by David Larrabee, CFA
Brian D. Singer, CFA, told delegates at the 67th CFA Institute Annual Conference in Seattle that fundamental analysis is no longer sufficient for investing in the new world order. We are more interconnected than ever, and that means data alone is not enough to properly understand and measure risks. To recognize the difference between price and value today requires a deductive framework that combines fundamental analysis - and all its uncertainties - with new disciplines to manage portfolios.
Singer, who heads the dynamic allocation strategies team at William Blair & Company, made his case by first recounting the evolution of thought and reasoning, from Aristotle to Sir Isaac Newton. His argument: we are on the cusp of a major leap in the financial industry that necessitates a change in thinking on the part of investors. Aristotle represented inductive reasoning at its core - the observation of data points from the material world. Saint Thomas Aquinas ushered in an era of deductive thought, which said that knowledge came from divine revelation and not the observation of data. With the Protestant Reformation, Martin Luther reintroduced the concept of inductive thinking, and Sir Isaac Newton's work further embraced the idea that knowledge comes from data, effectively doubling down on inductive thinking and spawning the scientific method, where we are today in the world of finance. Singer thinks it's time for the pendulum to swing back to a deductive process when it comes to investing.
Stock returns in the United States during the 20th century should be considered in two parts, he argued. "The last half of the last century is absolutely unique in the history of human capitalism," he said, noting that it was marked by three important influences: the post-war baby boom between 1946 and 1964; the introduction of Modern Portfolio Theory by Harry Markowitz with the publication of Portfolio Selection in 1952; and the Cold War, which began in the 1950s and concluded by century's end with the so-called "peace dividend." The end of geopolitical stability and the "demographic dividend" are two reasons why Singer believes the financial industry is on the cusp of a major change.
To understand the U.S. today, Singer encouraged delegates to study the period 1900 to 1932. Parallels include income disparity, geopolitical instability, domestic political polarization, high debt levels, and a central bank in uncharted territory (the Federal Reserve was created in 1913, and today is engaged in unprecedented quantitative easing).
In addition to a strong grounding in fundamental analysis, properly assessing investment opportunities today requires an understanding of game theory, geopolitics, macro-thematics, and, of course, risk.
Singer focused on the challenge of accurately assessing risk, and distinguished between backward-looking risk, or volatility, and forward-looking risk, or uncertainty. He invoked both the Ellsberg Paradox and "Chicago school" economist Frank Knight when he told delegates that risk can have a probability associated with it and is a "knowable unknown," while uncertainty is an "unknowable unknown." The job of investors is to take those unknowable unknowns (uncertainties) and make them knowable unknowns (risks). Rather than the inductive empiricism of Aristotle's day, this challenge requires a deductive framework to guide thinking.
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