Ignored Risks of Factor Investing

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typical.investor
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Ignored Risks of Factor Investing

Post by typical.investor » Fri Dec 07, 2018 4:24 am

Key Points:

[*]The risks of factor investing are usually understated (perhaps, severely so), and the diversification benefits tend to be overstated.

[*]Because factor returns substantially deviate from normality and because correlations between factors are not constant over time, a multi-factor portfolio may retain exposure to the risk drivers of the individual factors. Thus, portfolios invested in multiple factors may still experience severe drawdowns and decade-long periods of underperformance.

https://www.researchaffiliates.com/en_u ... sting.html

(The point of this post is to present information which might discourage people from undertaking factor tilts that they will later abandon due to underperformance. I don't believe it's in anyone's best interest to do so)

Valuethinker
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Re: Ignored Risks of Factor Investing

Post by Valuethinker » Fri Dec 07, 2018 6:17 am

typical.investor wrote:
Fri Dec 07, 2018 4:24 am
Key Points:

[*]The risks of factor investing are usually understated (perhaps, severely so), and the diversification benefits tend to be overstated.

[*]Because factor returns substantially deviate from normality and because correlations between factors are not constant over time, a multi-factor portfolio may retain exposure to the risk drivers of the individual factors. Thus, portfolios invested in multiple factors may still experience severe drawdowns and decade-long periods of underperformance.

https://www.researchaffiliates.com/en_u ... sting.html

(The point of this post is to present information which might discourage people from undertaking factor tilts that they will later abandon due to underperformance. I don't believe it's in anyone's best interest to do so)
Thank you. It looks to be very informative and well reasoned.

stan1
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Re: Ignored Risks of Factor Investing

Post by stan1 » Fri Dec 07, 2018 7:51 am

typical.investor wrote:
Fri Dec 07, 2018 4:24 am
Key Points:

[*]The risks of factor investing are usually understated (perhaps, severely so), and the diversification benefits tend to be overstated.

[*]Because factor returns substantially deviate from normality and because correlations between factors are not constant over time, a multi-factor portfolio may retain exposure to the risk drivers of the individual factors. Thus, portfolios invested in multiple factors may still experience severe drawdowns and decade-long periods of underperformance.
For some reason you picked the first two key points but omitted the third so I'll add it for you. You admitted your reason for posting was to discourage factor investing so I'll guess that explains the reason you didn't include it.

[*]Factor investing, for patient investors who understand the risks, has the potential to improve a portfolio’s long-term risk-adjusted return, especially when strategies used are transparent, use sufficiently researched factors, and have low management fees and good implementation characteristics.

Note that the authors are Research Affiliates and are smart beta advisors.

I'd also note that this third bullet is exactly what every book and well written post on this board about value and small investing have said in the years I've been here.

I agree many (most) people should not use factor investing. A three fund or probably even a two fund portfolio without international is good enough. What matters most is saving more money and managing risk by using equities and fixed income, although there are plenty of successful investors who have been 100% equities for decades during accumulation who have turned out just fine. So maybe the real take away is that if you save a lot you will have a lot.
Last edited by stan1 on Fri Dec 07, 2018 7:55 am, edited 1 time in total.

B4Xt3r
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Re: Ignored Risks of Factor Investing

Post by B4Xt3r » Fri Dec 07, 2018 7:54 am

stan1 wrote:
Fri Dec 07, 2018 7:51 am
typical.investor wrote:
Fri Dec 07, 2018 4:24 am
Key Points:

[*]The risks of factor investing are usually understated (perhaps, severely so), and the diversification benefits tend to be overstated.

[*]Because factor returns substantially deviate from normality and because correlations between factors are not constant over time, a multi-factor portfolio may retain exposure to the risk drivers of the individual factors. Thus, portfolios invested in multiple factors may still experience severe drawdowns and decade-long periods of underperformance.
For some reason you picked the first two key points but omitted the third so I'll add it for you. You admitted your reason for posting was to discourage factor investing so I'll guess that explains the reason you didn't include it.

[*]Factor investing, for patient investors who understand the risks, has the potential to improve a portfolio’s long-term risk-adjusted return, especially when strategies used are transparent, use sufficiently researched factors, and have low management fees and good implementation characteristics.

Note that the authors are Research Affiliates and are smart beta advisors.

I'd also note that this third bullet is exactly what every book and well written post on this board about value and small investing have said in the years I've been here.
Thank you for attempting to make the representation more even-handed!

typical.investor
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Re: Ignored Risks of Factor Investing

Post by typical.investor » Fri Dec 07, 2018 8:15 am

stan1 wrote:
Fri Dec 07, 2018 7:51 am

For some reason you picked the first two key points but omitted the third so I'll add it for you. You admitted your reason for posting was to discourage factor investing so I'll guess that explains the reason you didn't include it.
Seriously? The link to the article is there. I don't see a problem with expecting people to look into it. Factor investing is complicated enough that if people need to be spoon fed, perhaps they shouldn't do it.

So let's look at what I wrote and compare it to your "interpretation".
typical.investor wrote:
Fri Dec 07, 2018 4:24 am
(The point of this post is to present information which might discourage people from undertaking factor tilts that they will later abandon due to underperformance. I don't believe it's in anyone's best interest to do so)
I'm not trying to discourage factor investing, I am just pointing out that it's not as easy as proponents make it seem. In particular, there is often the idea promoted here that various factors are uncorrelated with each other and diversifying over factors will mean, for instance, momentum will save your bacon when value is floundering.

The typical view of factor proponents on this site is one where people are better diversified by concentrating on certain factors which are expected to increase returns.

