John and Boomer,
I love to see Backtesting spreadsheets and hope that they would really help my portfolio's performance, especially now while I am retired and depend on withdrawals for a living.
If Backtesting has any merit in it why was I criticized by Ozark542 on M* discussion board in APR 2003? See it here:
Ozark542 = Ozzy
Vig = Viggy
Predicting the past
Actually, Viggy, I'm wide awake. Or at least I was until I tried reading the stuff at Dr. Sortino's web site.
Here's the deal, Viggy. If you feel you can improve your portfolio's asset allocation by running the portfolio through various computer programs, measuring and grading various risk/reward relationships, feel free. It's okay with me. Honest. For myself, I'm not interested.
I'm also not interested in running reams of data through a computer program in order to discover how much I can withdraw yearly from my portfolio and never go broke.
Without having studied it, I'm willing to assume the Risk Grades deal is similar to the well known Efficient Frontier concept: Invest in a mix of assets that will give the best return for the least risk.
Wonderful. The problem in execution is this; both these approaches would seem to be limited to looking at PAST risk/return relationships, in order to predict FUTURE such relationships.
This approach hasn't worked very well and it never will.
There's lots of stuff we can learn by studying the past. One thing we can't learn, though, is how much the future will resemble the past.
There really is an Efficient Frontier. There really is a withdrawal rate that will allow my wife and I to spend all our money during our life times, but never go broke.
But Viggy? These things are unknown and unknowable, going forward. Such things are only knowable looking backward.
Given that such things are only knowable looking backward, academics with more letters after their names than I have money in the bank, have spent unconscionable amounts of time goobering through the past. They thus invented Modern Portfolio Theory---Beta, Alpha, R-Squared, and the crowning achievement, Sharpe Ratio. These accomplishments were celebrated and awards were given. Yes.
And then...a funny thing happened on the way to the bank. These numbers turned out to have little or no predictive value, regarding returns. And since they couldn't predict returns, they also failed to predict risk/return ratios.
Joining in the fun, M* invented their first Star Rating system, a system that graded...yep...risk- adjusted, past performance.
I wish I had 10 bucks for every post I've read where the poster said, essentially, "I have a balanced portfolio, made up entirely of 4 and 5 star funds." Too late, these jokers discovered what M* eventually discovered; past risk-adjusted performance doesn't predict future risk-adjusted performance.
I don't want to discover the Sharpe Ratio of my portfolio, Vig. I don't want to discover its Beta. I don't want to discover its Risk Grade. I have absolutely no confidence that adjusting the portfolio so that these numbers become more favorable will improve future risk/reward.
If others do want to do that, that's okay with me. I seriously doubt, though, that many successful mutual fund managers select securities in that manner. If any do, or if any money managers set their asset allocations in that manner, I'd be interested in their long-term results---results over periods of, say, 10 years, or more.
In short, Vig, computers are wondrous tools, but that's all they are. Every computer on Earth, all linked up and working 24/7, from now on, won't tell me my survivable withdrawal rate. Neither will they tell me what asset allocation would give me the best risk/reward ratio.
In my opinion, these things can't be calculated. We have to forge ahead without knowing these things. Deal with it.
My post to Ozzy:
Thanks Ozzy for the reply. You still need to explain why you go at all for mutual funds in which managers "waste" days and nights on Computerized Optimization, Indexing, Sortino's returns, paying huge amounts (your money!) to Mr. William Sharpe's company, etc.
Nature abhors a vacuum
Humor me a minute here, Vig. List all the mutual funds in which I invest, and tell me how many managers of those funds employ the techniques you describe, in selecting individual stocks and bonds for their portfolios. Also list all my managers who pay huge amounts to Bill Sharpe or similar worthies.
You might also list for us 5 money managers who use the techniques you talk about. Don't forget to supply their total returns over the last 1, 3, 5, and 10 years.
Meanwhile, I'm busy calculating the Reynold's Number for my portfolio. Assuming it to still be liquid, of course.
p.s. the remark about the Reynold's Number was that Ozzy as an ex Jumbo jet pilot never bothered checking the the plane's turbo engines which the technicians had to do on his behalf by using computers.