Investing in Irrational Markets

“The world is greedy – it still believes in magic,” summarized Tom Davidson, CFP, Summit Financial Strategies, in explaining market behaviors in last week’s personal financial planning Hot Topic Webinar on post-modern portfolio theory.

While I am most certainly not a financial planner, I enjoy quick updates that make me a more well-rounded professional in managing a variety of functions within business operations. I feel it’s an important part of our core value of professional competence, and Davidson was entertaining and timely in hitting the issues that I’m worrying about today.

Over the years, we’ve been comforted by the diversification of our portfolios, secure in our knowledge that by regularly investing small dollar amounts over a long period of time, dollar cost averaging will earn us a return commensurate with our stomach for risk, as reflected in our asset allocations…you’ve heard all of this before, and probably teach it regularly to your customers or clients.

Per Davidson, what changes in an irrational market is the meaning of “diversification” in this scenario. In yesterday’s portfolio theory, we believed that asset allocation among a variety of stock and bond funds, including some cash and some exposure to international markets and smaller companies, provided us with diversification. In irrational markets, this type of asset allocation may be insufficient.

Davidson studies correlations between types of investment classes, and has found that in an irrational market (defined as no longer tied to underlying fundamentals,) the correlation in terms of direction of movement of various asset classes grows closer and closer to 1.0. In other words, they all move in the same direction, more or less the same amount – i.e., no diversification benefit.

We are definitely in a period where there will be greater volatility, and modern portfolio theory takes advantage of volatility by combining individual volatile assets into portfolios to reduce risk. But as we’ve learned from the mortgage market, that theory doesn’t work either when all of the individual assets move in the same direction.

Post-modern portfolio theory looks for investment alternatives that have a negative correlation to your other investments. In an increasingly global marketplace, the size of business or nation of origin are less likely to provide negative correlations to your standard asset classes. So the trick is to identify new asset classes that provide less correlation. But one fault of this approach is that it relies on historical correlations, rather than forward-looking projections.

So how do we look forward in expanding the asset classes we are willing to consider in our investment strategies? Not being a registered investment advisor, I won’t attempt to suggest the right assets to select in today’s market. But bottom line, we may need to open our minds to what may be better “diversifiers” that are acceptable for our businesses’ or our own personal risk tolerance.

Davidson recommends “Asset Allocation” by Roger Gibson (2008,) “The Only Guide to Alternative Investments You’ll Ever Need” by Swedroe and Kizer (2008,) and “Pioneering Portfolio Management” by Swenson (2009 – particularly for institutional investing.)

As I have no specialization in financial planning, this simply opens my eyes for discussions with our professional investment advisor. But what I’ve learned most significantly is that you can gain critical knowledge in small chunks that makes you more effective as a CPA professional.

Check out the OSCPA online library for past hot topic Webinars on your topics of interest.

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One Response to Investing in Irrational Markets

  1. Easily, the post is actually one of the best Ive read in the investment field. I concur with your conclusions and will look forward to your upcoming posts. Just saying thanks will not just be sufficient, for the extraordinary understanding of trading and investment including the clarity in your writing. If you dont mind, Im grabbing your rss feed to stay informed of any updates. Delightful work and much success in your future business endeavors!

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