“One of the earliest and most succinct expressions of the concept of the equity risk premium came from John Stuart Mill in his 1848 classic Principles of Political Economy,” narrate the authors.

Mill wrote thus, about a farmer considering investment in land: “… he will probably be willing to expend capital on it (for an immediate return) in any manner which will afford him a surplus profit, however small, beyond the value of the risk, and the interest which he must pay for the capital if borrowed, or can get for it elsewhere if it is his own.”

The farmer’s profit, according to Mill, has three parts: one, the riskless rate, which is the interest paid on borrowed capital, ‘determined in terms of the alternative opportunity cost of money’; two, ‘the value of the risk associated with the investment,’ which is equivalent to the equity risk premium; and three, surplus profit, or ‘the alpha’ in modern parlance.

Mill’s idea took a long time for adoption, because economists tended to focus ‘on the apparent paradox of profit and perfect competition rather than risk and return’.

However, Frank Knight, a Chicago economist, asserted the importance of risk; his 1921 book Risk, Uncertainty and Profit rued the lack of useful models of risk and return in economic research.

The first significant attempt to advocate equity investing as a means to achieve higher investment returns was of Edgar Lawrence Smith.

His 1924 book Common Stocks as Long Term Investment approached the problem empirically and measured the relative performance of two asset classes, viz. stocks and bonds.

In 1938, Alfred Cowles III published Common Stock Indices, the most carefully crafted analysis, using punched cards, of ‘monthly highs and lows by stock and dividends from 1872 to 1937 for stocks on the NYSE’…

The book by Goetzmann and Ibbotson has in-depth chapters on topics such as simulation and forecasting, survivorship and selection bias.

The book concludes with a simple multiple-choice question: “What part of fund performance is explained by asset allocation policy: 40 per cent, 90 per cent, 100 per cent, or all of the above?” The answer, according to the authors, is this: “Asset allocation explains about 90 per cent of the variability of a fund’s returns over time, but it explains only about 40 per cent of the variation of returns among funds”

There’s more: “On average, across funds, asset allocation policy explains a little more than 100 per cent of the level of returns. So, because the question can be interpreted in any or all of these ways, the answer is ‘all of the above’.”

For the research-minded.

Business cycles, employment numbers, retail sales statistics, import and export prices, yield curve, inflation… If you find it difficult to make sense of these, here is Bernard Baumohl to give you ‘hidden clues to future economic trends and investment opportunities’ in The Secrets of Economic Indicators’ ( www.whartonsp.com ).

“The subject of economic indicators can be lethally boring because of its impenetrable jargon and reliance on tedious statistics,” cautions the author. He then embarks on a mission to make the subject approachable and interesting.

You would find the book readable, even if you have little experience navigating the maze of key economic statistics; Baumohl’s aim is ‘to dispel the notion that you need to have an economics degree, an MBA, or a CPA’ to decode these numbers.

‘The most troubling revelation’ that spurred the author to write the book was that ordinary investors were ‘utterly dependent’ on ‘so-called experts for virtually all investment advice’.

Didn’t these experts – ‘veteran portfolio managers and long-time professional market watchers’ – help?

No, they failed miserably in their responsibility to help protect the assets and curb the losses of their investing clients, fumes the author.

“Worse still, investors became justifiably furious when they realised they were also being lied to by some of the companies they had invested in and even by the brokerage firms with whom they had entrusted their hard-earned money…”

Compulsory read.

More Stories on : Books | Book Value

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page