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Asset allocation approach to understanding stock market dynamics

Nuttall, John (2006): Asset allocation approach to understanding stock market dynamics.

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Equity portfolio managers typically convey instructions to their traders in the form of target portfolio weights for the various shares in their portfolio. We present a set of differential equations that allows the calculation of the share prices, number of shares, and value of each manager's portfolio over time, in terms of share weights. It is also necessary to know the amount of cash flowing into each portfolio and the number of each type of shares outstanding.

We suggest some potentially useful information that might be derived from this formalism, such as a quantitative estimate of the main driver of share price changes, the influence of index investing on the market, and the origin of the equity premium.

We believe that this realistic method could be the basis for a better understanding of how financial markets operate, as compared with the conventional academic approach. In our view standard asset pricing theory makes implausible assumptions about the existence of stochastic processes, the ability of participants to foretell the future, and their capacity to make sound deductions from the information they have. Even an imperfect alternative should be better than that house of cards.

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