Morningstar Magazine - February/March 2014 - (Page 8)
Letter From the Board
Preparing for the Next 50 years
By Warren Miller
Change is inevitable. Look no further than the
advancements of the past 50 years to
realize that investment innovation is alive and
well. The Capital Asset Pricing Model was
introduced in the early 1960s. Eugene Fama
introduced the efficient market hypothesis
in 1965. The Black-Scholes-Merton model of
option pricing was developed in the early 1970s.
Arbitrage pricing theory, the equity risk
premium puzzle, robust portfolio construction,
multifactor risk modeling, and other innovations
have sprouted in the past 50 years.
Of course, not all advents in finance were
theoretical. Personal computers and the
Internet democratized processing power and
data storage and knowledge. As a result,
the raw data available for analysis exploded.
Retail investors now execute trades at speeds
that would have been inconceivable to the
largest institutional investors in decades past,
and some funds now approach the limits
of physics when executing trades based on new
information in real time.
Furthermore, as innovation begets innovation,
the pace of change is increasing. Consequently,
our ability to prepare for and adapt to change
has never been more important. Can we
predict the changes of the next 50 years? Not
with much precision. But we can make educated
guesses about the trends of the coming
decades and position ourselves to benefit.
Moore's law dictates that the processing power
per chip will double every 24 months. This
trend is alive and well in 2014, but is expected
to break down in the not-to-distant future.
Filling the void will be distributed computing,
Morningstar February/March 2014
which allows calculations to be broken into
small chunks and spread across many
chips to be computed in parallel-resulting in
remarkable efficiencies. Many problems in
investing lend themselves to this massively
parallel structure, leading to three implications.
First, demand for unique and novel datasets
will skyrocket as it becomes easier and cheaper
to process massive amounts of it. Second,
investors will use numerical methods and
simulation instead of finding closed-form (read:
mathematically elegant/tractable) solutions to
investing problems. Finally, investors will
automate more of their investment processes to
capitalize on opportunities in real time.
Much of technological advancement ends up
bringing humanity closer together. The printing
press, automobile, airplane, telegraph,
computers, and the Internet have all made it
easier to share information and resources.
What does more interconnectedness mean for
financial markets? As information and resource
sharing becomes easier and cheaper, investors
will expect more of it. Consequently, it will
be harder to justify the obstruction of data from
those who would use it and derive value
from it, and financial markets will continue their
march toward additional transparency.
Investing is all about deciding which risks to
take. The variety of risky instruments available
to investors has grown. This growth often
follows from theoretical innovations that allow
us to split apart distinct but comingled risks.
As financial theory continues to evolve,
our ability to split risks and build corresponding
products should grow in proportion. In other
words, the opportunity set for investors should
grow as new products are created to
divide and distribute various forms of risk.
These three predictions are not specific enough
to warrant a precise set of instructions on
how to achieve a person's investing goals over
the next 50 years. Still, investors who follow
the following three rules will fortify themselves
against the unpredictable onslaught of change:
1. Keep an open eye and open mind toward
technological innovation. Contrary to
popular belief, accepting new technology does
not require rejection of long-held investment
philosophies. Technology is just a tool to make
us more efficient at what we choose to do.
2. But stay skeptical. Not all innovation will
be useful. Healthy skepticism will help filter out
the novelty that is too complex, ill- conceived,
or just plain impractical.
3. Build an enduring investment philosophy
based on principles that will persist.
Avoid rat-race strategies in which fastest
investor earns all the rewards or you will
find yourself swaying in the winds of change
rather than cutting through them.
Predicting the future is difficult, and it's human
nature to avoid difficult tasks. Luckily you
don't need a crystal ball to position yourself
well for the future and protect your investment
process from obsolescence. K
Warren Miller, CFA, is vice president of global
quantitative research with Morningstar. He is a member
of the editorial board of Morningstar magazine.
Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2014
Morningstar Magazine - February/March 2014
Letter From the Editor
Preparing for the Next 50 Years
Morningstar Managers of the Year
Fixing the Trust Deficit
Rethinking the Path to Retirement
Same Old, Same Old
The Economic Implications of an Older World
Banking on Performance
Is the Affordable Care Act Healing Health Care’s Woes?70
Baxter Has a Positive Prognosis
Leading Fidelity’s Charge for RIAs
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Moving the Goal Post
Morningstar Magazine - February/March 2014