Investment using Flawed Principles

We have been concerned for years now, that many commonly used investment principles are flawed.  It seems these principles are still being taught at universities, and are widely used by large financial institutions and investment professionals alike.  It is no wonder that many investors have had bad experiences in the past with investment funds and advisers.  Maybe the theories used should be reviewed. 

Not enough work has been done in properly profiling a client's risk tolerance, then designing an appropriate portfolio for each specific investor.  If that had been correctly done, many investors may have been spared the anguish of large portfolio meltdowns when the markets reacted to the credit crisis.   We just don't believe that every investor will fit into l out of 4 or 5 models, without some customisation to suit.  Yet this is the approach taken by the majority of the investment industry, especially the banks and nationwide investment groups.  Go into a bank or a nationwide investment group and say that you have $250,000 to invest, and the chances are that you will be advised to invest in one of several different balanced funds or Masterfunds. 

Constructing good portfolios for investors should be a core competency for any financial planner or investment adviser.  Asset allocation (i.e.  having the right investment mix of the different assets, e.g.  fixed interest, property, shares) is a key component of quality portfolio construction. 

Our belief is that a typical asset allocation process consists of five steps:
1. Return forecasting - estimating the expected returns of each asset class for the period in question.
2. Risk estimation - estimating the risk of both individual assets as well as the way that assets behave compared to others, or how correlated assets are.
3. Optimisation - determining what portfolio gives the best return for any particular level of risk.
4. Profiling - determining what the suitable level of risk is for any particular individual, institution or circumstance.
5. Implementation - putting it into practice.

To most people, this would make sense.  So then, why is that Asset Allocation theory taught in Universities and used by many of our colleagues is based on such principles as: Investment markets are always efficient, e.g.  the underlying assets are neither cheap nor expensive; future forecasts are based on historical returns (i.e.  Predicting the future from the rear view mirror) and volatility is risk.

If markets were efficient, it would not be possible for some managers to consistently outperform the markets by large margins, mainly through buying assets that are cheap, then selling when expensive.  Using past returns to forecast the future encourages investors to load up on past winners at a high point and ignore past poor performers at a low point.  It completely ignores the fact that everything goes in cycles.

The belief in efficient markets by many managers and advisers leads either consciously or subconsciously to the chasing of past returns. Invariably most investment ends up in the latest top performing assets, and stay away from the poorly performing assets. This of course leads to investing in overvalued assets.  And we know what happens when the market corrects!