The problem though, which RA points out (and yes I am well aware of what types of funds they offer as I use their multi-factor funds), is that people don't/can't stay the course.

Another quote I should have used is that:
"The reality is that correlations between factors are not constant over time and multiple factors may be exposed to the same underlying risk drivers. Thus, investors with exposure to multiple factors may still experience severe drawdowns and decade-long periods of underperformance."
That is not the view most commonly expressed by the factor proponents on this site. I do apologize if bring that up is upsetting to some, but think people should understand that before launching into a factor tilt that they later abandon.

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vineviz
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Re: Ignored Risks of Factor Investing

Post by vineviz » Fri Dec 07, 2018 8:25 am

typical.investor wrote:
Fri Dec 07, 2018 8:15 am
I'm not trying to discourage factor investing, I am just pointing out that it's not as easy as proponents make it seem. In particular, there is often the idea promoted here that various factors are uncorrelated with each other and diversifying over factors will mean, for instance, momentum will save your bacon when value is floundering.
This is a gross mischaracterization of the level of discourse on this site.

The vast majority of factor proponents on this forum have a much more complete and nuanced understanding of risk factors than this dismissive (and, frankly, snarky) aside gives them/us credit for.

Show me one place where someone claimed that "momentum will save your bacon". I'll wait.

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Seriously, I truly wish that more people took the time to educate themselves about the way that factor investing works. We'd have a lot fewer scary headlines to debunk if they did.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

typical.investor
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Re: Ignored Risks of Factor Investing

Post by typical.investor » Fri Dec 07, 2018 8:43 am

vineviz wrote:
Fri Dec 07, 2018 8:25 am
typical.investor wrote:
Fri Dec 07, 2018 8:15 am
I'm not trying to discourage factor investing, I am just pointing out that it's not as easy as proponents make it seem. In particular, there is often the idea promoted here that various factors are uncorrelated with each other and diversifying over factors will mean, for instance, momentum will save your bacon when value is floundering.
This is a gross mischaracterization of the level of discourse on this site.

The vast majority of factor proponents on this forum have a much more complete and nuanced understanding of risk factors than this dismissive (and, frankly, snarky) aside gives them/us credit for.

Show me one place where someone claimed that "momentum will save your bacon". I'll wait.

.

.

.

.


Seriously, I truly wish that more people took the time to educate themselves about the way that factor investing works. We'd have a lot fewer scary headlines to debunk if they did.
Sure, whatever.

The "you aren't diversified if you don't use factors tilts" claim by factor proponents is the real scare mongering.

Anyway, yeah I agree education. Read the article:
Unfortunately, the risks of factor investing are usually understated (perhaps, severely so) and the diversification benefits tend to be overstated. Investors who underestimate the risks associated with factors, and who expect more reliable alpha than is plausible with factor investing, may well be disappointed in their performance and switch strategies at the wrong time, lessening the likelihood they will make their long-term return targets.

zuma
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Re: Ignored Risks of Factor Investing

Post by zuma » Fri Dec 07, 2018 8:51 am

typical.investor wrote:
Fri Dec 07, 2018 8:43 am
The "you aren't diversified if you don't use factors tilts" claim by factor proponents is the real scare mongering.
I admit that I don't follow these factor threads closely (I'm a total market investor), but I've never seen a claim that "you aren't diversified if you don't use factors". Who is saying this?

typical.investor
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Re: Ignored Risks of Factor Investing

Post by typical.investor » Fri Dec 07, 2018 8:57 am

zuma wrote:
Fri Dec 07, 2018 8:51 am
typical.investor wrote:
Fri Dec 07, 2018 8:43 am
The "you aren't diversified if you don't use factors tilts" claim by factor proponents is the real scare mongering.
I admit that I don't follow these factor threads closely (I'm a total market investor), but I've never seen a claim that "you aren't diversified if you don't use factors". Who is saying this?
It’s a common refrain by factor proponents. They say you only have exposure to beta if you don’t use factor tilts.

Random Walker
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Re: Ignored Risks of Factor Investing

Post by Random Walker » Fri Dec 07, 2018 9:36 am

I certainly fall on the side of diversifying across factors. More expensive to do so. I would make two points.

1. For those who tilt to SV, they can increase their allocation to safe bonds and keep expected return about the same as TSM portfolio. That moves in the direction of risk parity and is more efficient.

2. When looking at the tables, readers need to make sure they look at the bottom rows where the author looks at portfolios diversified across the factors. The key to factor investing is diversifying across the uncorrelated sources of return. If one has conviction about the individual factors, conviction about the basics of modern portfolio theory, and perhaps increases safe bond allocation a bit, the investor can have a tremendous amount of conviction about his portfolio as a whole and stick with it through tough times.

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Re: Ignored Risks of Factor Investing

Post by Morse Code » Fri Dec 07, 2018 10:03 am

For whatever it's worth, I get tired of the argument that others shouldn't invest a certain way because they are likely to abandon the strategy during times of under-performance. I find this a little arrogant, presumptuous and could be said of any investment strategy, including investing in equities versus fixed income or vise versa.
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zuma
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Re: Ignored Risks of Factor Investing

Post by zuma » Fri Dec 07, 2018 10:13 am

typical.investor wrote:
Fri Dec 07, 2018 8:57 am
zuma wrote:
Fri Dec 07, 2018 8:51 am
typical.investor wrote:
Fri Dec 07, 2018 8:43 am
The "you aren't diversified if you don't use factors tilts" claim by factor proponents is the real scare mongering.
I admit that I don't follow these factor threads closely (I'm a total market investor), but I've never seen a claim that "you aren't diversified if you don't use factors". Who is saying this?
It’s a common refrain by factor proponents. They say you only have exposure to beta if you don’t use factor tilts.
It seems to me that the claim is generally "you can increase diversification by including factors", not "you aren't diversified if you don't include factors".

