Monday, January 14, 2013

Crowder, Schneeweis, and Kazemi, Postmodern Investment

Postmodern Investment: Facts and Fallacies of Growing Wealth in a Multi-Asset World by Garry B. Crowder, Thomas Schneeweis, and Hossein Kazemi (Wiley, 2013) is a cautionary book. “Financial myths contain enough plausibility to encourage intellectual laziness; enough truth to support the lie; enough pathos to snare the human condition; and, enough visceral appeal to be widely embraced. But, more importantly, myths and misconceptions are usually based on rigorously tested past truths.” (p. xix)

The authors analyze a range of asset classes—equity and fixed income, hedge funds, managed futures, commodities, private equity, and real estate. Yes, they analyze; they don’t merely describe or explain. In the process they poke holes in common myths and misconceptions about each asset class as well as the overarching theories of asset allocation and risk management.

We live in “interesting” times. Old rules of investing have been tested and often found wanting; newer rules have sometimes been even worse. Markets keep evolving, with new products and new challenges for investors. It is up to the individual investor or portfolio manager to keep abreast of current market realities and to adjust his investments accordingly.

Let’s look at just a couple of points the authors make. First, they argue that it’s a myth that “commodities provide a natural diversifier to traditional assets.” As they write, “The concept of a natural diversifier often refers to the idea that the return movement of a particular investment will consistently offer positive (or negative) returns when the other asset performs poorly (or well). The problem is that because many commodities do not have a long-term positive expected rate of return … the natural return may be regarded as near zero. An analysis could reveal a low correlation between the commodity and a stock or bonds return simply because the commodity has no consistent return pattern. The commodity could be called a diversifier in the same way a U.S. Treasury bond would be identified—a low expected return and no correlation with risky assets.” (p. 184)

And speaking of diversification, what about time diversification? That is, despite the volatility of stocks and bonds in the short run, does time diversification reduce their volatilities in the long run? No, the authors contend. “[S]ome believe that in the long run, traditional stock and bond investments can be viewed as almost riskless because U.S. stock and bond investments have always offered positive returns over long investment horizons (e.g., 20 years). Nothing could be further from the truth. Simply put, the two-year expected rate of return should be twice the one-year expected rate of return and, all else equal, the three-year expected rate of return is three times the one-year return. The same linear relationship exists for risk. The two-year expected variance is twice the one-year rate, and the three-year expected variance is three times the one-year variance. Summarizing, in the long run both the expected return and the expected risk increase—there is no free lunch. It is the linear relationship between expected return, risk, and investment horizon that makes reducing risk a prime goal for investors (e.g., the long-term rate of return is related to the annual return and volatility such that the lower the annual volatility, the greater the long-term rate of return).” (p. 58)

Postmodern Investment challenges the investor to rethink his portfolio—and his often misguided preconceptions. It’s a breath of fresh air.

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