Modern Portfolio Theory

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staythecourse
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Re: Modern Portfolio Theory

Post by staythecourse »

pkcrafter wrote:And to throw another sticky wrench into the mix, we also need to know the difference between uncertainty and risk.
I would say those are not even the biggest views of risk that folks are not understanding. The biggest is that folks do NOT seem to understand by decreasing one risk (volatility) they are INCREASING another risk (shortfall risk). The problem is one has to basically choose between assets that will not lose money in the short term (cash, short term bonds, savings bonds, MM, CD, etc..) which are great because you don't lose money in the short run, but DO increase the chances of inflation and taxes eating into long term returns.

This is why I don't view stocks risky long term as I have crunched the numbers and higher equity portfolios give a better chance of overcoming the drag by inflation, taxes, and costs to invest then do more conservative portfolios.

Roger Gibson talks about this in his excellent book "asset allocation" about in the end there are only two risks: volatility and shortfall risk. And in keeping with "there is no free lunch" decreasing one risk IS accompanied by increasing the other.

Good luck.
Last edited by staythecourse on Mon Jun 17, 2013 2:23 pm, edited 1 time in total.
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Re: Modern Portfolio Theory

Post by Kevin M »

Incidentally, I didn't finish what I wanted to do in the Risk and Return wiki article. I'm not good at creating charts and am kind of lazy about it, so I petered out on the efficient frontier topics. It would be great if someone wants to finish it off (and of course improve it). I've seen some nice charts in some of Nisiprius's posts on MPT.

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Re: Modern Portfolio Theory

Post by richard »

staythecourse wrote:I would say those are not even the biggest views of risk that folks are not understanding. The biggest is that folks do NOT seem to understand by decreasing one risk (volatility) they are INCREASING another risk (shortfall risk). The problem is one has to basically choose between assets that will not lose money in the short term (cash, short term bonds, savings bonds, MM, CD, etc..) which are great because you don't lose money in the short run, but DO increase the chances of inflation and taxes eating into long term returns.

This is why I don't view stocks risky long term as I have crunched the numbers and higher equity portfolios give a better chance of overcoming the drag by inflation, taxes, and costs to invest then do more conservative portfolios.

Roger Gibson talks about this in his excellent book "asset allocation" about in the end there are only two risks: volatility and shortfall risk. And in keeping with "there is no free lunch" decreasing one risk IS accompanied by increasing the other.
Three issues here. The first is equating risk with volatility, the second is the implicit assumption that stocks become less risky in the long term and the third is crunching numbers. OTOH, the idea that there is a trade-off between hoped for return and risk is the essential insight of portfolio theory.

Risk probably means not having enough money when you need it. Another formulation is doing badly when times are bad. Volatility is a simplistic way to model that, but volatility and risk are not the same thing. If nothing else, look at the Fama French three factor model. They include three risk factors (market, size, value). If there is only one risk factor (volatility), why is FF so popular and why has it had any empirical success?

The key is that risk and expected return are two sides of the same coin - if you want more return, you have to take on more risk. William Sharpe, who has some association with portfolio theory, said it well "Why should anyone expect to earn more by investing in one security as opposed to another? You need to be compensated for doing badly when times are bad. The security that is going to do badly just when you need money when times are bad is a security you have to hate, and there had better be some redeeming virtue or else who will hold it? That redeeming virtue has to be that in normal times you expect to do better. The key insight of the Capital Asset Pricing Model is that higher expected returns go with the greater risk of doing badly in bad times."

Alas, if higher returns for a security or portfolio were assured over any time period, then that security or portfolio could not be said to have higher risk. If we believe the trade-off between risk and the hope for a higher return, how can we believe higher risk leads to higher return if only we wait a while. As Vanguard once considered both sides of the issue and concluded "there is little empirical evidence to support the claim that time moderates the risks inherent in risky assets" (although went on to say "other factors may warrant the consideration of an investment time horizon in the asset-allocation process.")

Most of us have to take risk in order to have any hope of meeting our investment objectives. However, we should not fool ourselves into thinking risk is not risky.

Crunching numbers typically involves looking at a relatively brief period of history that may or may not have any implications for the future. We only have about 100 years of reliable data. If we are trying to predict 30 years into the future, we only have about three independent data points. That's not enough. Add in the possibility that conditions in the past are different from current and future conditions, and it should be clear that we should not have much confidence in our ability to predict the future based on crunching numbers.
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Re: Modern Portfolio Theory

Post by Frengo »

Two notes:
1) It is only the risk you can't diversify away that pays.

2) Unless the God of Markets appears and tells you that the S&P500 follows a Cauchy distribution, you can only try to guess what distribution is from your observations. All observations in a finite number have a mean and a standard deviation.
staythecourse
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Re: Modern Portfolio Theory

Post by staythecourse »

Richard,

ALL analysis is done on past data. How do we know stocks are a risk that pays off vs. single company risk?? The reason is that folks crunched the data and found it so. Not because at the beginning of time someone knew inherently that ERP vs. manager risk or single company risk is something to be compensated for.

ALL of finance and any analysis done is done by crunching data. That is how a theory is proved or disproved. Folks don't write papers on "Well I think this because I think it makes sense". It is because they take the data that has occurred already and analyzed it.

Only several years ago folks laughed at stomach ulcers being caused by a bacteria. How do we know now that it is obvious?? Because someone took scrappings from a whole bunch of folks and it grew the same bug.