Random Walker
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Re: Ignored Risks of Factor Investing

Post by Random Walker » Fri Dec 07, 2018 10:33 am

zuma wrote:
Fri Dec 07, 2018 10:13 am
typical.investor wrote:
Fri Dec 07, 2018 8:57 am
zuma wrote:
Fri Dec 07, 2018 8:51 am
typical.investor wrote:
Fri Dec 07, 2018 8:43 am
The "you aren't diversified if you don't use factors tilts" claim by factor proponents is the real scare mongering.
I admit that I don't follow these factor threads closely (I'm a total market investor), but I've never seen a claim that "you aren't diversified if you don't use factors". Who is saying this?
It’s a common refrain by factor proponents. They say you only have exposure to beta if you don’t use factor tilts.
It seems to me that the claim is generally "you can increase diversification by including factors", not "you aren't diversified if you don't include factors".
I think the way Larry Swedroe phrases it is excellent. He says we need to look at diversification differently. Instead of looking at diversification as number of stocks, we should look at diversification as number of uncorrelated sources of return. TSM has many stocks but has net exposure to only one factor, market beta. A portfolio diversified across factors has perhaps 4-6 independent sources of return. For most all of us though, even the most highly tilted long only portfolios are still dominated by the market factor.

Dave

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Re: Ignored Risks of Factor Investing

Post by Elysium » Fri Dec 07, 2018 10:34 am

First, conviction about factor based investing and conviction about MPT aren't same. One can implement an MPT based portfolio with or without the factors. Stocks, Bonds, Cash is enough at a basic level, and within that Domestic and Intl, Short term and Long Term, that's enough. Some may say Real Estate and Gold too. Factors are taking it to next level, you could keep going like that.

Second, stick it through tough times is a phrase often used to imply that at the end of the tough period things will reverse for the good and factor overweighting will pay off. This is not certain at all. Many involved in the research are now expressing doubt whether Value factor is still persistent, and whether Momentum factor can be leveraged cost effectively. In case of low volatility, it is implied the expectation is to only lower risk and have no return premium. Size is expeccted to be weak and almost non-existent going forward. This is not me saying, these are all legitimate concerns raised in the paper, and we have heard similar doubts from others papers posted here before.

In the end, what seems to be remaining is a belief that after long periods of underperformance, some of the factors will turn around and reward investors for the painful times. Perhaps after a 20 year period.

We now had 10 years of non existent value premium, and others have been very weak, what now? wait another 10 years for a total of 20, and if it doesn't show up even after that then what?

Random Walker
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Re: Ignored Risks of Factor Investing

Post by Random Walker » Fri Dec 07, 2018 10:49 am

My point about MPT and factors is simply that uncorrelated sources of return mix to build more efficient portfolios

Dave

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Re: Ignored Risks of Factor Investing

Post by rkhusky » Fri Dec 07, 2018 11:14 am

Note that the Fama French factor analysis does not provide guidance on what to invest in. A Large Growth portfolio is just as efficient as a Small Value Portfolio and has the same amount of "factor diversification".

Random Walker
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Re: Ignored Risks of Factor Investing

Post by Random Walker » Fri Dec 07, 2018 11:18 am

Elysium wrote:
Fri Dec 07, 2018 10:34 am
First, conviction about factor based investing and conviction about MPT aren't same. One can implement an MPT based portfolio with or without the factors. Stocks, Bonds, Cash is enough at a basic level, and within that Domestic and Intl, Short term and Long Term, that's enough. Some may say Real Estate and Gold too. Factors are taking it to next level, you could keep going like that.

Second, stick it through tough times is a phrase often used to imply that at the end of the tough period things will reverse for the good and factor overweighting will pay off. This is not certain at all. Many involved in the research are now expressing doubt whether Value factor is still persistent, and whether Momentum factor can be leveraged cost effectively. In case of low volatility, it is implied the expectation is to only lower risk and have no return premium. Size is expeccted to be weak and almost non-existent going forward. This is not me saying, these are all legitimate concerns raised in the paper, and we have heard similar doubts from others papers posted here before.

In the end, what seems to be remaining is a belief that after long periods of underperformance, some of the factors will turn around and reward investors for the painful times. Perhaps after a 20 year period.

We now had 10 years of non existent value premium, and others have been very weak, what now? wait another 10 years for a total of 20, and if it doesn't show up even after that then what?
With regard to long periods of underperformance like value over the last decade, our long only equity portfolios are still dominated by market beta, and benefitted from that. What matters is achieving goals, not keeping up with some other person’s portfolio over a given time period. Market beta could do poorly for a decade or more as well.

Dave

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nedsaid
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Re: Ignored Risks of Factor Investing

Post by nedsaid » Fri Dec 07, 2018 11:57 am

I am reminded of the Yogi Berra quote, "That restaurant is so crowded, nobody goes there anymore." The Small/Value restaurant looks like it is getting very crowded indeed as Small/Value is 2% of the US Total Stock Market according to Morningstar. If you add in Mid/Value, you get up to 8% and that looks better. You just have to wonder about the persistence of this premium when so many folks are piling into a relatively small percentage of market capitalization. The problem is compounded with less liquidity in this segment of the market. I also couldn't help but notice that Morningstar has taken this corner of the Stylebox down from 3% of the market down to 2%.

