nisiprius wrote: ↑
Sun Nov 26, 2017 6:59 pm
Jason Zweig has an interesting story about Harry Markowitz. Markowitz is the economist who won the Nobel Prize for developing modern portfolio theory. I'm going to quote from a New York Times blog posting
; the article, in turn, is referring to Zweig's Your Money or Your Brain
“There is a story in the book about Harry Markowitz,” Mr. Zweig said the other day. He was referring to Harry M. Markowitz, the renowned economist who shared a Nobel for helping found modern portfolio theory — and proving the importance of diversification. It’s a story that says everything about how most of us act when it comes to investing. Mr. Markowitz was then working at the RAND Corporation and trying to figure out how to allocate his retirement account. He knew what he should do: “I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.” (That’s efficient-market talk for draining as much risk as possible out of his portfolio.)
But, he said, “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. So I split my contributions 50/50 between stocks and bonds.” As Mr. Zweig notes dryly, Mr. Markowitz had proved “incapable of applying” his breakthrough theory to his own money. Economists in his day believed powerfully in the concept of “economic man”— the theory that people always acted in their own best self-interest. Yet Mr. Markowitz, famous economist though he was, was clearly not an example of economic man.
Riddle: was Markowitz acting wisely or foolishly?
Very difficult riddle. I had to think about this one for a while.
My answer: There is a 36.43% chance that he was acting wisely.
Here all the possible answers I came up with to respond to the question of "Was Markowitz acting rationally by investing 50/50 instead of using MPT?"
Yes, because he was avoiding taking more risk then he was emotionally willing to take, which must be avoided.
Maybe, because rationally taking emotional issues into account (if you have them) is rational.
No, because emotional issues are ultimately behavioral errors that should be corrected
No, because he was not a purely rational individual as is required by "economic man" theory
No, because his own rationally and mathematically justified theory should have been used, not using it is a behavioral issue.
Yes, because MPT was not fully proven as being perfect and a 50/50 portfolio may have been the best option while theory was still being developed
Maybe, depending on tax considerations, fund availability, etc
Maybe, depending on his beliefs regarding leverage
Maybe, depending on what the output of the MPT model was saying at the time.
No, because he should have taken into account skew and kurtosis of return distributions instead of using MPT alone
No, because he should have invented factor theory and overweighted small caps instead of using MPT alone
Total: 2 yes answers, 4 maybe answers, 5 no answers.
Assign a value of -1 to no answers, +1 to yes answers, 0 to maybes. Compute a mean and a standard deviation, and find the percentage of the resulting probability distribution function above 0. (I used this calculator: http://onlinestatbook.com/2/calculators ... _dist.html
Given the probabilities involved, I would say he was not being wise by a preponderance of the evidence standard but there is no proof of this beyond a reasonable doubt.
Do you have any better way to answer the riddle?
That riddle is something that puzzles me. Are investing-related emotions (if you have them) behavioral issues that must be corrected, or innate unchangables that must be compensated for?
Essentially, should you change your emotional propensities (if you have them) or your investment strategies?
I think the answer comes from whether the emotional propensities can be corrected for in a manner that still allows for a reasonable portfolio. If one feels that one can't emotionally take any risk beyond 100% cash (despite clear need to take risk in order to have money in retirement) then anxiety is affecting life so much that one should try to "seek help" for this emotional issue. If one is rationally best with 60/40 but is emotionally OK with a 50/50 portfolio, then maybe making allowances by using the 50/50 portfolio is better.
I believe that there is substantial evidence that I am able to be the ideal rational agent that theory requires me to be. I always strive to ensure that intrapersonal emotional considerations do not impact my decisions. Ultimately, it seems as though a uniquely rational individual should be able to find a more complicated, non-3-fund portfolio that better suits their characteristics.
I have studied the willingness/ability/need to take risk framework and find it useful. I believe that average individuals should take it into consideration. However, in my circumstances, I believe that ability to take risk is overwhelmingly the most relevant factor.
Need is always present for me because a) the theories I use require non-satiety (and I must adhere to the theory) and b) I could always in theory give to family members or charity - there's always a need there.
Willingness, for someone who is (or tries to be) fully rational (as theory asks of me) is not really particularly relevant in my situation. It would of course be highly relevant to someone with a propensity to panic-sell.
Thus, I'm trying to develop a long-term portfolio that is overwhelmingly global equities, with 5-15% in safer assets like cash for short or intermediate term spending needs (I include emergency fund assets in my AA). I will accept substantial normal (Gaussian) risk but do not like kurtosis/black swan risk. Presumably, by building a complex portfolio, it may be possible to eliminate the cash drag on the portfolio (increasing returns while increasing risks), while also increasing portfolio skewness and decreasing kurtosis.