My partner in practice often says (and correctly the longer I have looked at folks personality) there are some where no matter how much data is enough.

Good luck.
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Re: Modern Portfolio Theory

Post by LadyGeek »

grayfox wrote:Nice work! I especially like your discussion of risk in the section Risk as the uncertainty of returns The charts comparing T-Bill, 10-YearBond and Stock returns do a good job of showing the increasing uncertainty of riskier assets. It's good that you put all on the same scale.
I helped create those graphs for Kevin M (the file is available for download in the "External links" section). The only reason I'm mentioning this is that I attempted to replicate those results for our sister Canadian site, Risk and return - finiki, the Canadian financial Wiki, of which I'm the primary author.

I simply wanted to reproduce the "risk vs. reward" results for Canadian securities. It didn't reproduce. :shock: The Canadian market (Toronto Stock Exchange (TSX)) is no where near as large as the US. Does that make a difference? (I aligned the US and Candian images side-by-side.)

ImageImage

Does this change anything discussed here? (The finiki page is the equivalent to the wiki's Risk and return: an introduction for new investors.)
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Re: Modern Portfolio Theory

Post by Rodc »

LadyGeek wrote:
grayfox wrote:Nice work! I especially like your discussion of risk in the section Risk as the uncertainty of returns The charts comparing T-Bill, 10-YearBond and Stock returns do a good job of showing the increasing uncertainty of riskier assets. It's good that you put all on the same scale.
I helped create those graphs for Kevin M (the file is available for download in the "External links" section). The only reason I'm mentioning this is that I attempted to replicate those results for our sister Canadian site, Risk and return - finiki, the Canadian financial Wiki, of which I'm the primary author.

I simply wanted to reproduce the "risk vs. reward" results for Canadian securities. It didn't reproduce. :shock: The Canadian market (Toronto Stock Exchange (TSX)) is no where near as large as the US. Does that make a difference? (I aligned the US and Candian images side-by-side.)

ImageImage

Does this change anything discussed here? (The finiki page is the equivalent to the wiki's Risk and return: an introduction for new investors.)
Graphs look like they have a distinct family resemblance, especially given the different time periods. A rather stronger family resemblance than the graphs of US vs Int that nisi posted very early in the thread. If you had time and interest, remaking the US to use the same time period as the Canadian might be interesting.
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Re: Modern Portfolio Theory

Post by richard »

Staythecourse,

Analysis in finance is done on past data because there's no alternative. The important thing is not to take it too seriously, due to the lack of sufficient data and uncertainty whether the data we have is applicable to the future. We only have about three independent data points if we want to look at 30 year periods. We don't know if the conditions that generated those data points are applicable to the future. If not, we have even fewer useful data points.

It's similar to what's been called the streetlight effect. A policeman sees a man searching for something under a streetlight and asks what the man has lost. He says he lost his keys and they both look under the streetlight together. After a few minutes the policeman asks if he is sure he lost them here, and the man replies, no, that he lost them in the park. The policeman asks why he is searching here, and the man replies, "this is where the light is."

We can derive much of useful finance advice from first principals. If markets are efficient, investors in general will be better off in cap weighted index funds, although due to individual circumstances some may want to vary. If we have no talent for stock picking, we are not going to do better picking individual stocks than holding a diversified portfolio. Bonds are safer than stocks due to their position in the capital structure (bonds get paid first and the issuer is obligated to pay) and because of the relation between price and yield (lower price means higher yield for bonds, but both price and dividends can fall for stocks).

Data can be used to refute some claims (the claim X is always true can be refuted with a counter-example). It is obviously better to have a theory confirmed by data and one which is refuted, but we really should attend to the standard statements about past data and the future.

It is possible to run controlled experiments in hard sciences. The same is not true for finance. There's a major qualitative difference between discovering the link between bacteria and stomach ulcers and computing, for example, the forward equity risk premium.
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Re: Modern Portfolio Theory

Post by grayfox »

LadyGeek wrote:
I helped create those graphs for Kevin M (the file is available for download in the "External links" section). The only reason I'm mentioning this is that I attempted to replicate those results for our sister Canadian site, Risk and return - finiki, the Canadian financial Wiki, of which I'm the primary author.

I simply wanted to reproduce the "risk vs. reward" results for Canadian securities. It didn't reproduce. :shock: The Canadian market (Toronto Stock Exchange (TSX)) is no where near as large as the US. Does that make a difference? (I aligned the US and Candian images side-by-side.)

ImageImage

Does this change anything discussed here? (The finiki page is the equivalent to the wiki's Risk and return: an introduction for new investors.)
Crazy stuff! Long bonds with 10% SD and stocks with 17% SD had the same 11% mean return. I think that proves that Canadians are bonkers. :D

Image
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Re: Modern Portfolio Theory

Post by nisiprius »

I strongly object to the notion of "shortfall risk." It mixes up risk with return. It is a complicated way of taking the legitimate concept of "low return" and calling it a "risk."

Bonds do not become risky because their returns have dropped. They become lower-returning investments. The money in our checking account did not become risky just because the bank used to pay 2% and now pays 0.01%, it is still safe; what makes it safe is not how much interest the bank pays, it's that that we know it is there and we know how much there is.