The explosion of factor investing has made you wonder if the premiums for the various factors will hold up. It is almost like all this made Large Growth, in a sense, the sector of the market that is cheapest relative to expectations. In other words, valuations for Value are still low but higher than they would have been, and valuations for Growth are still high but less than they would have been. The factor chasing has made the expectations for Value harder to beat and the expectations for Growth easier to beat, not by much but enough to affect the factors.

An alternative take is that after the 2008-2009 financial crisis and bear market that we saw a flight to quality. Folks felt more comfortable with the tried and true, those well known blue chips. Investors seeking safety also piled into the low volatility stocks, slower growth and higher dividend stocks, they piled into these so much that low volatility stocks went from being Value stocks to being Growth stocks. You could see this in the Morningstar styleboxes and comparison of Price/Earnings ratios. Low interest rates also caused yield chasing, higher dividend stocks were chased pretty hard. So the markets were pretty well distorted by rattled investors and super low interest rates.

If I had to guess it is that Wall Street will eventually get bored with all of the factor chasing and that at some point factors, particularly Value, will reassert themselves. We certainly have seen the end of yield chasing. I have always believed that factors exist because of deep seated human nature and human behavior, It is the old greed and fear thing. It will all come back when the research starts saying that the factors don't work anymore. What we don't know is if the historical relationships between different segments of the stock market will return. My suspicion is that it will, particularly as interest rates are creeping up again.
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Re: Ignored Risks of Factor Investing

Post by garlandwhizzer » Fri Dec 07, 2018 11:58 am

Enjoyed reading the article. Thanks for posting, typical.investor. I believe RA makes some good points regarding realistic expectations for those who choose to do factor/multi-factor and for those who don't.

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Re: Ignored Risks of Factor Investing

Post by Lastrun » Fri Dec 07, 2018 12:16 pm

vineviz wrote:
Fri Dec 07, 2018 8:25 am
typical.investor wrote:
Fri Dec 07, 2018 8:15 am
I'm not trying to discourage factor investing, I am just pointing out that it's not as easy as proponents make it seem. In particular, there is often the idea promoted here that various factors are uncorrelated with each other and diversifying over factors will mean, for instance, momentum will save your bacon when value is floundering.
This is a gross mischaracterization of the level of discourse on this site.

The vast majority of factor proponents on this forum have a much more complete and nuanced understanding of risk factors than this dismissive (and, frankly, snarky) aside gives them/us credit for.

Show me one place where someone claimed that "momentum will save your bacon". I'll wait.

.

.

.

.


Seriously, I truly wish that more people took the time to educate themselves about the way that factor investing works. We'd have a lot fewer scary headlines to debunk if they did.
I think this thread would lead the uneducated here, perhaps wrongfully in your opinion, to typical investor's conclusion. Not trying to say he is right, but defending him on his statement.

viewtopic.php?t=256524

"Diversifying across complementary factors makes sense. Doing so will mitigate the aforementioned cyclicality associated with owning any one factor in isolation."

"In theory multi-factor approaches are very appealing, offering the opportunity for outperformance without the increased volatility of single factor approaches which typically go through volatile alternating periods of underperformance and outperformance. . . . . As value factor exposure increases, for example, momentum becomes more negative, . . . ."

Elysium
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Re: Ignored Risks of Factor Investing

Post by Elysium » Fri Dec 07, 2018 12:37 pm

Random Walker wrote:
Fri Dec 07, 2018 11:18 am
Elysium wrote:
Fri Dec 07, 2018 10:34 am
First, conviction about factor based investing and conviction about MPT aren't same. One can implement an MPT based portfolio with or without the factors. Stocks, Bonds, Cash is enough at a basic level, and within that Domestic and Intl, Short term and Long Term, that's enough. Some may say Real Estate and Gold too. Factors are taking it to next level, you could keep going like that.

Second, stick it through tough times is a phrase often used to imply that at the end of the tough period things will reverse for the good and factor overweighting will pay off. This is not certain at all. Many involved in the research are now expressing doubt whether Value factor is still persistent, and whether Momentum factor can be leveraged cost effectively. In case of low volatility, it is implied the expectation is to only lower risk and have no return premium. Size is expeccted to be weak and almost non-existent going forward. This is not me saying, these are all legitimate concerns raised in the paper, and we have heard similar doubts from others papers posted here before.

In the end, what seems to be remaining is a belief that after long periods of underperformance, some of the factors will turn around and reward investors for the painful times. Perhaps after a 20 year period.

We now had 10 years of non existent value premium, and others have been very weak, what now? wait another 10 years for a total of 20, and if it doesn't show up even after that then what?
With regard to long periods of underperformance like value over the last decade, our long only equity portfolios are still dominated by market beta, and benefitted from that. What matters is achieving goals, not keeping up with some other person’s portfolio over a given time period. Market beta could do poorly for a decade or more as well.

Dave
Dave, with due respect, you keep repeating these same talking points, about efficiency, uncorrelated returns, moving away from beta, but all of that has been based on some dubious backtested data and little else evidence. There is no need to do any of these things, to get to our goals, the broad market portfolio of stocks and bonds are efficient. Not even the academics are this sure about the factor persistence, and it's effectiveness in portfolio building.

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Re: Ignored Risks of Factor Investing

Post by vineviz » Fri Dec 07, 2018 12:44 pm

typical.investor wrote:
Fri Dec 07, 2018 8:43 am
Sure, whatever.

The "you aren't diversified if you don't use factors tilts" claim by factor proponents is the real scare mongering.
Again, I'll wait here while you point out even one time someone has written " "you aren't diversified if you don't use factors tilts".

