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A Few Notes on Wave Theory for Alternative Investments

February 21, 2011 • Posted in Big Ideas

In his 2010 book Wave Theory for Alternative Investments: Riding the Wave with Hedge Funds, Commodities, and Venture Capital, author Stephen Todd Walker asserts that “dynamic asset allocation (as opposed to static allocation) is imperative… In my view, now is the time that one should be adding alternatives to a well-diversified portfolio. It is time to get out the surfboard. I believe alternatives move in waves, and this next wave will be worth riding. …Investors should consider all asset classes, especially those they do not fully understand, because that is where an investor will likely find the best opportunity going forward. …No one possesses a crystal ball, but it is not impossible to identify a certain trend or wave forming with alternatives.” The book first introduces the author’s Wave Theory of asset class performance and then examines some alternative asset classes. Some notable points from the book regarding dynamic asset class allocation are:

From Chapter 1, “Wave Theory” (Page 3): “Wave theory is simply the belief that all securities move in waves (patterns, cycles, or trends). History sometimes repeats itself, but with alternatives an investor can typically see similar waves repeating themselves.”

From Chapter 2, “Surfing Alternatives Waves” (Pages 31, 44): “Investing in alternatives is not too different from riding a wave on which the alternative(s) can serve as a surfboard. …The paradox of investing during a financial storm is identical to surfing when there is a storm or hurricane because it might produce the best wave to ride in both scenarios.”

From Chapter 3, “Wave Action, Reflection, and Mastery” (Page 58): “Every professional surfer or institutional investor in alternatives has a unique, individualized style. It is best to develop one’s own strategy, but an investor might consider the following ‘Top-25 Alternative Surfing Maneuvers’ list…”

From Chapter 6, “Venture Capital Market Dynamics” (Page 133): “…it is my belief that the years following the recession from 2007 to 2009 have yielded an environment in which the venture capital industry is extremely attractive…”

From Chapter 9, “Venture Capital Investment Vehicles” (Pages 219): “…If one invests in venture capital, they should have a 10-year horizon in mind.”

From Chapter 11, “Commodity Investing” (Page 283): “…commodities will be one of the fastest growing alternatives for investors to explore.”

From Chapter 13, “Gold Waves and Investments” (Page 330): “The best time to buy gold appears to be when the stock market is doing well and gold is low in price. …The ideal time to invest is when the stock market is overvalued or when a crisis first breaks out. Typically, this is the time to dust off the surfboard.”

Reservations about the book include:

  • The book presents no rigorous research supporting the asserted belief that asset class valuations rise and fall with the predictability implied by the name “Wave Theory.” The empirical support offered for this belief is little more than examples of historical valuations going up and down. In other words, there is no attempt to distinguish predictable waves/cycles from random variation. While this defect does not preclude the possibility that an experienced investor can have useful intuitions about which asset classes will be hot and which will be cold, it does undermine confidence in the book’s value proposition.
  • The surfing maneuvers (guidelines for dynamic allocation) described in Chapter 3 are generally vague and unsupported by analysis or citation of formal research. In other words, the book does not offer testable strategies for translating Wave Theory into successful dynamic asset class allocation.
  • In contrast, the book makes a reasonably good (though scattered) case for diversification across asset classes. It does not make a good case for dynamic allocation (market timing).

For examples of quantified/testable strategies for “surfing” asset class return waves, see the momentum and value-momentum strategies cited in “What Works Best?”.

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