"Shortfall" can be measured only with respect to some target. Usually, you get to set your own financial goals, and you get to revise them if they turn out to be unrealistic. That's what we do with most financial planning in life. If we realize that we can't afford a new car this year, we mourn our disappointment and move on; we don't say "O! I have a 'need to take risk'" and run off to the casino with the rent money in order to avoid "shortfall risk."

There's no neutral way to measure "shortfall" unless you have some neutral, agreed-on way to determine what the target should be. If you set a target high enough, then the portfolio that minimizes shortfall risk is 100% lottery tickets.

The facts of the matter are pretty clear, and they're pretty interesting, and fully justify a stock allocation. Very roughly speaking, bonds have a fairly tight dispersion of returns, and at any moment in time they are fairly predictable going forward--and the return is low. Very low currently. However most of the sky-is-falling rhetoric implicitly assumes that it isn't going to stay that way forever; the exact same guesses that would project a bleak short-to-medium-term futures necessarily also predict rosy long-term futures. Stocks have a very very wide dispersion of returns, and the low end of the distribution is just about the same as the center of the distribution for bonds.

If you made prudently pessimistic assumptions for your portfolio, there is very little "shortfall risk." There is only "shortfall risk" if you are foolish enough to plan and save the way the retirement workbooks we were given in 1999 suggested--plan on stocks returning their "historical" average return going forward. If you put your target around the average for stocks, then, indeed, there is "shortfall" risk. With such a target, then of course you have predetermined your results. "Shortfall risk" is high to begin with, and, duh, increases if you increase the allocation to safer, lower-returning assets. But the so-called "shortfall risk" isn't a characteristic of the portfolio at all, it's a characteristic of the target you chose to pick.

Every simulation I've seen shows the same thing, but I'll mention specifically the Fidelity Retirement Income Planner (Monte Carlo withdrawal rate simulator). I was trying to use it dead-seriously around 2007, and was cranking in all sorts of detailed numbers relevant to my personal situation. The interesting point is that their default is to assume 10th-percentile stock market performance, i.e. the results that you've historically have gotten 90% of the time. And when I cranked in my real numbers, the prediction was that I would likely run out of money around age 94, and it made a strong suggestion that I increase my equity allocation sharply. So I took its suggestion, re-ran the simulation--and got almost exactly the same result!

Using their own prudently-pessimistic assumptions (10th-percentile stock market performance) their simulation turned out to be amazingly INsensitive to stock allocation. It also turned out to be VIOLENTLY SENSITIVE to even the smallest changes in withdrawal rate. Spending matters a lot, portfolio composition hardly mattered at all.

You control "shortfall risk" by spending less.
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Re: Modern Portfolio Theory

Post by grayfox »

nisiprius wrote:I strongly object to the notion of "shortfall risk." It mixes up risk with return. It is a complicated way of taking the legitimate concept of "low return" and calling it a "risk."

...

You control "shortfall risk" by spending less.
:thumbsup I think this argument should bury the idea of "shortfall risk" as a separate risk, or risk factor.

Shortfall is an outcome, not a risk. It results from the risk and return characteristics of the portfolio and as nisiprius says, some goal.

Most of the time these "experts" that try to tack extra things onto MPT with new "risks" or whatever, they just muddy things up and add to the confusion. Or maybe that was their intention. No Nobel Prize for Gibson or whoever came up with it. :thumbsdown
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Re: Modern Portfolio Theory

Post by FabLab »

richard wrote:Staythecourse,

Analysis in finance is done on past data because there's no alternative. The important thing is not to take it too seriously, due to the lack of sufficient data and uncertainty whether the data we have is applicable to the future. We only have about three independent data points if we want to look at 30 year periods. We don't know if the conditions that generated those data points are applicable to the future. If not, we have even fewer useful data points.

It's similar to what's been called the streetlight effect. A policeman sees a man searching for something under a streetlight and asks what the man has lost. He says he lost his keys and they both look under the streetlight together. After a few minutes the policeman asks if he is sure he lost them here, and the man replies, no, that he lost them in the park. The policeman asks why he is searching here, and the man replies, "this is where the light is."

We can derive much of useful finance advice from first principals. If markets are efficient, investors in general will be better off in cap weighted index funds, although due to individual circumstances some may want to vary. If we have no talent for stock picking, we are not going to do better picking individual stocks than holding a diversified portfolio. Bonds are safer than stocks due to their position in the capital structure (bonds get paid first and the issuer is obligated to pay) and because of the relation between price and yield (lower price means higher yield for bonds, but both price and dividends can fall for stocks).

Data can be used to refute some claims (the claim X is always true can be refuted with a counter-example). It is obviously better to have a theory confirmed by data and one which is refuted, but we really should attend to the standard statements about past data and the future.

It is possible to run controlled experiments in hard sciences. The same is not true for finance. There's a major qualitative difference between discovering the link between bacteria and stomach ulcers and computing, for example, the forward equity risk premium.

