost every man and his dog in the City have turned into short-term momentum or tactical traders. The Barclays Capital Equity-Gilt Study shows that lousy decades for equity investors have usually been followed by good decades. The fact that most people do not believe this will happen is the best reason I can think of for expecting equity investors who are prepared to stick to old-fashioned methods today to get rich slowly over the next decade.

Chris Gilchrist is director of Churchill Investments and editor of The IRS Report


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There are 8 comments at the moment, we would love to hear your opinion too.

  1. Chris Wicks CFP 25th April 2011 at 2:14 pm

    Excellent article. It never ceases to surprise me how difficult some people seem to find the concept of evidence based investment. The academic evidence in favour of modern portfolio theory, the three factor approach, efficient markets etc. was not cooked up by complete idiots who are out of touch with the markets and the ‘real world’.This probably explains why an increasing level of institutional money as well as that under the advice of the better educated and more professional financial advisers is being run acccording to these principles. Those who still fiddle about chopping and changing from one actively managed fund to another in the pursuit of performance really need to take a close look at what they are doing and the damage they are inflicting to their clients’ wealth.

  2. Well said. Buying assets that continue to grow thier dividends and asset base will always make you more money over the longer term. Investing in markets is and should always be a long term basis. I believe that all these various derivative based products are put together to attract money that shouldn’t be going there in the first place. Because of the gearing when thinks go well it if fine however one bad trade can kill any profits. Remember Barings. Low debt companies that make widgets or whatever may not be or soung the most exiting companies in the world however if they are well run you are likely to make more money from them over the long term than any fancy mathematical derivative trade. I find that all these mathematical theories are put together to justify why things have gone wrong not right. CAPM, alph, beta, and all the others out of the manual. End of day if company is well run, low gearing, has products that sell and is increasing sales while keeping costs under control it will make you lots of money. E|verything else is just a smokescreen and will probably lose you money!

  3. I think RDR has a part to play in this recent change of attitude.

    Once upon a time a investor was advised to take a long term view – to invest and then basically forget the investment for a number of years.

    Today the need to justify ever more expensive fees and compliance requirements go hand in hand with investors being encouraged to rebalance their portfolios, and frequently indulging in activity for its own sake.

    The FSA are going to require evidence of service if ongoing fees are to be taken so services will be created with short term managing being one of the most likely services to be provided.

    Most amusing of all is to see advisers waxingly lyrical about the merits of passives and then seeing them expensively manage them on one of the new ( more expensive) wrap platforms.

    Sorry but I see very few advised clients being allowed to follow the old fashioned route to getting rich slowly. The vested interests of providers, the regulator and advisers will just not allow it.

  4. This is a load of drivel. There has never been a more important time for asset allocation. We are still in a secular bear market (in equities). Gold and commodities are clearly in a bull market, bonds are entering a bear market and the US dollar is in decline. If your investment recommendations do not reflect this then your clients will lose money !

  5. No theory works all of the time – if any did, we’d all stick with it. We have to apply common sense, no matter what the charts say, no matter what everyone else is doing. Asset allocation means taking market views – sometimes some assets are cheaper than others; are we to ignore that?

  6. I agree with a small part of what you are saying but your assessment of momentum based investing or as it’s more commonly known, “trend following”, is quite incorrect. I can show you very long track records of a very large number of trend followers who have consistently outperformed (net of fees), especially in years such as 2008 when other strategies really suffered. To say markets are always efficient is nonsense and to suggest that investors just buy and hold equities is a very dangerous game to play. Were it not for the numerous bailouts, the DOW would have probably halved from where it was and the whole “buy and hold” game would have been destroyed forever. Diversification is crucial in order to achieve smooth returns over time and simply holding equities alone cannot possible achieve this, regardless of the sector or geography

  7. Thanks so much for this! I haven’t been this moved by a blog for a long time! You’ve got it, whatever that means in blogging. Anyway, You are definitely someone that has something to say that people need to hear. Keep up the good work. Keep on inspiring the people!
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  8. Hello There. I found your blog using msn. This is a really well written article. I will be sure to bookmark it and return to read more of your useful information. Thanks for the post. Ill definitely return.

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