Evolution of Investment Theory
Momentum investing is a soundly based phenomenon which provides an answer to many questions left open by traditional methods of analysis and as such can complement other approaches to investing.
Since it emerged in the mid-twentieth century the “Modern Financial Theory” has been unreceptive to the idea that observing what is actually happening can provide a better structure for understanding how markets operate than focussing on a logical deduction from various empirical inputs. With the arrival of the Efficient Market Hypothesis (EMH) in the mid-1960’s the idea that in freely operating markets, with many varied participants all looking to maximise their own returns and each possessing perfect information basing decisions on historic data (momentum) attracted little interest.
Despite its wide-spread acceptance among academics and practitioners alike the EMH kept falling foul of an increasing number of exceptions. This led to the gradual acceptance that there were three forms of market efficiency; weak, semi-strong and strong but no real challenge to the notion that its basic assumptions were flawed.
It was only in the early 1990’s that real challenges began to emerge questioning the very basic ideas of the EMH. Researchers demonstrated that forming portfolios solely based on price trends over preceding months produced superior returns even after allowances were made for cost and risk. The notion of momentum, or trend following in the stock market gained credibility. While this was not new to a number of practitioners it certainly was to the accepted wisdom of the time.
As behavioural and complexity economics developed so did the recognition that people did not necessarily make economic decisions in the same way that had been traditionally assumed. Understanding how decisions are made could no longer be reduced to a few simple mathematical formulas and assumptions about perfect information and rationality. The role of “complexity” is gradually being recognised in economics and financial markets and has profound implications.
In a complex system what happens is determined by the interaction of many different agents whose action is determined by what they think others will do. This whole process is constantly adapting as it reacts to new information and preferences. Such a system is continuously out of equilibrium as new niches; new possibilities and new potential are created.
Economics and finance have not been alone in revising their thinking. Researchers in disciplines and drivers such as mathematics, biology, computer science and sociology increasingly recognise that models depending on an assumption of equilibrium are likely to provide a poor representation of reality.
Grand ideas such as “Complexity Economics” and “Dynamical Systems Theory” are receiving much attention and are providing useful explanations as to why economies and markets work in the way they do. In Finance, the original EMH is being superseded by the Adaptive Market Hypothesis (AMH) or at a more practical level by George Soros’ reflexivity.
With such fundamental changes in the understanding of economics and financial markets going on, a new way to think about and manage portfolios is required. We believe we have one such way.