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Re: Modern Portfolio Theory

Post by YDNAL »

staythecourse wrote:
YDNAL wrote: What sense does it make to diversify out of an asset class that’s returning 30%?... investors don’t experience upside volatility as risky at all - investors aren’t risk-averse per-se, they’re loss-averse.
I don't understand what you mean here?? Yes investors are loss aversive that is why if you are one of them you do NOT want a 30% return.
I believe that we ALL take some level of risk for expected return to meet goals/objectives.
  • Seeking expected return with reasonable (related) level of risk risk aversion.
  • Conversely, regardless of "expectation" because we all should be prepared to see a 30% drop in the Stock Market, all hell appears to break loose every time it happens (loss-averse).
NO ONE (that I know) sets out to reasonably expect (or "want") a 30% annual return - but these can surely influence the way we look at risk in times of exuberance (a la 1990s). Not everyone is wired equally, of course, especially Bogleheads who rebalance methodically (and strictly) following 5% Bands, or something else. :D
Frengo wrote:
YDNAL wrote:1. MPT's central tenet - that diversification mitigates portfolio risk - collapsed in 2008 when all asset classes were mauled. Treasuries provided a haven, but according to MPT, Treasuries don’t even count - they’re just the risk-free baseline at the bottom of the return axis. Conversely, during the technology boom of the late 1990s when “risk” was a dirty word, MPT also failed in the real world. What sense does it make to diversify out of an asset class that’s returning 30%?... investors don’t experience upside volatility as risky at all - investors aren’t risk-averse per-se, they’re loss-averse.
Yeah, but in finance "risk" is the possibility of an outcome different from the expected one. It can be a less desirable outcome, or more desirable, it doesn't matter.
The fact that MPT makes you get out of an asset returning 30% is actually evidence that it works: The objective of diversification is not to increase expected returns (it lowers them!), but to lower volatility. Therefore you should expect to avoid market spikes in both directions and be happy about that.
Frengo, I have zero interest to engage in a definition contest of "risk."

MPT, EMH, what-have-you, do NOT control human emotion and behavior. That is what the quote you selected says for the most part.
Frengo wrote:
YDNAL wrote:2. MPT treats both upside and downside volatility as risk and there is a bell-shaped curve that shows the mean variance - with standard deviations - each unit above or below the mean. But, real market returns aren’t symmetrical. Stock market crashes like 1987, 2000, 2008 are supposed to be outlier events - yet reality drags Markowitz’s bell curve away from orderly distribution around the mean, and reality adds extra-bad outcomes on the negative side of the mean (fat tails). For instance, according to MPT, the S&P 500 should have shown a monthly decline of more than 15% (three standard deviations) only once in 80+ years - but it happened something like 10 times (if I recall).
MPT doesn't assume a gaussian distribution.
I don't know what Markowitz' assumed, but he showed a bell-shaped curve with a mean variance - and standard deviations - each unit above or below the mean. In the mean*time, market returns aren't symmetrical. What else can I tell you ?

* no pun intended
Frengo wrote:
YDNAL wrote:The best portfolio optimization/design is known in retrospect, so:
a) Save as much as you can.
b) Diversify those savings.
c) Don't pay more than you have to.
And MPT tells you how to diversify for maximum effect.
I don't believe this comments adds anything to b) above.
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Re: Modern Portfolio Theory

Post by Frengo »

YDNAL wrote:
Frengo, I have zero interest to engage in a definition contest of "risk."
Definitions are important: They help us understand what we are talking about.
I don't know what Markowitz' assumed, but he showed a bell-shaped curve with a mean variance - and standard deviations - each unit above or below the mean. In the mean*time, market returns aren't symmetrical. What else can I tell you ?
He showed where ? If you saw a bell shaped curve it means that if markets were following a gaussian statistics, then application of the MPT would give you a result such and such.
I don't believe this comments adds anything to b) above.
Hell yeah! You can certainly diversify for minimum, or even negative, effect.
Last edited by Frengo on Tue Jun 18, 2013 4:45 pm, edited 2 times in total.
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Re: Modern Portfolio Theory

Post by dbr »

pkcrafter wrote:
And to throw another sticky wrench into the mix, we also need to know the difference between uncertainty and risk.

Paul
You do that by creating a list of all the things that someone might want to consider to be risk and look at when and to what degree one simply has either consequences of uncertainty of returns or simply different words for uncertainty of returns. Since this has already been done anywhere one wants to read a systematic basic discussion of risk, it should not be necessary to repeat any of it here.

It should also be noted that when one uses the word risk thinking of the variability in return over successive periods of time, one is still just talking about return and not about something different. Those plots of expected return and risk are just plots of where the possible return centers (in some specific statistical sense) and how widely the possible return can vary around that center (in some specific statistical sense). Both of the statistics are equally meaningful and important parts of the characterization, but neither more than the other. MPT is valuable to the extent the investor finds it meaningful to think about investing as a statistical phenomenon. To the extent the investor does not use this model, MPT is not wrong but meaningless.

Extensive work my be required to extract measures of various meanings of risk that are consequences of uncertainty. One of the most interesting and relevant examples is the chance of running out of money while withdrawing from a portfolio invested in a certain way. The result and our certainty in knowing that result is a direct consequence of the distribution of returns. Extracting that result is not simple. The problem of determining how much money one will have at any future date, meaning whether or not one can lose money and how much, withdrawals or no, is the same problem and derives from the same uncertainty. The consternation in some quarters should not be with the basic concept but with lack of effort and success at making meaningful predictions.
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Re: Modern Portfolio Theory

Post by pkcrafter »

Yeah, but in finance "risk" is the possibility of an outcome different from the expected one. It can be a less desirable outcome, or more desirable, it doesn't matter.
To the theorist it doesn't matter, to the average investor it matters a great deal.

dbr, thanks, I agree.


