Saturday, August 6, 2011

Introduction to "Expected Returns: An Investor's Guide to Harvesting Market Rewards" - By Antti Ilmanen

Health warning: We should humbly recognize the limits of our understanding. Realized returns are dominated by randomness, structural uncertainty, and rare events. Expected returns are unobservable, at best estimated with noise. We should resist hindsight biases wired in us—the outcomes that materialized seem more inevitable or predictable than they truly were. It is worth recalling that experts can only explain a fraction of realized return variation afterwards, and this is an inherently easier task than predicting. Any observed return predictability is mild, possibly spurious, and rarely robust. Therefore I stress humility in interpreting empirical results and even more in making predictions and in trading based on them.

My hope is that this book improves the reader’s understanding of expected returns while not adding to overconfidence. With better understanding comes a healthy respect for investment risks. I do not denounce risk taking, since it is the main way to enhance long-run returns, but investors should choose carefully which risks to take and how much of each, accepting them mainly when they are well rewarded.

I review key investment takeaways in Chapters 28 and 29, but here is a one-paragraph summary: there are many ways to enhance long-run returns; several can be pursued in parallel. Investors should collect risk premia from diverse sources, not just equity premia but also illiquidity premia and value, carry, and momentum style tilts. Investors can further try to exploit leverage, contrarian timing, and view-driven active management — all of which can help when used with moderation.


Book: Expected Returns: An Investor's Guide to Harvesting Market Rewards