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.

.

While I wait, let's enjoy this picture of a different kind of strawman.

Image
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Ignored Risks of Factor Investing

Post by stlutz » Fri Dec 07, 2018 1:03 pm

Somebody is always underperforming something. I don't see why that is always discussed as being unique to concentrating ones investments on certain corners of a given market. The same issues impact anyone who engages in true diversification--e.g. adding bonds to your stock portfolio, adding international stocks to your US stock portfolio, adding gold, residential real estate etc.

Individual investors are not paid based on their performance vs. a benchmark as a professional is. Professionals have the risk of straying from whatever their benchmark is. For those of us who think about investing as a hobby, we are well aware of who we are getting beat by. Small value investors currently know they are getting beat by large cap growth over the past 5 years. At some point the opposite will happen.

Getting beat by somebody else is something we all have to live with.

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Re: Ignored Risks of Factor Investing

Post by stlutz » Fri Dec 07, 2018 1:09 pm

Finally, it's a pedantic point that's been explained multiple times here, but the purpose of risk-factor modeling is to measure risk. Not return. High factor exposure indicates concentration of risk, not diversification of it. The most conceivably diversified portfolio would have all factor weights be equal to zero. Of course, such a portfolio would be undesirable as everything that could offer diversification doesn't necessarily offer returns. High exposures to a factor is not necessarily a bad thing (many people go in search of it), but high exposure indicates you are concentrating in the risk that is being measured.

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Re: Ignored Risks of Factor Investing

Post by stlutz » Fri Dec 07, 2018 1:22 pm

Again, I'll wait here while you point out even one time someone has written " "you aren't diversified if you don't use factors tilts".
Nobody here is perfectly nuanced in their writing--I'm not; you're not; the OP is not. This a web forum as opposed to an academic journal.

The argument that using only smallcap value stocks is "more diversified" than buying a total market fund is commonly made here and yes that does and had led to the fear among some that they are inadequately diversified if they don't have a SV tilt.

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Re: Ignored Risks of Factor Investing

Post by cheezit » Fri Dec 07, 2018 1:31 pm

stlutz wrote:
Fri Dec 07, 2018 1:22 pm
The argument that using only smallcap value stocks is "more diversified" than buying a total market fund is commonly made here and yes that does and had led to the fear among some that they are inadequately diversified if they don't have a SV tilt.
As I understand it (and without making any commentary of my own here about which of these is right), the more common variant of this is the argument that something like a 50/50 TSM/SV domestic equity allocation is more diversified than a 100% TSM domestic equity allocation, or perhaps that equal-weighting market cap buckets is more diversified than cap-weighting all equities.

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Re: Ignored Risks of Factor Investing

Post by nedsaid » Fri Dec 07, 2018 1:36 pm

stlutz wrote:
Fri Dec 07, 2018 1:22 pm
Again, I'll wait here while you point out even one time someone has written " "you aren't diversified if you don't use factors tilts".
Nobody here is perfectly nuanced in their writing--I'm not; you're not; the OP is not. This a web forum as opposed to an academic journal.

The argument that using only smallcap value stocks is "more diversified" than buying a total market fund is commonly made here and yes that does and had led to the fear among some that they are inadequately diversified if they don't have a SV tilt.

Diversification is in the eye of the beholder as it can be defined in different ways. The diversification across factors argument, in the old days we called these investing styles, makes a lot of sense to me. We all know that segments of the stock market perform differently from each other. You can diversify across sectors. You can diversify internationally. Diversification can be defined in part by the number of securities in your portfolio. With dollar cost averaging, you can achieve so-called time diversification. You can be diversified across sources of return. You can diversify with alternatives which really are repackaged versions of traditional asset class but introducing leverage and shorting and perhaps trying to capture an illiquidity premium.

So someone who is invested in many thousands of securities through a US Total Stock Market Index, a Total International Stock Index, the US Bond Market Index, and perhaps a Total International Bond Index has a hard time understanding why they aren't diversified. A good question to be asked is this, "Why do I have to split my stock investments into segments to be more diversified rather than just being invested in the market itself?" The answer is rather nuanced and not easy to explain but like I said investing across factors makes sense. Certain segments of the market perform differently than the market itself.

A lot of this is attempting to boost returns while at the same time trying to reduce volatility. In theory it is a beautiful thing but in practice the actual results are uneven. Just ask us Value investors who are being tested by 10 years of underperformance.
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Re: Ignored Risks of Factor Investing

Post by vineviz » Fri Dec 07, 2018 1:55 pm

stlutz wrote:
Fri Dec 07, 2018 1:22 pm
Again, I'll wait here while you point out even one time someone has written " "you aren't diversified if you don't use factors tilts".
Nobody here is perfectly nuanced in their writing--I'm not; you're not; the OP is not. This a web forum as opposed to an academic journal.

The argument that using only smallcap value stocks is "more diversified" than buying a total market fund is commonly made here and yes that does and had led to the fear among some that they are inadequately diversified if they don't have a SV tilt.
I'm a pretty regular participant in SCV threads and I sincerely cannot recall EVER seeing someone say that using only smallcap value stocks is "more diversified" than buying a total market fund. My experience is that the conversation has revolved around some combination of the two funds that is MORE diversified than owning either one by itself.

On the other hand, it probably is technically true that the typical smallcap value fund is more diversified than a the typical total market fund. Perhaps if diversification were a better understood topic, this possibility wouldn't be so scary to contemplate.
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Re: Ignored Risks of Factor Investing

Post by packer16 » Fri Dec 07, 2018 2:29 pm

The point of a SCV/TSM being more diversified is where I miss the train. This implies that the market pricing set by alot of market participants is not providing a diversified weighting of stocks but you have to use historical construct (factors) to provide you a more diversified portfolio. Does this not conflict with an efficient market? (i.e. somehow the market weightings are not providing the best diversification benefit).

