Investment Philosophy and Principles
Vericrest’s investment philosophy is rooted in Nobel Prize winning research. Our strategy is guided by Asset Allocation, Efficient Market Theory, Modern Portfolio Theory, and Diversification
An overwhelming amount of research and evidence supports the fact that a diversified buy-and-hold, long-term approach to investing produces superior long-term results.
Asset Allocation
An asset class is a group of securities which have similar risk and return characteristics and behave similarly in the financial marketplace. The goal of asset allocation is to minimize risk by dividing assets among the major asset classes and subclasses of stocks and bonds. The basic premise is that different asset classes offer returns that are not perfectly correlated; therefore, diversifying investment portfolios across asset classes will help to optimize risk adjusted returns.
A landmark 1986 study published in the Financial Analysts Journal claimed that asset allocation is the main determinant of a portfolio’s return variability, with security selection and market timing playing minor roles. The authors Gary P. Brinson, Randolph Hood, and Gilbert Beebower (known collectively as BHB) concluded that asset allocation explained 93.6% of the variation in a portfolio’s return. While other factors, such as individual stock selection and market timing, make up the rest. In 1991, Brinson, Hood, and Brian D. Singer published an updated study and found a return variance of 91.5%, essentially confirming the results of the original study. Both studies have been widely quoted in the investment management industry.
The studies were challenged in the 1990s, and critics argued that the BHB study focused on explaining return volatility rather than portfolio returns. In 2000, Ibbotson and Paul D. Kaplan addressed the debate in their paper “Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?” The authors studied 10 years of return data for 94 balanced mutual funds and quarterly returns for 58 pension funds and confirmed the BHB study, concluding that asset allocation did explain about 90% of the period-to-period variability of a portfolio. The bigger finding from the study was that mere exposure to capital markets was the primary factor in overall returns. Just staying invested accounted for 60% of total return over time.
We believe choosing an appropriate asset allocation is one of the most important drivers of long-term performance. It's a fundamental investing principle because it has the potential to help investors maximize profits while managing risk.
Efficient Market Theory
The efficient market theory (EMT) states that all known information about investment securities is already factored into the prices of those securities. Therefore, assuming this is true, no amount of analysis can give an investor an edge. Simply put, no one can consistently “beat the market.” An investment security represents a claim on future cash flows, and, therefore, the intrinsic value is the present value of the cash flows the owner of the security expects to receive.
As early as 1889, George Gibson wrote in The Stock Exchanges of London, Paris, and New York that when “shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them.” French mathematician Louis Bachelier performed the first rigorous analysis of stock market returns in his 1900 dissertation Theorie de la Speculation. His exceptional work documents statistical independence in stock returns, meaning that the return of today is no sign or indication of tomorrow’s return. Unfortunately, Bachelier’s dissertation was widely ignored until the 1950s.
In 1953, British statistician Maurice Kendall analyzed 22 price-series at weekly intervals and found that they were essentially random. Harry Roberts found similar results in 1959 for the Dow Jones Index.
It wasn’t until the mid-1960s, through the work of Eugene Fama and Paul A. Samuelson, that the efficient market theory gained widespread acceptance. Paul A. Samuelson argued that randomness in returns should be expected in a well-functioning stock market. The key insight was that investing in the stock market is fair game. Meaning that an investor cannot expect to “beat” the market without some informational advantage.
Eugene Fama spent ten years testing his hypothesis that stock prices reflect all known information and instantaneously adjust to reflect new information. Fama defined an efficient market as a market: (a) with many rational profit maximizers competing against each other to predict future market values of securities and (b) in which important current information is almost freely available to all participants.
Fama defined three different forms of market efficiency: weak form, semi-strong form, and strong form. In a weak-form efficient market, future returns cannot be predicted by analyzing past prices. In a semi-strong efficient market, prices fully reflect all the relevant, publicly available information. This includes corporate actions, earnings reports, and SEC filings. In a strong form, the highest level of market efficiency, prices reflect all public and private information. This is rare because capturing private information is not realistic.
As Eugene Fama concluded (Efficient Capital Markets II), market efficiency is a continuum. As transaction costs and investment fees continue to fall, including the costs of obtaining information, the more efficient the market becomes. Furthermore, financial markets became more efficient in 2000 when the SEC implemented Regulation FD (Fair Disclosure) which prohibits public companies from privately disclosing material information to select financial professionals. Today, reliable information about public companies has become easy to obtain.
The concept of efficient markets has been the subject of thorough academic research and has been debated in investment circles for over a century. The theory does come with some criticism. Efficient market hypothesis assumes all investors perceive all available information in precisely the same manner. Of course, that is not always realistic. Despite the increasing use of machines to evaluate securities, most decision-making is still done by human beings and, therefore, is subject to human error. Market efficiency doesn’t rule out the possibility that some investors will earn above-normal returns over a period of time. But the number of investors who “beat the market” will be no greater than what is expected by chance, and the pursuit of beating the market comes with added risk.
The massive growth in the use of index funds over the past decade provides evidence the money management industry is moving away from market timing to the principles of efficient market hypothesis. The goal of a long-term investor is not to time the market but to adhere to sound strategies that will help investors achieve their long-term financial goals.
Diversification
A diversified portfolio owns a piece of many asset classes, so it can benefit from owning top performers without suffering the full effect of owning bottom performers. Diversification is different from asset allocation. Asset allocation covers the mix of stocks and bonds while diversification is a portfolio approach within one asset class.
Although it may seem like common knowledge that a diversified portfolio is a prudent way to invest, few realize that diversification is explored in great detail by Nobel Prize-winning economist Harry Markowitz. Through his work, Markowitz created what is known as modern portfolio theory, a framework for a way to construct portfolios to maximize expected return based on a given level of market risk. With an expected return, an investor can construct a portfolio with the lowest possible risk. Based on measures such as variance and correlation, an individual’s investment performance is less important than how it affects the entire investment portfolio. Basically, a portfolio’s total risk and return profile is more important than the risk/return portfolio of an individual investment. By understanding this, it's possible to build a diversified portfolio of multiple investments that will maximize returns while limiting risk. Markowitz referred to diversification as “the only free lunch in finance.”
According to the principles of modern portfolio theory, an investor’s ideal portfolio will be the one that maximizes the potential return while minimizing risk. Modern portfolio theory says stocks face both systematic risk (risk inherent to the entire market) and unsystematic risk (issues specific to each stock, such as management, a scandal, industry slump, etc.). Proper diversification of an investment portfolio cannot prevent systematic risk, but it can mitigate unsystematic risk.