There has been too much research to touch on all of these points and so I have focused on the most important decision:

“I have capital to invest; what lessons can I learn from academic research?”

In this article I will demonstrate the following five points:

1. Asset allocation drives investment returns

2. Diversification works

3. Passive investing outperforms active investing over the long term

4. Fund selection is hard – is it skill or luck?

5. Patience is a key virtue to investing

Early financial theory research focused on calculating the intrinsic value of stocks (Graham and Dodd 1934, John Burr Williams 1938) but more recently extensive empirical work has elucidated the most important decision for any capital allocator.

This is the question of whether to be invested in financial markets at all, which asset classes and when – so-called asset allocation. A study by Ibbotson and Kaplan in 2000 looked at how five asset classes (large-cap US equities, small-cap US equities, non-US equities, US bonds, and cash) explained ten year returns of 94 balanced mutual funds. The results highlighted that asset allocation accounted for virtually 100 per cent of the fund returns.

Numerous academic papers before and since (Brinson, Hood and Beebower 1986) corroborate these findings and suggest that asset allocation explains at least 90 per cent of fund returns. The importance of asset allocation was best exemplified last year in 2008 when the only assets to own were cash or government bonds.

This academic research tells us that the main question for charity finance practitioners and their investment managers today is not which stocks to buy but rather what is the asset allocation. It is of course an extremely difficult decision to make, especially over shorter periods, and there is no single right answer for all investors. Among other factors it depends on willingness and ability to take risk, time horizon, and expected withdrawals. Within asset allocation there is the longer term or strategic asset allocation and also the shorter term tactical asset allocation. What is important is the process of asset allocation decision making which can determine outcomes such as how often you rebalance the portfolio.

Once we have made the all important decision of the asset allocation of the capital then what does finance theory tell us about portfolio construction? Harry Markovitz’s seminal work at the University of California Berkeley in the 1950s identified how rational investors (who choose the lowest risk portfolio for a given level of return) should construct portfolios.

His work identified the tradeoff between risk (as measured by standard deviation) and return. This was the birth of "Modern Portfolio Theory" which shows that by investing in a portfolio of stocks, which are not correlated, an investor can reap the benefits of diversification. Much of his work is taken for granted in modern investment management theory.

Implementation of MPT highlights the problems of relying upon the underlying assumptions. Long Term Capital Management, an infamous hedge fund run by Nobel laureates Scholes and Merton, used more complex models based on Markowitzian assumptions to invest capital. After several very successful years the fund collapsed in 1998 losing $4.6 billion in less than four months. The positions went against them, even though this was "irrational" and "improbable". As the economist John Maynard Keynes said: “the market can remain irrational longer than you can remain solvent” (1946). Overall what we can take from Markovitz’s work is the simple idea of not keeping all your eggs in one basket, and ideally making sure that the various baskets are not too closely correlated.

Investors are always trying to gain a competitive edge when it comes to picking individual stocks for portfolios. However academic research shows that this is an extremely difficult game and explains why the majority of fund managers fail to beat a relevant index over time. William Sharpe, a Nobel prize winner in 1990, who is famous as one of originators of the Capital Asset Pricing Model and also the Sharpe ratio (which measures risk-adjusted performance) suggested that index investing is a prosaic way to beat the performance of the average investor (2002). His argument is that, given it is difficult to pick consistently outperforming active managers, an average of all active managers delivers an index return.

However when you include the higher fees on active managed funds this means that on average active managers deliver the index return minus fees.

To support the idea that picking the outperforming funds is extremely difficult I set out below an example from Nassim Taleb’s Fooled by Randomness. Imagine that you have 10,000 people who toss a coin once a year. After five years you should have 313 people who have come up with heads every time. This highlights that even by chance some managers will outperform over a five year period. It is extremely hard to differentiate luck from skill.

Active managers can and do generate alpha, i.e. outperform a relevant index, but doing this consistently is a big problem. As shown below there is a high dispersion of returns from actively managed European funds, and this changes actively over time, and so therefore there is quite a high likelihood that you will pick a future loser.

In comparison, index funds or straightforward exchange traded funds (ETF) have had extremely low dispersion and so are very reliable over time, as they own the market.

Thus research tells us that over the long term passive investing, i.e. buying the market, as opposed to using active managers, is generally the more profitable and less risky choice. As I suggested, active managers can produce alpha but very few can produce it consistently over time and even some of these are simply lucky. Some skilled investors are well known; everybody knows Warren Buffet’s name but this is the exception that proves the rule. There are very few long term investors who have consistently beaten markets.

Classical financial and economic theory has been severely tested in recent years, and the new strand of thinking under the title of behavioural economics has garnered much support. Akerlof and Shiller’s fantastic 2009 book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism offers a very plausible explanation of the recent financial market crisis, and of market cycles in general, and gives recommendations for macroeconomic policy going forward. In my view, as financial markets are socially constructed we should not be surprised that human behaviour – especially fear and greed – is a crucial element to causing market cycles.

If you can be patient and invest on an ultra long term time horizon then, if the last 109 years are anything to go by, you can hope to expect a real return (after inflation) of 4.9 per cent per annum from equities (Barclays Equity Gilt Study 2009). The real returns per annum for the various UK asset classes from 1900 to 2008 are 5.25 per cent for equities, 1.37 per cent for bonds and 1.04 per cent and cash (Dimson, Marsh and Staunton ABN AMRO/LBS Global Investment Returns Yearbook 2008, JP Morgan). Another way to highlight this is the following example: if you had invested $100 at the end of 1925 in US equities, bonds and cash (and reinvested the income gross) then you would have had $16,492, $832 and $173 respectively in 2009 (Barclays Equity Gilt Study 2009). Having said this, before you invest all the capital in equities today, the last twenty years have been an extremely poor time for equities and so to minimise your investment risk invest little and often (pound cost averaging) and diversify across asset classes.

Overall if you are patient and can hold your nerve, which is easier said than done, then equity investing in the long term is your best bet to protecting and growing your wealth.

There has been significant and far reaching academic research since Irving Fisher’s work at the start of the 20th century. The most important messages to take away from this are that asset allocation is key, diversification works, passive investing is a better bet than active investing, fund selection is difficult and that patience is a key attribute to investing. Good luck.

References

George Akerlof and Robert Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism, 2009.

Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, Determinants of Portfolio Performance, The Financial Analysts Journal, July/August 1986.

Gary P. Brinson, Brian D. Singer, and Gilbert L. Beebower, Determinants of Portfolio Performance II: An Update, The Financial Analysts Journal, 47, 3 1991.

Benjamin Graham, David Dodd and Sidney Cottle, Security Analysis, 1934.

Roger G. Ibbotson and Paul D. Kaplan, Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance? The Financial Analysts Journal, January/February 2000.

William F. Sharpe, Indexed Investing: A Prosaic Way to Beat the Average Investor Presented at the Spring President's Forum, Monterey Institute of International Studies, May 1, 2002.

Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, 1776.

Nassim N. Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, 2007.

John Burr Williams, The Theory of Investment Value, 1938.

iShares, A Comparison of Mutual Fund and ETF Returns September 2009.

J.P.Morgan, Asset Management Guide to the Markets Q4 2009.

Barclays Capital, Equity Gilt Study 2009.