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Re: Modern Portfolio Theory

Post by Frengo »

pkcrafter wrote:
Yeah, but in finance "risk" is the possibility of an outcome different from the expected one. It can be a less desirable outcome, or more desirable, it doesn't matter.
To the theorist it doesn't matter, to the average investor it matters a great deal.
The average investors should better realize that he cannot reduce risk on one side only.
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Re: Modern Portfolio Theory

Post by hq38sq43 »

richard wrote:Markowitz on how to apply MPT:
Dr. Markowitz first got to choose how to divide his assets between a stock fund and a bond fund not long after publishing his pioneering article "Portfolio Selection" in the prestigious Journal of Finance. Following his own breakthroughs, he should have made intricate calculations, based on historical averages, to find the optimal trade-off between risk and return. But, Dr. Markowitz told me, that isn't what he did: "Instead, I visualized my grief if the stock market went way up and I wasn't in it -- or if it went way down and I was completely in it. My intention was to minimize my future regret."

Dr. Markowitz paused, then added wryly: "So I split my contributions 50/50 between bonds and equities."
http://online.wsj.com/article/SB123093692433550093.html
Meaning no respect to Professor Markowitz or his Nobel, I suggest he really missed his calling. With a few more such one-liners he could make a fortune as a stand-up comic.

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Re: Modern Portfolio Theory

Post by magician »

richard wrote:Markowitz on how to apply MPT:
Dr. Markowitz first got to choose how to divide his assets between a stock fund and a bond fund not long after publishing his pioneering article "Portfolio Selection" in the prestigious Journal of Finance. Following his own breakthroughs, he should have made intricate calculations, based on historical averages, to find the optimal trade-off between risk and return. But, Dr. Markowitz told me, that isn't what he did: "Instead, I visualized my grief if the stock market went way up and I wasn't in it -- or if it went way down and I was completely in it. My intention was to minimize my future regret."

Dr. Markowitz paused, then added wryly: "So I split my contributions 50/50 between bonds and equities."
http://online.wsj.com/article/SB123093692433550093.html
With all due respect to the author of that quote, he needs to research it better.

When I interviewed Dr. Markowitz in 2009 I asked him about that quote. He pointed out that he had a choice of a stock fund and a bond fund, so every combination of those two was on the optimal frontier, and that the 50/50 combination was on the efficient frontier (i.e., above the point of minimum variance). He needed to choose a point on the efficient frontier: he chose the 50/50 point.

He did, indeed, use MPT; he simply used it in a situation so simple that he didn't have to do any elaborate calculations.
richard wrote:Bad things about MPT (Markowitz mean variance model):
- even its creator does not actually use it for portfolio decisions
Untrue.
Simplify the complicated side; don't complify the simplicated side.
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Re: Modern Portfolio Theory

Post by nisiprius »

Magician, I think it is very unlikely that any actual MPT calculation based on actual data would happen to come up with exactly 50.0000% and 50.0000%.

As I think I recall, but haven't been able to find the source, he was quoted as saying "I knew that I ought to calculate the covariances but..." It stuck in my mind precisely because he used the word "covariances" rather than "correlations." And the quotation certainly implied that he did not calculate the "covariances."
Last edited by nisiprius on Tue Jun 18, 2013 8:29 pm, edited 1 time in total.
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Re: Modern Portfolio Theory

Post by Frengo »

If it is based on real data it will probably come out as exactly 40÷60% and 60÷40% :)
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Re: Modern Portfolio Theory

Post by rocket »

If you use a model portfolio for asset allocation, you are using MPT.
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Re: Modern Portfolio Theory

Post by magician »

nisiprius wrote:Magician, I think it is very unlikely that any actual MPT calculation based on actual data would happen to come up with exactly 50.0000% and 50.0000%.

As I think I recall, but haven't been able to find the source, he was quoted as saying "I knew that I ought to calculate the covariances but..." It stuck in my mind precisely because he used the word "covariances" rather than "correlations." And the quotation certainly implied that he did not calculate the "covariances."
If you have only two assets, any combination of those two will be optimal, and all of those above the minimum-variance portfolio will be efficient. As bond funds generally have lower returns and lower standard deviations of returns than stock funds, the 50/50 portfolio will generally be above the minimum-variance portfolio; hence, efficient. Harry knew this.

I don't see why a 50/50 mix is any more unlikely than any other mix: the bond fund has an expected return of 4%, the stock fund has an expected return of 10%, and Harry decides that he'd be happy with a 7% return. What's the likelihood that an actual MPT calculation would come up with exactly 39.3752% and 60.6248%?
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Re: Modern Portfolio Theory

Post by YDNAL »

Frengo wrote:
YDNAL wrote:Frengo, I have zero interest to engage in a definition contest of "risk."
Definitions are important: They help us understand what we are talking about.
Unless we make-up our own... you are describing "LIFE" not risk. Where do you get this stuff ?
Frengo wrote:Yeah, but in finance "risk" is the possibility of an outcome different from the expected one. It can be a less desirable outcome, or more desirable, it doesn't matter.
Since "definitions are important" to you, here's what Larry Swedroe wrote recently about this.
Larry Swedroe wrote:The academic literature makes clear that the vast majority of the risk and expected return of a portfolio is determined by its asset allocation, or exposure to factors that explain returns. Among these factors are stock market risk, the risk of small stocks, the risks of value stocks, momentum, profitability, term risk and default risk. Since your portfolio's risk is determined by these factors, it's critical that you be able to control your exposure to them. Failing to do so can result in your portfolio being exposed to more risk than you have the ability, willingness or need to take. And when risks inevitably show up, investors who have taken too much risk are often driven to panic selling and commit what I refer to as "portfolio suicide"....
Frengo wrote:
I don't know what Markowitz' assumed, but he showed a bell-shaped curve with a mean variance - and standard deviations - each unit above or below the mean. In the meantime, market returns aren't symmetrical. What else can I tell you ?
He showed where ? If you saw a bell shaped curve it means that if markets were following a gaussian statistics, then application of the MPT would give you a result such and such.
Is that how you "define" Gaussian [normal] distribution ?

