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The New Wealth Management: The Financial Advisor's Guide to Managing and Investing Client Assets by Harold Evensky, Stephen M. Horan, Thomas R. Robinson, Roger Ibbotson

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CHAPTER 7

MATHEMATICS OF INVESTING

Two things cause a stock to move—the expected and the unexpected.

—Gary Helms1

The incredible pace of both academic and practitioner research in investment theory over the past 30-plus years can be attributed to four forces—theoretical breakthroughs, the development of comprehensive and accurate market databases, the refinement of analytical tools, and the availability of high-powered personal computers.

While wealth managers need not become expert in all of these areas, there are many analytical concepts they should understand and numerous academic theories they should be familiar with. A sound knowledge of these issues is one of the attributes that distinguishes a professional wealth manager from the nonprofessional.

The ultimate responsibility of the wealth manager is to integrate these issues, concepts, theories, and models into an investment philosophy to use as a guide in designing plans and providing recommendations for clients.

For example, does the wealth manager accept Eugene Fama’s weak or perhaps the semistrong efficient market hypothesis? Do you agree with William Sharpe’s capital asset pricing model (CAPM) and other asset pricing theories that unsystematic risk should be avoided? Should you follow the conclusions of Harry Markowitz’s modern portfolio theory (MPT)? Is the market leptokurtic? Will the wealth manager determine allocation recommendations by using a parametric quadratic optimizer, optimizing for semivariance? Is multiple ...

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