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Re: Ignored Risks of Factor Investing

Post by Random Walker » Fri Dec 07, 2018 2:56 pm

stlutz wrote:
Fri Dec 07, 2018 1:03 pm
Somebody is always underperforming something. I don't see why that is always discussed as being unique to concentrating ones investments on certain corners of a given market. The same issues impact anyone who engages in true diversification--e.g. adding bonds to your stock portfolio, adding international stocks to your US stock portfolio, adding gold, residential real estate etc.

Individual investors are not paid based on their performance vs. a benchmark as a professional is. Professionals have the risk of straying from whatever their benchmark is. For those of us who think about investing as a hobby, we are well aware of who we are getting beat by. Small value investors currently know they are getting beat by large cap growth over the past 5 years. At some point the opposite will happen.

Getting beat by somebody else is something we all have to live with.
This brings up what I think is an important point. Us individual investors have one advantage over the big institutional investors. We don’t need to be compared quarterly to a benchmark. We only need to know where we are relative to our own goals.

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Re: Ignored Risks of Factor Investing

Post by Random Walker » Fri Dec 07, 2018 3:00 pm

stlutz wrote:
Fri Dec 07, 2018 1:09 pm
Finally, it's a pedantic point that's been explained multiple times here, but the purpose of risk-factor modeling is to measure risk. Not return. High factor exposure indicates concentration of risk, not diversification of it. The most conceivably diversified portfolio would have all factor weights be equal to zero. Of course, such a portfolio would be undesirable as everything that could offer diversification doesn't necessarily offer returns. High exposures to a factor is not necessarily a bad thing (many people go in search of it), but high exposure indicates you are concentrating in the risk that is being measured.
The thing is though that most all of our long only portfolios are dominated by market beta. Even a 60/40 portfolio has about 90% of its risk wrapped up in market beta. So us factorheads are just trying to diversify away from that one dominant risk in our portfolios. This is especially true for those who increase SV tilt and concomitantly increase safe bond allocation.

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Re: Ignored Risks of Factor Investing

Post by Random Walker » Fri Dec 07, 2018 3:06 pm

packer16 wrote:
Fri Dec 07, 2018 2:29 pm
The point of a SCV/TSM being more diversified is where I miss the train. This implies that the market pricing set by alot of market participants is not providing a diversified weighting of stocks but you have to use historical construct (factors) to provide you a more diversified portfolio. Does this not conflict with an efficient market? (i.e. somehow the market weightings are not providing the best diversification benefit).

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I think there is a distinction between an efficient market and an efficient portfolio. The market can price market beta, size, value efficiently but a portfolio can be made more efficient by more equally balancing across these unique independent sources of risk.

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Re: Ignored Risks of Factor Investing

Post by vineviz » Fri Dec 07, 2018 3:14 pm

packer16 wrote:
Fri Dec 07, 2018 2:29 pm
The point of a SCV/TSM being more diversified is where I miss the train. This implies that the market pricing set by alot of market participants is not providing a diversified weighting of stocks but you have to use historical construct (factors) to provide you a more diversified portfolio. Does this not conflict with an efficient market? (i.e. somehow the market weightings are not providing the best diversification benefit).
I think that many investors struggle with this, and I'll admit it took me a while to get it too.

The place to start, I think, is here: there is nothing in modern portfolio theory that suggests that the total stock market (aka market cap weighted portfolio of all investable equities) must or even should correspond to the most diversified portfolio possible.

In theory the market portfolio is the mean-variance optimal portfolio: the combination of stocks that offer the most return per unit of variance.

A portfolio that is optimized instead to be the maximal diversification portfolio might, and usually does, look different.

There is no conflict with the efficient market hypothesis, per se, because we are talking about two portfolios optimized according to different goals.

It's like the difference between the best defensive player on a team, the best offensive player on a team, and the best balanced player on the team. They MIGHT all be the same person, but they probably aren't in most cases.
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Re: Ignored Risks of Factor Investing

Post by packer16 » Fri Dec 07, 2018 3:33 pm

But by using factor weightings vs. what the market provides as weightings, you are stating that these factor weights provide a more efficient portfolio than what the market weight is telling you. One of the beauties of market weights is the use of the market mechanism to incorporate information into prices. By not using the market weights (using factors for example), you are saying you know better than the market what is required to develop the best risk adjusted portfolio (similar to an active value investor stating that he/she knows the value of a business better than the market). This is a large assumption & presumes you have an edge over what the market weight provides. This is where I differ from most of the factor proponents. The "edge" appears in the historical data (the example of investing in SCV with more bonds vs. TSM with less bonds is an example of a historical edge this strategy had - same return less risk) & when many folks invest this way the "edge" goes away. IMO just because you see an effect in historical data such as factors, a fund investor cannot count on after-fee benefit for themselves. Putting aside if these factors will persist because of competition, probably most if not all the benefit will go to the providers of the funds/services used to harvest these factors. Also, while these factors appear simple in theory, in practice the implementation of them in portfolio can be as or more complicated than active investing in terms of the number of inclusion & weighting decisions that need to be made for implementation.

IMO one of the hallmarks of indexing & Bogleheads is simplicity. Simplicity does not require you to be right with alot of decisions only a few. Factor investing at the theory & implementation appear to be complex. All of this complexity IMO makes factor investing more akin to quantitative active investing. I am not saying factor investing will not work it just that the odds become higher against it the more complex the strategy. I think QSPIX is a case in point where you a levered complex strategy having a difficult time working.