MPT models an asset's return as a normally distributed function, defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets, so that the return of a portfolio is the weighted combination of return from the assets. Don't forget, and the main point in my comment to OP, is that MPT assumes that investors are rational. - further on this below.
Frengo wrote:
YDNAL wrote:
Frengo wrote:
YDNAL wrote:The best portfolio optimization/design is known in retrospect, so:
a) Save as much as you can.
b) Diversify those savings.
c) Don't pay more than you have to.
And MPT tells you how to diversify for maximum effect.
I don't believe this comments adds anything to b) above.
Hell yeah! You can certainly diversify for minimum, or even negative, effect.
YOU, Frengo, may diversify for minimum or even negative effect from diversification. Most investors invest for maximum effect.
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Re: Modern Portfolio Theory

Post by Frengo »

YDNAL wrote: Since "definitions are important" to you, here's what Larry Swedroe wrote recently about this.
Did you read it ? Those are sources of risk.
"Since your portfolio's risk is determined by these factors", right ?
Is that how you "define" Gaussian [normal] distribution ?
?? Where did I define a gaussian distribution ? Which, by the way is a trivial thing to do :confused :confused
MPT models an asset's return as a normally distributed function, defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets, so that the return of a portfolio is the weighted combination of return from the assets.
Yea, but it doesn't assume a Gaussian distribution. It is up to you to plug in the most suitable one.
Don't forget, and the main point in my comment to OP, is that MPT assumes that investors are rational.
That's CAPM, not MPT, but at this point...
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Re: Modern Portfolio Theory

Post by YDNAL »

Frengo wrote:
YDNAL wrote:
Frengo wrote:
YDNAL wrote:Frengo, I have zero interest to engage in a definition contest of "risk."
Definitions are important: They help us understand what we are talking about.
Unless we make-up our own... you are describing "LIFE" not risk. Where do you get this stuff ?
Frengo wrote:Yeah, but in finance "risk" is the possibility of an outcome different from the expected one. It can be a less desirable outcome, or more desirable, it doesn't matter.
Since "definitions are important" to you, here's what Larry Swedroe wrote recently about this.
Larry Swedroe recently wrote:The academic literature makes clear that the vast majority of the risk and expected return of a portfolio is determined by its asset allocation, or exposure to factors that explain returns. Among these factors are stock market risk, the risk of small stocks, the risks of value stocks, momentum, profitability, term risk and default risk. Since your portfolio's risk is determined by these factors, it's critical that you be able to control your exposure to them. Failing to do so can result in your portfolio being exposed to more risk than you have the ability, willingness or need to take. And when risks inevitably show up, investors who have taken too much risk are often driven to panic selling and commit what I refer to as "portfolio suicide"....
Did you read it ? Those are sources of risk.
"Since your portfolio's risk is determined by these factors", right ?
OK, one last time.

Frengo invests capital to make money taking "the possibility of an outcome different from the expected that can be less desirable, or more desirable, it doesn't matter."

I invest capital to make money - where a desirable outcome MATTERS - taking "controlled exposure to risk [lose money] factors to avoid panic selling and commit portfolio suicide."

And, yeah, but at this point....
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Re: Modern Portfolio Theory

Post by magician »

Frengo wrote:
YDNAL wrote:MPT models an asset's return as a normally distributed function, defines risk as the standard deviation of return, and models a portfolio as a weighted combination of assets, so that the return of a portfolio is the weighted combination of return from the assets.
Yea . . .
Sounds like you agree with YDNAL's statement (in particular, that MPT models an asset's return as a normal distribution), but . . .
Frengo wrote:. . . but it doesn't assume a Gaussian distribution.
. . . it appears that you believe that "normal" and "Gaussian" are different.
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Re: Modern Portfolio Theory

Post by Frengo »

MPT doesn't assume any particular distribution. Not gaussian (normal, if you like it better), nor three-spiked, with fat tails and slim waistline.
If you want to obtain numbers, you have to assume a particular one.
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Re: Modern Portfolio Theory

Post by Frengo »

YDNAL wrote: Frengo invests capital to make money taking "the possibility of an outcome different from the expected that can be less desirable, or more desirable, it doesn't matter."
I can't control it. It is not possible to choose only "positive risk". Of course when the market does -10% I'm sad, when it does +20% I'm happy. But they are both sides of the same coin: The 10% average annual return.
taking "controlled exposure to risk [lose money] factors to avoid panic selling and commit portfolio suicide."
Did you copied it from the prospectus of a third-rated fund ?
If you want low risk and buy something which suddenly goes up 30%, be very worried. That means whatever you bought is not low risk, even if it went up!
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Re: Modern Portfolio Theory

Post by YDNAL »

Frengo wrote:
taking "controlled exposure to risk [lose money] factors to avoid panic selling and commit portfolio suicide."
Did you copied it from the prospectus of a third-rated fund ?
Frengo,

Do you post for the sake of posting?

