Markets Work

Most money managers believe, implicitly, that markets consistently fail to price securities correctly.  We disagree.

Our approach to portfolio management is based on the notion that capital markets are highly efficient. Market efficiency simply means that any that new public information (changes to projected earnings, new lines of business, new economy-wide data, etc.) is rapidly disseminated and incorporated into security prices. New information is by definition random, and it has been demonstrated clearly that security prices respond by changing randomly as well.

In capital markets with randomly changing security prices, it is not possible to consistently predict which assets within the capital markets will “outperform” or “underperform” the market as a whole. This explains why active management strategies, which seek to add value through security selection and market timing, invariably fail. So instead we adopt a passive approach to portfolio construction, which seeks to simply reward investors with capital market returns in the most cost effective manner possible.

Efficiency also implies that markets reward investors for the capital they supply. Companies compete with one another for investment capital and investors compete with each other to find the most attractive returns. This competition drives security prices to their fair value, ensuring that no investor can expect greater returns without bearing greater risk.

While higher returns are not obtainable without assuming greater risk, one can assume more risk without any expectation of earning a higher return. There is, if you will, “good risk” and “bad risk.” We can identify the reckless risks and do away with them through careful and deliberate diversification. This leaves a portfolio exposed only to that risk which cannot be “diversified away.” One can therefore expect to be compensated with higher returns in exchange for bearing this risk.

While we target higher expected returns, these are not guaranteed, and precipitous declines in value could occur along the way. We therefore strive to include asset classes that not only have historically provided strong levels of appreciation over the long term, but also have provided short-term returns that are independent of one another. By holding these assets in proper proportion we aim to minimize the overall volatility of your portfolio’s value without sacrificing growth. This rationale assumes that the historical performance of capital markets is a reliable guide to the future.

The particular investment vehicles (mutual funds, ETFs, or direct equity investments) we have chosen have consistently outperformed the vast majority of actively managed mutual funds in their respective asset classes. Moreover, those actively managed funds that do manage to outperform our recommended assets over a given short-term period rarely do so again over subsequent periods. This supports our contention that these occurrences amount to a random phenomenon. In addition, actively managed funds typically assess fees far above those levied by the passive investment vehicles we prefer.

In the following sections we discuss each of our eight recommended asset classes, which we have identified through empirical analysis of monthly historical returns going back as far as reliable data exists, in some cases beginning in 1926. For a thorough explanation of our approach, including a comprehensive review of historical data, please see AIER's book How to Invest Wisely.