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Re: Ignored Risks of Factor Investing

Post by vineviz » Fri Dec 07, 2018 4:05 pm

packer16 wrote:
Fri Dec 07, 2018 3:33 pm
But by using factor weightings vs. what the market provides as weightings, you are stating that these factor weights provide a more efficient portfolio than what the market weight is telling you. One of the beauties of market weights is the use of the market mechanism to incorporate information into prices. By not using the market weights (using factors for example), you are saying you know better than the market what is required to develop the best risk adjusted portfolio (similar to an active value investor stating that he/she knows the value of a business better than the market).
I'm going to stop the quote here because it already contains some things that are confusing and/or incorrect.

The phrase "more efficient portfolio" is somewhat vague, but in finance it USUALLY refers to the how mean-variance efficient the portfolio is. In other words, a portfolio optimized to have the highest possible high Sharpe ratio (aka highest possible risk-adjusted return). Such a portfolio may or may not be the most diversified portfolio possible.

Optimizing a portfolio to be the highest possible level of diversification possible may or may not have the highest risk-adjusted return.

These are different (and sometimes competing) goals, and should not be confused as being the same thing.
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Re: Ignored Risks of Factor Investing

Post by cheezit » Fri Dec 07, 2018 4:13 pm

vineviz wrote:
Fri Dec 07, 2018 3:14 pm
packer16 wrote:
Fri Dec 07, 2018 2:29 pm
The point of a SCV/TSM being more diversified is where I miss the train. This implies that the market pricing set by alot of market participants is not providing a diversified weighting of stocks but you have to use historical construct (factors) to provide you a more diversified portfolio. Does this not conflict with an efficient market? (i.e. somehow the market weightings are not providing the best diversification benefit).
I think that many investors struggle with this, and I'll admit it took me a while to get it too.

The place to start, I think, is here: there is nothing in modern portfolio theory that suggests that the total stock market (aka market cap weighted portfolio of all investable equities) must or even should correspond to the most diversified portfolio possible.

In theory the market portfolio is the mean-variance optimal portfolio: the combination of stocks that offer the most return per unit of variance.

A portfolio that is optimized instead to be the maximal diversification portfolio might, and usually does, look different.

There is no conflict with the efficient market hypothesis, per se, because we are talking about two portfolios optimized according to different goals.

It's like the difference between the best defensive player on a team, the best offensive player on a team, and the best balanced player on the team. They MIGHT all be the same person, but they probably aren't in most cases.
Here is the problem: within the context of MPT, mean-variance optimization is well defined. Without defining what the maximal diversification portfolio is or how diversification can be quantified, there can be no reasoned discussion of the relative diversification of different portfolios. Just a bunch of people talking past each other.

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Re: Ignored Risks of Factor Investing

Post by vineviz » Fri Dec 07, 2018 4:20 pm

cheezit wrote:
Fri Dec 07, 2018 4:13 pm
Here is the problem: within the context of MPT, mean-variance optimization is well defined. Without defining what the maximal diversification portfolio is or how diversification can be quantified, there can be no reasoned discussion of the relative diversification of different portfolios. Just a bunch of people talking past each other.
Maybe, but there are plenty of ways to quantify diversification. My experience has been that very few people have an interest in developing an understanding of how to to measure diversification: it's apparently a lot easier to insert some Jack Bogle quote about simplicity as a way of waving away the discussion.
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Re: Ignored Risks of Factor Investing

Post by packer16 » Fri Dec 07, 2018 4:21 pm

I agree that the most diversified portfolio may not be the efficient portfolio. Is not the goal of diversification to get an efficient portfolio with the highest risk adjusted return (Sharpe ratio)? What is the point of getting a more diversified portfolio if it provides you less risk-adjusted return than a market portfolio?

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Re: Ignored Risks of Factor Investing

Post by Phineas J. Whoopee » Fri Dec 07, 2018 4:21 pm

vineviz wrote:
Fri Dec 07, 2018 12:44 pm
typical.investor wrote:
Fri Dec 07, 2018 8:43 am
...
The "you aren't diversified if you don't use factors tilts" claim by factor proponents is the real scare mongering.
Again, I'll wait here while you point out even one time someone has written " "you aren't diversified if you don't use factors tilts".
...
Former posters EDL (since removed) and Larry Swedroe regularly made that point here. Others have as well, but those are the two I best remember. Naturally they used their own words.

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Re: Ignored Risks of Factor Investing

Post by stlutz » Fri Dec 07, 2018 4:24 pm

vineviz wrote:
Fri Dec 07, 2018 1:55 pm

I sincerely cannot recall EVER seeing someone say that using only smallcap value stocks is "more diversified" than buying a total market fund
On the other hand, it probably is technically true that the typical smallcap value fund is more diversified than a the typical total market fund.
:confused

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Re: Ignored Risks of Factor Investing

Post by stlutz » Fri Dec 07, 2018 4:38 pm

packer16 wrote:
Fri Dec 07, 2018 4:21 pm
I agree that the most diversified portfolio may not be the efficient portfolio. Is not the goal of diversification to get an efficient portfolio with the highest risk adjusted return (Sharpe ratio)? What is the point of getting a more diversified portfolio if it provides you less risk-adjusted return than a market portfolio?

Packer
Diversification is not fundamentally about return. It's about managing risk. The *most* diversified portfolio will not provide the highest risk-adjusted return--it's not even seeking that.

