Wednesday, November 20, 2013

Wilcox & Fabozzi, Financial Advice and Investment Decisions

Financial Advice and Investment Decisions: A Manifesto for Change by Jarrod W. Wilcox and Frank J. Fabozzi (Wiley, 2013) is meant as a wake-up call for individual investors (and, presumably, their financial advisers as well). The book is comprised of thirteen chapters and four appendices. The chapters cover such topics as the extended balance sheet approach to financial planning, properties of mostly efficient markets, growing discretionary wealth, coping with uncertain knowledge, controlling investing behavioral biases, tax efficient investing, matching investment vehicles to needs, active vs. passive strategies, performance measurement, and organizational investment. The final chapter looks at causal feedback loops in society that are affected by financial decision making.

The authors believe that investors have to up their game. First, they should prepare for economic dislocations. Structural factors contributing to our current high unemployment, for example, are “likely to get worse over the longer term”; moreover, “the most important processes involved are strongly nonlinear in their progress.” (p. 255) So people should save to compensate for possible future unemployment or underemployment. Second, odds are that they will live longer, which again means they will need more savings. As the authors write, “[T]echnology is rapidly improving and will likely substitute for not only traditional healthcare but insurance practices. What happens when moderate amounts of life extension become an optional consumption good rather than insurable events? Better start saving.”(p. 258)

Some of the themes of this book have been covered elsewhere (although usually not within a single volume), but other material is new—at least to this reader. Wilcox, for instance, offers a surplus growth model (akin to a neglected model devised by Mark Rubinstein in 1976) which applies the Kelly optimal growth model “not to the investment portfolio” but to “the surplus wealth that could be lost without failing to meet financial obligations.” (p. 85) This intriguing model is described briefly but with some mathematical precision. It maximizes the expected log return of discretionary wealth. “Using only two terms of a Taylor series, and approximating, this amount[s] to maximizing LELE2V/2 where L is leverage, E is the expected portfolio return, and V is portfolio return variance.” (pp. 102-103)

On another front, trying to capture the essence of “mostly efficient markets,” the authors write: “If market cycles operated as smooth outcomes of simple feedback loops, they would be subject to anticipation by intelligent speculators, thereby losing their force. In practice, however, the behavior of multiple linked feedback loops is not only complex, but its character may be disguised by frictions—thresholds that must be exceeded before action is taken—that make their operation spasmodic. … Because of the resulting lumpy nature of the actual purchases, the sources of system risk that develop across multiple investors and investments are often obscured. This kind of emergent behavior, whether in terms of small movements of a single security or cataclysms over most of the world’s financial system, can be better understood if we think of its operation through a network of investors.” (p. 51) The authors illustrate properties of investor networks—and network contagion--with simple grid diagrams.

This book is written for the serious retail investor who wants more than the usual financial advice pap. It doesn’t offer stock tips or even the standard fundamental/technical words of wisdom. Instead, it provides a framework within which to make intelligent investment decisions. And a good framework is worth a thousand stock tips.

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