Other seemingly logical assumptions also fail to hold in practice. For example, the old adage that value as a style always outperforms is surprisingly often true in theory, but often fails in practice. This is because assumptions such as these are often underpinned by theory which ignores important issues, such as trading costs. A well-structured ‘value’ portfolio has a good chance of outperforming very consistently, but with a likely turnover of several hundred percent needed to create a basket of true ‘value’ stocks, practice shows that the assumption cannot hold in reality. This assumption also ignores the importance of time. While in the longer term value may outperform, in any market there can be significant periods of time when this style is out of favour and other styles do better. An investor buying in at the beginning of such a period would need strong conviction in the veracity of the assumption to maintain his market positioning in these circumstances.
We cannot and should not worry that we have to make assumptions, but we should take care to ensure that they are well reasoned and accurate, as well as regularly reviewing the assumptions we have made in the past to make sure they remain valid in the present. Being open to debate and, where possible, bringing together multiple experienced and seasoned investors increases the likelihood that assumptions are closer to reflecting reality. Remember to adapt the well-known saying, that the road to hell is based on good assumptions.
James Bateman is head of multi-manager and multi-asset portfolio management for Fidelity Worldwide
