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By M. Isi Eromosele
Today’s investment management practices are based on Modern
Portfolio Theory, a framework first conceived during the post-World World II
era and based on many assumptions and conditions that are now obsolete.
Confidence in the financial system has been shaken by recent
events such as the 2008 meltdown, the European debt crisis, and the ideological
crosscurrents in the United States .
These events have created uncertain times and a global audience that is awake,
frightened, and open to shifts in their investment policies and practices.
Risk And Uncertainty
Modern Portfolio Theory, as practiced today, addresses a
limited scope of risk, which can be managed because it can be quantified.
Uncertainty, on the other hand, involves that which is unknown and therefore
not manageable in the same way.
Statistical models and quantitative analysis work well with
MPT’s definition of risk but not with uncertainty. However, simply because
uncertainty cannot be modeled precisely within the framework that MPT or other
theories set forth, these powerful dynamics had been ignored.
Qualitative analysis can contribute to a deeper, more
nuanced understanding of uncertainty, differentiating between aspects of
uncertainty that are truly unknown and those that are uncertain because their
scope and/or timing are unknown.
Limited Definition Of Risk
Modern Portfolio Theory defines risk as a single number -
volatility, measured by the variance (or standard deviation) of returns around
a mean. Beta measures the “systematic” part of risk, that is, the volatility of
a portfolio or security that is a function of the overall market.
A relatively newer measure, Value at Risk (VaR), uses
probability distributions to measure the magnitude of expected losses over a
particular period of time, typically using historical data to develop
statistical probabilities.
These attempts to distill risk to a statistic are
problematic. In essence, and regrettably, the obsession with the quantification
of risk (beta, standard deviation, VaR) has replaced a more fundamental,
intuitive, and important approach to the subject. Risk, clearly isn’t a number.
It is a multidimensional concept, and it is absurd to try to reduce it to a
single figure.
Investors must understand that risk not only is made up of
known probability distributions but also is immeasurable because there is a
complete lack of knowledge
about what the future may bring.
Forecasted returns used for financial modeling focus on the
direct financial risk to the investing entity and do not consider the potential
negative societal (universal) impacts of certain behaviors.
These elements of risk are sometimes categorized as
externalities because they are not measured as direct financial costs to
enterprises and are, therefore, not reflected in financial statements and
valuation models.
As long as these externalities were relatively small, it was
thought that they could be ignored or assumed away. But, in an interconnected
global economy with rising population and consumption, it is increasingly
imprudent to minimize their importance.
Ultimately, businesses, governments, and societies are faced
with the costs of externalities, which impact their financial performance.
New Foundational Principles
The three principles described below are founded on observed
facts and market behavior in contrast to simplified assumptions and generalizations.
These New Foundational Principles should form the basis for investment
decision-making in place of a theory that can only be substantiated by making
unwarranted and unrealistic assumptions about risk, growth and utility.
Integrated Risk
Integrated Risk includes the externalities that are not
priced into the market but which threaten to inhibit or shift returns.
Integrated Risk considers the potential impact of ecological limits as they
manifest in business disruptions, shortages, and social/political upheaval.
Integrated Risk is science-based while acknowledging that
uncertainty, although not quantifiable, must not be ignored. It moves
beyond the historical financial payoff characteristics of a particular asset
(debt, equity, etc.) to deal with the specific nature of the asset. It takes a
multi-dimensional approach to asset analysis, so that observable risks and
uncertainty are dealt with in a much more granular way.
Selective Growth
Economic prosperity is dependent on a successful transition
from an extractive economic system to one that is based on energy and materials
efficiency, renewal of natural systems, and resilience.
Resilience refers to the ability of a system to adapt to
rapidly changing conditions. Because of uncertainty, resilience requires high
levels of diversity and redundancy. This fundamental necessity to shift to a
different economic model is not embedded in Modern Portfolio Theory.
Asset allocation and security selection models traditionally
assume positive economic growth by using positive expected mean returns on
investments as input. Volatility inputs allow for the possibility of negative
short-term returns, but the long-term expectation is consistently positive. But
these are short-term measures taken as part of a cyclical strategy.
The end of growth does not mean the end of the economy, but,
because the economy must curtail throughput, there will be clear winners and
losers. Rather than a “rising tide lifting all boats”, the new economy will
resemble a zero sum game with respect to throughput-driven growth.
The term Selective Growth refers to the fact that growth can
occur even if average economic growth is zero or negative, but it will be
unique to particular sectors and companies rather than a function of rising per
capita material consumption.
Multi-dimensional Utility Functions
Leverage and speculation increasingly dominate financial
markets, changing the investment landscape, invalidating current methodology
and forcing long-term investors to resort to short-term strategies. In the face
of securities markets in which prices fluctuate based on changes in short-term
outlook, it is challenging to take a long-term view.
Yet there is a deep desire and often a stated commitment on
the part of many asset owners to make constructive long-term investments. They
find high utility in knowing that their financial activities are contributing
to the creation of long-term economic value and their returns are derived from
real economic activity.
This expanded view of investing ties the concept of value to
the efficacy of the whole economic system rather than limiting it to the
specific outcomes for the investor alone. For these investors, we suggest a
deceptively simple question as a tool for differentiating speculation from investment
and thus providing clarity with respect to the underlying activity.
The question is: “Does your financial return depend upon
appreciation in the underlying value of the asset, or does your return depend
merely on appreciation of the price of the asset?”
There are no right or wrong definitions, but investors who
aspire to invest in accordance with Multi-dimensional Utility need to be fully
conscious and informed as to the nature of financial transactions, vehicles and
strategies.
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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