The quote you posted above is written exactly as YOUR "definition" of risk (bold/italic/quotes). It comes from here.
Larry Swedroe recently wrote:The academic literature makes clear that the vast majority of the risk and expected return of a portfolio is determined by its asset allocation, or exposure to factors that explain returns. Among these factors are stock market risk, the risk of small stocks, the risks of value stocks, momentum, profitability, term risk and default risk. Since your portfolio's risk is determined by these factors, it's critical that you be able to control your exposure to them [risk factors]. Failing to do so can result in your portfolio being exposed to more risk than you have the ability, willingness or need to take. And when risks inevitably show up, investors who have taken too much risk are often driven to panic selling and commit what I refer to as "portfolio suicide".... (my emphasis for Frengo's benefit)
Your definition of risk is re-posted below (bold/italic/quotes). Actually funny when put in a sentence to replace the word "risk."
Frengo invests capital to make money taking "the possibility of an outcome different from the expected that can be less desirable, or more desirable, it doesn't matter."
I have nothing further to discuss here.

To Nathan (OP),
ngutman » Sat Jun 15, 2013 10:52 am wrote:Is anyone here dabbling with Harry Markowitz's Modern Portfolio Theory for portfolio optimization/design?
Thanks, Nathan
MPT is an imperfect tool since it ignores investor behavior. The best portfolio optimization/design is known in retrospect, so:
YDNAL wrote:a) Save as much as you can.
b) Diversify those savings.
c) Don't pay more than you have to.
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Re: Modern Portfolio Theory

Post by Frengo »

YDNAL wrote: The quote you posted above is written exactly as YOUR "definition" of risk (bold/italic/quotes). It comes from here.
That simply means "Don't take more risk than you can handle". It is not a definition of risk.
Your definition of risk is re-posted below (bold/italic/quotes). Actually funny when put in a sentence to replace the word "risk."
I' glad learning is a fun activity for you too.

Let me reiterate that a sure loss of a million is less risky than tossing a coin and "you win $100 if it comes up tail, zero otherwise", in financial terms.
The risk of a sure loss is zero: It is certain. In the coin case you have an expected return of $50 and a 100% standard deviation: Lotsa risk!
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Re: Modern Portfolio Theory

Post by magician »

Frengo wrote:Let me reiterate that a sure loss of a million is less risky than tossing a coin and "you win $100 if it comes up tail, zero otherwise", in financial terms.
The risk of a sure loss is zero: It is certain. In the coin case you have an expected return of $50 and a 100% standard deviation: Lotsa risk!
The technical term for the sure loss of a million is: a problem.

It's not a risk.
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Re: Modern Portfolio Theory

Post by Howard Donnelly »

Here is a quote from Janet Lowe's book, Warren Buffett Speaks:

"Buffett's partner, Charlie Munger, when asked about Modern Portfolio Theory, instantly replied, 'Twaddle!' He added that the concepts are 'a type of dementia I can't even classify.'"

Any thoughts or comments about Charlie's opinion?
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Re: Modern Portfolio Theory

Post by Frengo »

Howard Donnelly wrote:Here is a quote from Janet Lowe's book, Warren Buffett Speaks:

"Buffett's partner, Charlie Munger, when asked about Modern Portfolio Theory, instantly replied, 'Twaddle!' He added that the concepts are 'a type of dementia I can't even classify.'"

Any thoughts or comments about Charlie's opinion?
If I knew which companies are much better than the others I wouldn't need to diversify and MPT would be counterproductive.
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Re: Modern Portfolio Theory

Post by Kevin M »

Howard Donnelly wrote:Here is a quote from Janet Lowe's book, Warren Buffett Speaks:

"Buffett's partner, Charlie Munger, when asked about Modern Portfolio Theory, instantly replied, 'Twaddle!' He added that the concepts are 'a type of dementia I can't even classify.'"

Any thoughts or comments about Charlie's opinion?
Yes. Most people are not able to and do not invest like Warren Buffet and Charlie Munger. Buffett also says bonds are not good investments right now, and that one should hold stocks and cash, yet most Bogleheads continue to hold bond funds. I doubt Buffett and Munger own index funds (yet Buffett does recommend them for most people). I don't think Buffett believes in efficient markets either, but I don't have the skills he has to exploit any inefficiencies that might exist, so I invest to a large extent on the assumption that markets are reasonably efficient.

As I said in my first post in this thread, much of the way we invest is based on portfolio theory; at least portfolio theory gives us the theoretical basis for it. That doesn't mean we have to understand it to invest this way. We don't have to understand internal combustion engines to drive a (non-electric) car either.

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Re: Modern Portfolio Theory

Post by Verde »

The earth shattering revelation I got from MPT was the distinction between market risk and specific risk.
The fact that the market does not price the diversifiable specific risk an undiversified portfolio is exposed to.
The market only discounts market risk, if you fail to diversify fully you don’t get the full discount.

This adds another dimension to diversification beyond the old concept of not keeping all your eggs in one basket.

