merrill lynch head of investment strategy and research criticises the use of the theory as a way to assess future performance of asset classes
Using the efficient frontier theory to determine which asset classes will outperform is 'foolish', according to Merrill Lynch.
Speaking at a recent conference in Frankfurt, Ewen Cameron Watt, head of investment strategy and research at the group, said the theory may be correct but it tends to highlight asset classes that have already performed well, rather than those that will perform well in the future.
He said: 'The theory goes, if you have 100% in one asset class and 0% in another, you would have a 1.5% return for 11% risk. But if you put the other asset class in varying mixes, say 70%-30%, you get a higher return for less risk. The theory itself is correct but it is a stupid idea ' it tells you just what has done well, it does not predict future success.'
Efficient frontier was used in 1989 to suggest people carry on buying Japanese equities. He added: 'I'm ashamed to say that in my previous career as an emerging market manager that I used this argument to tell people they should buy emerging markets and I'd bet today it is being used by people to justify corporate bonds.'
Cameron Watt also dismissed the idea that diversification is the best way in which to reduce risk, noting that it, too, leads to investing in asset classes after they have performed well.
He said: 'Diversification is essentially hoping that if you scatter enough money across the water that eventually it is all going to work. Diversification is also a development of the greater fool theory ' there's a greater fool than me who is going to pay more for the asset I bought than I did in the first place.'
The best way to define risk is to determine what type of market exists at the moment. 'First of all, it is crucial to decide if you're in a bull or bear market. In a bull market, investors worry about missed opportunities, whereas in a bear market the worry is about insufficient savings.
'Risk is a function of each individual's decisions ' there is no such thing as a general attitude to risk, there are a thousand, a million, concepts of risk and it is important to recognise that,' he said.
Advisers must contend with rising expectations within a bull market. Clients tend to extrapolate along a set line based on the past performance, they start believing that what has worked in the past will work in the future.
Cameron Watt added: 'But at some point the value of the asset will fall. The difference between what they expected and what they have actually earned is a shortfall in their expectation, and if it is really serious, it is a shortfall in their earnings.'
In a bear market, the reverse happens ' people extrapolate downwards, believing everything will keep going down, he added.
'Investors start behaving in a way that is just as irrational as in a bull market. The successful investor is the one that realises that this extrapolated line downwards is an opportunity to buy just as the extrapolated line upwards is an opportunity to sell.'
If an investor believes risk is going to rise then the market is likely to be a bear one and asset classes expected to perform well include gold, commodities, cash and government bonds.
If the expectation is that risk will fall, then the market is entering a bull phase, and Cameron Watt believes equities, credit and index-linked bonds will outperform.
'We are moving to risk falling and recent equity falls are wholly irrelevant. I don't think we will cross completely from risk rising to it falling, but it is leaning more towards that direction.'
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