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D. Murali

EVER felt like a Hamlet by the poolside wondering, `To dip or not to dip?' Warren E. Bitters captures this predicament in Asset Allocation and Portfolio Optimization thus: "The water will eventually feel fine, once we get used to its temperature, but at first it can feel very cold." You have two choices: either take a dip or start wetting the body inch by inch. "Similarly, in investing, we have two choices: invest all at once or invest gradually over time," explains the book, published by Vision Books (visionbk@vsnl.com). It is either LSI or DCA — that is, lumpsum investing or dollar cost averaging.

What's DCA? A technique that means "investing the same fixed amount of money in a risky investment at regular intervals of time, regardless of whether prices go up or down." Proponents of DCA extol "the almost magical ability of DCA to enhance return and reduce risk." But Bitters is not one among them. He shows empirically and theoretically how DCA loses out to LSI, and goes on to explore the `psychological perspective' too. DCA is unnecessary when investing in low risk investments, the author points out. With a risky investment, the investor using DCA "feels joy that he avoided the full magnitude of the loss that would have occurred if he had invested all at once."

In the alternative, if investment rose in value, his return would be lower than if he had adopted LSI. "The loss from the DCA strategy is not really a loss, but an opportunity cost," explains the author putting you on a couch. "The mind processes the two outcomes as `avoiding a large loss' and `producing a gain'. The mind attaches a positive value to each result. Under LSI, the mind processes the two outcomes as `a large loss' and `a gain'. In this case, the mind attaches a negative value to the large loss and a positive value to the gain."

It was Harry Markowitz's `Portfolio Selection' in 1952 that revolutionised modern portfolio theory, notes Bitters, in a chapter on `the importance of asset allocation'. (Markowitz received the Nobel Prize in Economic Science in 1990). A path-breaking article `Determinants of Portfolio Performance' by Brinson, Hood, and Beebower (BHB) was published in 1986. "Their findings stunned the investment profession by focussing attention on the importance of asset allocation and the ability of active investment management to add to investment returns."

You can see the BHB effect in the bursting forth of "index funds and other types of passively managed funds" after "finding that professional investment managers generally subtract value, rather than add value, in the areas of market timing and security selection, while adding to overall portfolio risk."

Midway through the book, Bitters would introduce you to `a disciplined approach to active asset allocation' that would have two `important' qualities: "First, it must have demonstrated that it added value in the past and, second, it must have a logical reason behind it that leads us to believe it will continue to work in the future." An old saying that may provide some relief to heavy-duty investment theory goes like this: "If we torture a set of data long enough, sooner or later it will confess to something."

The author goes about "to develop a systematic approach" looking at the many published articles on the subject. Such as what Klemkosky and Bharati wrote in 1995: "Active allocation without transaction costs produced an arithmetic mean of annual returns of 16.06 per cent, with standard deviation of 9.25 per cent, and terminal wealth of $66.47 on an initial investment of $1.00."

Transaction costs reduced investment return by a full 2.79 per cent a year. How nice it would be if making money out of investment were not to necessitate understanding of all these theories but needed simply connecting your computer to Bloomberg or the Wall Street and the results just clang-clang into your bank account! With that dream at the back of your mind, you can read a scene that Bitters describes from Douglas Adam's The Hitchhiker's Guide to the Galaxy:

"There is a scene where the most powerful computer in the known universe is asked to answer the `ultimate question of life, the universe, and everything.' After pondering this question for 7½ million years the computer finally answered, `42'. Why such an implausible answer? Bad inputs. The answer was not correct. The question was simply not the right one. The solution, of course, was to build a more powerful computer to determine what the question should have been."

If money doesn't taste bitter to you, think of allocating cash for Bitters's book.

BookValue@TheHindu.co.in

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