A judgment of Solomon?

A judgment of Solomon?

Investment is a lot less fun today than it used to be. I have been hearing this more and more over the last year. Where to put my money? This is a question that is popping up more and more in the minds of managers of companies, institutional investors and individuals. The economies of almost all countries in the world are struggling at the moment, making investments in stocks a leap of faith. Turn to bonds then? With interest rates falling, investments in bonds are not expected to give substantial returns either. Real estate? Why is everybody laughing…? Alright, let us follow the old-age adagio of traders then –‘In a time of crisis, cash is king’, and put our money in a bank account? Not an attractive alternative either, as interest rates on savings accounts are low, and inflation may be eating the meager rates away, making you poorer in real terms.

If all of these classic investment vehicles do not work, maybe some more exotic investments, as for example private equity or hedge funds, might work. In January, the British weekly ‘The Economist’ published an article about the performance of hedge funds as a group. They returned 3% over the last year, and a cumulative 17% since 2003, even underperforming a simple savings account. The only people who got rich from investing in hedge funds are the managers of these funds, raking in hefty management and performance fees. Some individual hedge funds did show stellar performance over this period (ex post!), but this performance was not stable, and as an investor you must have had extreme luck to have the guts to invest a priori in those ex post star funds.

One of the mantras of modern portfolio theory is diversification. Harry Markowitz developed this idea way back in the 1950s and it still has a lot of support today. The theory gives us a way to determine how much wealth to put in a number of asset classes. So, that is it then? We just have to follow Markowitz’ theory, plug in some numbers, and we are done. Well, in my classes I sometimes use a quote by Markowitz himself, who claimed “I should have computed the historic covariances of the asset classes and drawn an efficient frontier. Instead, … I split my contributions fifty–fifty between bonds and equities”, when asked about how he actually constructed his own investment portfolios. Indeed, in a 2009 paper the Review of Financial Studies by Victor DeMiguel, Lorenzo Garlappi, and Raman Uppal, titled, ‘Optimal Versus Naive Diversification: How Inefficient is the 1/N Portfolio Strategy?’, these authors show empirically that the 1/N strategy is very hard to beat over a long horizon. So, why not make it easy for ourselves and follow this ‘naïve’ strategy? It has an interesting by-product as well. As investing becomes that easy, by following the 1/N rule, we would need a lot less highly paid investment analysts. Investment returns would then increase automatically, from the savings on the salaries of the analysts.

So what is a good investment for you? Well, do not let your thoughts wander off to exotic investment opportunities too quickly, but first take a look at yourself. Your wealth is not restricted to your wallet only. As an individual you have earning power or human wealth as economists call this. Every year that you are able to work, you can earn money. And, given the current developments in retirement finance arrangements (pensions), you get more and more years to do so. So think about smart ways to increase your earning power by choosing a smart career. But, who am I to say this? You have already made that choice and kick-started that stellar career, by becoming an econometrician!

Text by: Ronald Mahieu

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