I don’t think this fact was fully appreciated (if at all) prior to Markowitz’s work- for that he deserves all the accolades.
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Re: Modern Portfolio Theory

Post by Frengo »

Also the fact that the risk/reward ratio of your portfolio is not the weighted average of the risk/reward ratio of its components is pretty cool.
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Re: Modern Portfolio Theory

Post by Kevin M »

Yes, per the last two posts, you don't have to use the math to try to design an optimum portfolio to glean some interesting insights from the theory.

To expand on Frengo's observation, although the portfolio expected return is the weighted average of the individual asset expected returns, the variance (proxy for risk) of any two risky assets is less than the weighted average of the individual variances if the correlation between the two assets is less than 1. The lower the correlation, the lower the portfolio variance, and the higher the ratio of expected return to variance (or standard deviation).

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Re: Modern Portfolio Theory

Post by grayfox »

Howard Donnelly wrote:Here is a quote from Janet Lowe's book, Warren Buffett Speaks:

"Buffett's partner, Charlie Munger, when asked about Modern Portfolio Theory, instantly replied, 'Twaddle!' He added that the concepts are 'a type of dementia I can't even classify.'"

Any thoughts or comments about Charlie's opinion?
After giving it much thought, I have come to the conclusion that Charlie Munger is spot on.

If you take an approach to investing like Buffet and Munger, MPT is irrelevant.
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Re: Modern Portfolio Theory

Post by Dick Purcell »

Nisiprius:

In this thread you’ve said what I regard as the most important message in the thousands of posts I’ve read here at Bogleheads.

After a fine first post near the top of page 1 about the absence of data for MPT, in your third post just below the middle of that page you rang the bell with this:
A further sour remark. I certainly don't pretend to understand the social structure of the overlapping worlds of financial economics and investment companies, but I have been doing a long, slow double-take on the interrelations thereof. It appears as if economists who make important discoveries in financial economics either found very-much-for-profit commercial enterprises or get snapped up by very-much-for-profit commercial enterprises. This inevitably is going to lead to situations where legitimate-enough work is overhyped as a hugely important secret miracle ingredient.

Harry Markowitz serves on the "advisory panel" of Research Affiliates, the firm led by Rob Arnott which creates and sells "fundamental indexes" and I-don't-know-what-all else. I am sorry to say I can't retrieve details on a quick Google, but IIRC Markowitz also has some connection with a firm that actually provides commercial mean-variance optimizer software to financial advisors. If someone happens to know the name of the firm and the product, I'd like to know it.
The name of that product is AllocationMaster. The company was Frontier Analytics. Acquirer and current purveyor of that product is the giant SunGard.

Within months after Markowitz was handed his Nobel Prize, an article authored by Markowitz was published in which he honorably warned that for guiding individual investors, his theory is not the right approach. He said he designed his theory for pursuit of best interests of mutual funds! For people, Markowitz advised, one should instead use life-plan simulation.

But then a shocking reversal: Markowitz appeared on the website of little Frontier Analytics’s website, assuring the world that he endorsed its AllocationMaster software’s use of his MPT for guiding individual investors!

That Markowitz-backed product, along with a twin named Portfolio Strategist from the firm of Ivy League Yale Professor Ibbotson, rose to establish two decades of MPT-based misleading and fleecing of the investing public through these three steps:
  • 1. Use MPT and asset classes to divert the investor’s focus from his investment purpose, his future dollar goals, to a pair of technical specs of return-rate probability for the mere individual year – where he can’t see where he’s going and can’t see the long-term effect of fees.

    For this, change the names of those single-year technical specs to “expected return” (or just “return”) and “risk.” That will make those single-year technical specs appear to mean much more than they do.

    2. Mislead the investor to think that a speculation on any damn fool gamble WITHIN an asset class is the same as an investment in any of his chosen whole diversified asset classes. Entice investors with oceans of statistically meaningless “data” on thousands of actively managed funds -- with of course greater risk –- and higher fees!

    This is the very opposite of what the name of Bogle represents! Its presentation is blatantly dishonest!

    3. Give the investor false comfort that the result for his future dollar goals will be what “expected return” would deliver – which of course the basic math shows he will probably fall short of, likely short of by a lot.
For the last two decades, guidance of the investing public has been contaminated by this MPT-based three-step deception, under the banner of Nobel Prize winning theory taught by the universities, featured in required training for the financial advisor credentials said to provide assurance of guidance investors can trust.

Now there’s a great campaign to award this three-step misguidance another banner: that of “The Fiduciary Standard.” Under the banner of that campaign lurks the same MPT-based three-step misguidance introduced two decades ago by the Markowitz-backed AllocationMaster. It’s most clearly exposed by the “fiduciary” investor-guidance rules and tool of the leader of the campaign for “The Fiduciary Standard” named “Fiduciary360,” where the only change is to move AllocationMaster step 3, misleading use of the label of deception “expected return,” to the front of the three-step deception. That process’s wholly anti-fiduciary nature is exposed here:http://www.fiducio.com/

Nisiprius, I praise you for shining some light on the source of this prevailing MPT-based investor misguidance. I think that with all the banners of appearance of trust under with it marches – Nobel Prize winning, taught in our universities, required training for financial advisors said to be most trustworthy, and now “The Fiduciary Standard” – it represents an even greater opponent of what the name of Bogle represents than the financial industry fee-extracting machine into which this misuse of MPT feeds the investing public.

With this Bogleheads website’s marvelous concentration of people who understand the math and can see through this MPT-based misguidance, I hope that others here will join you in exposing this great deception.

Dick Purcell
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