In last week’s Market Update we introduced the three pillars that drive Surevest’s investment philosophy. Now we will dive into a little more detail on pillar one.
To quickly recap, we use a disciplined investment approach that is anchored on three main pillars:
- Dynamic Investment Process: The investment environment is not the same across time.
- Data Driven Approach: We must use supporting evidence that is statistically significant.
- Rules-based Decision-making Process: Minimizes emotion and cognitive biases in our investment decisions.
To put things in context, let’s go back to the 1950’s when Harry Markowitz developed his theory that became known as modern portfolio theory and resulted in a Nobel Memorial Prize in Economics Sciences in 1990. We will save all the academic details and focus on the main point, which was that investors should focus on the relationship between the investment risk and return. He mathematically constructed an efficient frontier that was made up of portfolios that maximized return per unit of risk, which he proxied by using standard deviation. This was groundbreaking at the time because prior to his work, investors solely focused on return without considering the risk that was taken to achieve that reward.
Several academics later introduced concepts that are used in the field today. Professor William F. Sharpe, now Professor of Finance at Stanford University and who won the Nobel Memorial Prize in Economics Sciences in 1990, developed the Capital Asset Pricing Model (CAPM) in the 60’s. In essence, he elaborated on the concept of risk by dividing it into two parts: systemic risk and idiosyncratic risk. He concluded that the latter risk can be diversified away, while the former risk cannot.
Professor Eugene Fama, who teaches at the University of Chicago Booth School of Business and who won the Nobel Prize in Economic Sciences in 2013, developed a theory in the 70’s that became to be known as the Efficient Market hypothesis. The core of his work is that prize is the best indicator of value and that markets are efficient and therefore you cannot beat the market.
As elegant and beautiful as these theories sound, there are fundamental assumptions that have been proven to be false by other academics that have also won the Nobel Prize in Economics. Professor Daniel Kahneman of Princeton University was awarded the prize in 2002 for providing solid evidence that undermines the work of professors Markowitz, Sharpe and Fama. Recently, Professor Richard Thaler of the University of Chicago won the Nobel Prize in Economic Sciences in 2017 for his work that challenges the fundamental principles of the traditional economic models.
Without having to read or understand the traditional framework, investors came to realize that the theory does not hold. There are countless of examples, but I will share one that we believe most people can remember. Going back to the late 90’s, the U.S. experienced the best bull market in history driven by the technology companies that had a business model that focused on the internet. If you go back to those times, any company that slapped a “dot-com” to their name and had an IPO (initial public offering) received a prize multiple that was not justified. It did not matter if the company was making money or had a viable business model because the market thought the company would eventually make a lot of money. Looking back, we all know that the NASDAQ Composite Index hit its high March of 2000 before dropping 77% to its bottom.
It took 15 years for the index to come back to values seen in the 2000’s. One would argue that if markets are in fact efficient with rational investors, then bubbles should not occur, yet in fact they do. That is the argument that professor Robert J. Shiller of Yale University has shown and was awarded the Nobel Prize in Economics in 2013 for his work.
At Surevest we believe the work of Professor Kahneman, Thaler and Shiller is more compelling. That has led us to think of the market as dynamic and not static. In other words, the investment environment is not constant across time, but changes because the landscape does not remain constant. The traditional economic framework assumes constant inputs, which have been proven to wrong.
In next week’s Market Update, we will share some of the data we use to quantify what metrics have proven reliable over an extended period of time. We will also build on what we have shared on pillar one.