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By
M. Isi Eromosele
Investment
is about risk and expected return.
No one likes risk and the higher
an investment’s expected return, the better. The investment strategies can be
divided into two types. Inefficient strategies incur risk that is not rewarded
sufficiently with higher expected return. Efficient strategies provide the
highest possible expected return for a given level of risk.
Return
and Risk
Expected
return and risk should be typically measured using short horizons. Most
investors are concerned with longer-term outcomes. To make a meaningful choice
among sensible investment strategies, an investor needs to see the implications
of each one for his or her needs and desires.
When an investment strategy is
aggressive, the chances of exceeding a high goal are higher (good), but the
chance of exceeding a low goal is lower (bad). Analysis such as this can help
investors make the difficult choices that lie at the heart of investment
decision-making.
When the strategy is
aggressive, the chances of exceeding a high goal are higher (good), but the
chance of exceeding a low goal is lower (bad). Summaries such as this can help
investors make the difficult choices that lie at the heart of investment
decision-making.
An efficient market can be
defined as one in which prices reflect the best possible set of predictions
about the chances of alternative future outcomes. Those who assume that markets
are efficient adopt passive or index investing strategies, named so since they
involve low portfolio turnover and tend to track the market.
Those who believe that they
can make better predictions than those reflected in market prices adopt active
strategies, which could involve more turnover as predictions change. In
practice, most investors fall along a spectrum from highly passive to highly
active. But those who choose highly active strategies almost certainly incur
higher costs in their search for securities that may or may not be mispriced.
In an efficient market, the
best portfolio for a representative investor will include all the marketable
securities available across the world, in proportion to their out-standing
amounts. Such a world market portfolio would have, say 1percent of all the
shares of IBM stock, 1 percent of each type
of bond issued by the Swiss government, and so on. The prototypical representative
investor is a conglomerate of all investors, rich and poor, from every country,
with those having more influence on security prices (such as the richer)
counted more heavily than those with less influence.
Appropriate
Investment Strategy
To
select an appropriate investment strategy it is useful to start with a world
market portfolio. The representative investor spends money all over the world.
If a client spends money primarily in the Eurozone, a strategy designed with
the euro as a base currency should be chosen. If a client is less tolerant of
risk than the representative investor, the portfolio should be tilted toward
more conservative investments.
In
an efficient market, high-risk efficient portfolios will have higher expected
returns than low-risk efficient portfolios. But this need not be the case for
individual securities or even broad classes of assets. Why? This is because
some kind of risk can be reduced or eliminated by diversification. In an
efficient market only risks that must be borne by someone will be rewarded with
higher expected return.
Predictable Inefficiencies
Other factors may influence
expected returns. Such factors are often associated with broad asset classes, European
stocks and Asian stocks, or growth and non-growth stocks. These approaches may
be based on a more complex notion of efficient markets or on the belief that
investors make repeated errors in the same direction, resulting in predictable
inefficiencies.
These
alternative approaches could lead to a characterization of an investment
strategy in terms of its exposures to movements in broad asset classes. Instead
of one beta, a strategy may have several. And a portfolio’s expected return may
be related to all its beta values.
Almost
by definition, an investment strategy is designed for medium- to long-term
investment. It relies on estimates of expected returns, risks and correlations
projected to apply over substantial periods. While it is tempting to base such estimates
on recent experience in capital markets, this is generally not a good choice.
The ability to identify broad
asset classes that will do especially well in the future is extremely valuable.
Information that would enable one to do so will be sought by many investors. As
they try to act on such information, prices will adjust to restore equilibrium
relationships.
M. Isi Eromosele is the President |
Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control © 2012 Oseme Group
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