Investment, like everything else in human life, is subject to fads and fancies, to waves of panic and euphoria. Emotion and psychology on the one hand and reason and knowledge on the other bear an inverse correlation to the passage of time. The shorter the time the more emotion and trend following take hold. As time lengthens reason and knowledge bear fruit.
The best way to understand market efficiency1 is to accept that the prediction of market values and interest rate movements over any short time period is fruitless because impossible. As one moves from individual securities to the micro economy and then to the macro economy the number of variables increases exponentially. This means that in practice investment in stocks and bonds, like politics and real estate, is local. Long-term values are pretty efficient but every environment within which investments are actually bought are short-term and thus subject to too much emotion to be very significant in terms of value precision. It is natural that there tends to be a disconnect between market price and business value in equities. And thus it is prudent to accept that timing and trading is almost always counterproductive.
The two most important factors for individual investors are cash flow and time. A wise investor will always strive to have time on his side so that he will always be able to take advantage of long-term market efficiencies and never have to sell inopportunely because of reliance on timing and trading. An understanding of the inherent relation of equities and income are helpful in relating time to cash flow.
Cash Flow/Time Model vs. Total Return
The typical professional investment model used today is a total return model2 in which all assets are treated as monetary commodities. This is the opposite of the cash flow/time model used at Pallas Athena. The total return model is actually a short-term model based on the assumption that macro economic prediction is possible. This model leads to the marketing of financial products and reliance on indexing and diversification as panaceas. Such products as wrap accounts, mutual and index based funds are the result. In reality there is no such panacea. Each asset class must be studied and implemented on its own merits.
Total return investing reduces all investment entities to commodities or mathematical aggregates. Treating equities as commodities leads to ironic and unprofitable predicaments because such a mentality tends to lead to systematic 3 losses due to a lack of attention paid to unsystematic 4 valuations. Hence, equity portfolios tend to be over-diversified. By the same token income securities must be treated differently from equities. Since income securities are proxies for the price of money, they tend to be more efficiently priced than equities, and should be treated systematically. The same irony and unprofitability occurs when income securities are treated as equities and put under the aegis of duration 5. They lose their transparency and lead to the same systematic losses as do equities, because the safety of individual maturities is forgotten. Hence, income portfolios tend to be under-diversified with respect to maturity laddering and the size of individual positions.
- The efficient markets hypothesis is based on the premise that the current price of an investment reflects all available information in the marketplace. Thus, the hypothesis assumes that market pricing and security value are the same.
- Total return of an investment is comprised of two components. There is the income component and the price appreciation (or depreciation) component. Thus, these two components are treated as one and the same by total return models.
- The Systematic Risk is the risk borne by investors inherent to the market in which the investment is made. This risk is often referred to by academics to being the non-diversifiable risk. Thus, systematic risk is the risk of the market itself treated as if it were an individual security.
- The Unsystematic Risk is the risk born by investors inherent to the individual securities that comprise the investment. This risk is often regarded by academics as the diversifiable risk. The premise is that by increasing the number of securities held (the act of diversification), the individual risks of the securities should be mitigated by the number of the investments and hence should be eliminated through diversification.
- The Duration of bonds is expressed in years and measures the price sensitivity of a bond or portfolio of bonds to changes in the level of interest rates. All else being equal, the longer (expressed in years) the duration, the larger the sensitivity to changes in the level of interest rates. Thus, duration models treat entire bond portfolios as single securities.