The Time Contradiction in Asset Pricing and Asset Management

Abstract

Investors live in a multi-period, volatile world and base their decisions on theories of asset pricing, and asset allocation, often derived from a single period model. They make assumptions about asset returns and volatilities and use optimizers to set their long term allocations, and often naively rebalance back to these allocations, hire managers etc. Even if they have perfect foresight in predicting asset returns, are they making decisions based on noise or truly useful information? Alternatively, what confidence can one have in these estimates over typical investment horizons of 5-10 years? Or how much time does one need to establish a successful investment outcome as opposed to just experiencing noise? A simple formula designed to examine whether asset managers are lucky or skillful can be used to examine these questions. This analysis suggests that the time window to have high confidence in the efficacy of the approach utilized by most investors is much greater than the typical horizon of these approaches – this is the time contradiction in investments. Alternatively, for a given investment horizon, this methodology suggests the degree of confidence an investor might have in their investment inputs and allocation decisions. Living in a volatile world implies that this confidence is low for short time windows. This time contradiction between required time horizon and that used by investors has interesting implications not only for the investment models and approaches used, including the examination of funded versus unfunded programs, but also for how investors are compared to peers and compensated.