The Right Way to Solve Asset Management

michael edessesThe current approach to investment management has no sound basis and doesn’t work. There is a better way.

I have written many articles pointing out that the current approach to investment management doesn’t actually work. The theory is all single-point-in-time. This is absurd for a process of investment, saving, and spending that takes place over the long term and aims at goals that are often far in the future. To extend the single-point-in-time theory to a continuing process over time, applications of the theory simply assume that the single-point-in-time solution applies to every moment or interval in time in the future.

That this approach is inapplicable has been made obvious by the need for “target-date funds” with their “glide paths,” which do not apply the same solution at every point in time. Yet the supposedly brilliant concept has nothing to offer that would provide an appropriate glide path for a particular set of future needs. Hence, glide paths are derived by rudimentary rule of thumb with no sound theoretical basis and little or no relationship to the single-point-in-time theory.

The current theory, which is taught in schools, and tested in CFA institute exams for certification purposes, has as its bedrock the mean-variance optimization model. In a truly appalling 2010 book, The Endowment Model of Investing: Return, Risk, and Diversification, the authors admitted that the model had to be “tortured” – by which they meant rigged – to produce acceptable outputs. They then went ahead and “applied” the model throughout the entirety of their 352-page book, quite openly manipulating the model to get the results on which their conclusions depend. It should be no wonder that the endowment model has failed so badly.

As I have shown before, most of the articles on investment management in financial journals are deeply flawed. They rest on performative mathematical exercises which are then interpreted by the authors to support their own preconceived non-mathematical conclusions, even when, which is very often the case, they do not actually support them.