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. Processing Power 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, 8 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. Interconnectedness 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. Risk Distribution 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. Be Prepared 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
Global Briefs
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