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Investing in securities cannot be separate from the concept of investment which, in economic terms, means adding to the stock of capital – tools, machines, plant & equipment, buildings and developed land. Physical capital is the means of production of useful things which are exchanged for income. Because capital generates income, traditional economics defines it as wealth.
Securities are not wealth but the means of parcelling up and dividing the ownership of productive assets and their profits. In free markets, security prices are just ‘a preponderance of accidents of the moment’ (Alfred Marshall 1894). Purchasing securities for the purpose of realising a short term gain is speculation. For every speculator that realises a gain there must be another speculator who realises an equal and offsetting loss. So speculation is a zero sum game for society whereas investment is not.
The security price of a company cannot grow faster than the wealth that company creates, over the long term. From a macroeconomic point of view, this means that total market capitalisation, which is the sum of the product of every security’s price and shares outstanding, cannot grow faster than the total wealth of the market.
A sophisticated definition of the market is readily available from any index provider like FTSE. Using company Book Values as a proxy for wealth, the sum of every company’s Book Value in a FTSE index provides a good estimate of total market wealth or capital stock. GWA builds strategy indices by calculating each constituent’s proportion of the total Book Value in a FTSE index. Another proxy for market wealth is the sum of every company’s Net Profit or Cash Earnings - the flow of income. All of our strategies are Wealth Weighted Indices.
In a free exchange economy, market cap weights are volatile in the short run but always move towards the wealth weights in the long run. Competition makes it so. Security prices over-shoot and under-shoot market wealth weights as they adjust to competitive forces that drive them towards this long term central limit. Rebalancing a Wealth Weighted Index every 90 days provides a buy low, sell high bias to our process that accounts for the proven out-performance of 200-400 bps p.a.
Our approach differs completely from Modern Portfolio Theory which contains no economics. MPT focuses only upon one variable, security prices, and ignores completely the capital stock and income of companies. Such a price based system is a useful toolkit for speculators but is not suitable for developing investment principles for long term investors as it shortens the time horizon.
GWA keeps fees low by using the infrastructure and expertise of world class implementers State Street, Mitsubishi, Sumitomo, Mizuho and Legal & General who passively implement our Wealth Weighted Index series.
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