For academics specialising in economics and finance, the ultimate accolade is to be awarded the Nobel Memorial Prize in Economic Sciences. The latest recipient has just been announced. It’s Claudia Goldin, an American economic historian, who has been recognised for her work on women's employment and the gender pay gap. Here at rockwealth we take a strong interest in this particular prize. Why? Because the evidence-based investment philosophy we champion is largely built on the work of previous winners. Here are seven valuable insights from Nobel laureates which help to inform the way we invest our clients’ money. The year each academic won the prize is in brackets.
Risk and return are directly related
Whether we like it or not, all investing involves a degree of risk. Without taking a risk, we cannot expect to receive a return. Generally speaking, the more risk you take, the more volatile your portfolio will be, but the higher your long-term returns will be as well. This direct relationship between risk and return was first properly explained by William Sharpe (1990) and led to the development of the concept of the "Sharpe Ratio”, a measure used to evaluate the risk-adjusted performance of an investment. In simple terms, the Sharpe Ratio is a tool that helps investors understand how much extra return they are getting for the extra risk they are taking.
Some types of risk deliver higher returns than others
One of the academics who built on Sharpe’s work was Eugene Fama (1990). He is best known for the Efficient Market Hypothesis, which states that all available information is quickly reflected in asset prices. Because of this, it's very hard for individual investors or even professional fund managers to consistently beat the market by picking specific stocks. Instead, Fama showed, the main drivers of investment returns are tied to broader risk factors and, in particular, the performance of specific types of stocks. By “tilting” their portfolios to these different factors, Fama and his colleague Kenneth French demonstrated how patient investors may be able to outperform the broader market over time.
Most investors should avoid active funds
Essentially, there are two different types of funds. Actively managed funds try to outperform the market by identifying the best stocks and by increasing or decreasing market exposure at the right time. Passively managed funds, on the other hand, simply aim to track the market, efficiently and at low cost. The problem with active funds is that successful stock selection and market timing are very difficult, and very few of them beat the market in the long run. It was Paul Samuelson (1970) who first expressed scepticism about the ability of active fund managers to outperform the market consistently, especially after accounting for fees and expenses. Samuelson suggested that, for most investors, passively managed funds are a better choice than actively managed funds.
Portfolios should be simply constructed
Many financial advisers and investment consultants like to make investing complicated. But the overwhelming evidence is that simple portfolio construction tends to yield superior results. One of the first academics to realise this was James Tobin (1981). Separation theorem, the concept Tobin is best known for, states that an investment portfolio should consist of just two distinct parts — the risky part and the safe part. The aim of the risky part is to generate the highest possible returns. The safe part of the portfolio, or the Risk-Free Asset as Tobin called it, is designed to reduce the portfolio’s overall risk. The percentage of your assets you should allocate to each part depends on how much risk you are willing to take.
Diversification is essential
It’s now generally accepted that it makes sense for investors to be broadly diversified, but most investors continue to hold portfolios that are too heavily concentrated in specific areas. As well as exposing them to unnecessary risk, this can also result in lower returns. The academic most commonly associated with diversification is Harry Markowitz (1990). By spreading your investments across different assets, Markowitz demonstrated, you can reduce your risk without necessarily sacrificing returns. By having a mix of investments, if one doesn't do well, others might, helping to balance things out. This idea is the foundation of what’s called Modern Portfolio Theory. Developed in the 1950s, MPT is still used in portfolio construction today.
Overconfidence can be very detrimental to returns
There’s been a growing consensus in recent decades that behavioural factors have a huge impact on investment outcomes. In short, investors are prone to a range of behavioural biases which can lead them to make irrational decisions. The psychologist Daniel Kahneman (2002) was one of the first non-economists to win the Nobel Prize in Economics. Kahneman particularly emphasises the danger of overconfidence as an investor. His research has shown that people often overestimate their own abilities and the accuracy of their information. This can lead to overtrading and taking on too much risk. In a recent interview, Kahneman described overconfidence as the bias he would most like to eliminate if he had a magic wand.
Investors should block out the noise
As well as being aware of their behavioural biases, investors should also try to keep their emotions in check. Arguably the most harmful emotions, in an investing context, are fear and greed. Another psychologist awarded the Nobel Prize in Economics is Richard Thaler (2017). The best way to stop your emotions derailing your investment strategy, Thaler argues, is to block out market “noise”. This refers to the short-term chatter and market volatility that can distract investors from their long-term goals. Paying too much attention to the media, Thaler says in his 2015 book Misbehaving, is particularly dangerous. “Whenever anyone asks me for investment advice,” he writes, “I tell them to buy a diversified portfolio heavily tilted toward stocks… and then scrupulously avoid reading anything in the newspaper aside from the sports section.” You’ll find more information about evidence-based investing and the academic research that underpins it on our website and our YouTube channel.