Some diversification will help in achieving the higher risk-adjusted return; some will hurt. The idea behind proposals like the "Larry Portfolio" is that by concentrating very narrowly within in two assets classes (only SV stocks and only T-bonds), you can achieve a higher risk-adjusted return. Even if that is true, this is not a particularly diversified portfolio.

Mean-variance optimization is focused on what you expect to happen. Diversification is about what you do not expect to happen. An investor may expect SV stocks to perform the best. If she is concerned about being wrong in that forecast, she will diversify into other other types of stocks.

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Re: Ignored Risks of Factor Investing

Post by Phineas J. Whoopee » Fri Dec 07, 2018 4:39 pm

Among the definitions of words we regularly argue about here, including investment, is diversification. Safe is another good one, as are best and efficient.
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Re: Ignored Risks of Factor Investing

Post by rkhusky » Fri Dec 07, 2018 4:40 pm

Random Walker wrote:
Fri Dec 07, 2018 3:06 pm
I think there is a distinction between an efficient market and an efficient portfolio. The market can price market beta, size, value efficiently but a portfolio can be made more efficient by more equally balancing across these unique independent sources of risk.
A portfolio on the efficient frontier cannot be made more efficient. If the Total Stock Market is on the efficient frontier, which I believe I have seen stated, then it cannot be made more efficient, although other portfolios can be as efficient.

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Re: Ignored Risks of Factor Investing

Post by cheezit » Fri Dec 07, 2018 4:51 pm

vineviz wrote:
Fri Dec 07, 2018 4:20 pm
cheezit wrote:
Fri Dec 07, 2018 4:13 pm
Here is the problem: within the context of MPT, mean-variance optimization is well defined. Without defining what the maximal diversification portfolio is or how diversification can be quantified, there can be no reasoned discussion of the relative diversification of different portfolios. Just a bunch of people talking past each other.
Maybe, but there are plenty of ways to quantify diversification.
Having multiple ways to quantify diversity is in some ways worse than having exactly one way to quantify diversification, because it means there are multiple distinct things that can be referred to by the same name :( If you had to pick one measure of diversification, what would it be? Looking at the wiki here and also the entry at Investopedia, I don't see a single formula.

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Re: Ignored Risks of Factor Investing

Post by Random Walker » Fri Dec 07, 2018 5:04 pm

rkhusky wrote:
Fri Dec 07, 2018 4:40 pm
Random Walker wrote:
Fri Dec 07, 2018 3:06 pm
I think there is a distinction between an efficient market and an efficient portfolio. The market can price market beta, size, value efficiently but a portfolio can be made more efficient by more equally balancing across these unique independent sources of risk.
A portfolio on the efficient frontier cannot be made more efficient. If the Total Stock Market is on the efficient frontier, which I believe I have seen stated, then it cannot be made more efficient.
I must admit that I have heard the same argument that TSM is on the efficient frontier and I don’t quite understand it. That being said, I can still readily disagree with it :-). In my mind, the efficient frontier is a hypothetical collection of portfolios that represent maximal returns for each given level of volatility. The goal for most of us is to create a portfolio that has a high likelihood of ending up close to the northwest corner of a return v. Volatility plot. Adding any additional asset that is less than perfectly correlated has the potential to move the portfolio in this direction. The simplest example would be adding total international to total US. This is why I say there is a distinction between an efficient market and efficient portfolio. Both TSM & TISM I’m sure we’d agree are efficient markets. I would venture to say that a portfolio with both TSM and TISM is likely to be more efficient than either alone. And we can certainly extrapolate that sort of thinking to other less than perfectly correlated sources of return: factors, styles, asset classes, geographies.

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Re: Ignored Risks of Factor Investing

Post by stlutz » Fri Dec 07, 2018 5:06 pm

Having multiple ways to quantify diversity is in some ways worse than having exactly one way to quantify diversification, because it means there are multiple distinct things that can be referred to by the same name :( If you had to pick one measure of diversification, what would it be? Looking at the wiki here and also the entry at Investopedia, I don't see a single formula.
Quantifying using risk factor models really is the way to do it. Small loadings=diversified.

The problem with that is that factor loadings are relative, not absolute. Is "the market" the US market or the global market? Is it just stocks or is it stocks and bonds together? Answer these questions differently and the results of your calculations change.

I would argue that diversification is best analyzed qualitatively, with the math formulas lending a hand. Graham and Dodd wrote very well on how to assemble a diversified portfolio long before MVO and risk factor models came along. In fact, my conclusion based on this thread is that the formulas have subtracted more from our understanding of diversification than they have added to it.

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Re: Ignored Risks of Factor Investing

Post by Random Walker » Fri Dec 07, 2018 5:11 pm

cheezit wrote:
Fri Dec 07, 2018 4:51 pm
vineviz wrote:
Fri Dec 07, 2018 4:20 pm
cheezit wrote:
Fri Dec 07, 2018 4:13 pm
Here is the problem: within the context of MPT, mean-variance optimization is well defined. Without defining what the maximal diversification portfolio is or how diversification can be quantified, there can be no reasoned discussion of the relative diversification of different portfolios. Just a bunch of people talking past each other.
Maybe, but there are plenty of ways to quantify diversification.
Having multiple ways to quantify diversity is in some ways worse than having exactly one way to quantify diversification, because it means there are multiple distinct things that can be referred to by the same name :( If you had to pick one measure of diversification, what would it be? Looking at the wiki here and also the entry at Investopedia, I don't see a single formula.
If I had to pick one measure of diversification it would be number of unique independent sources of risk/return. The argument begins with Total Stock Market Index. It can have thousands of stocks, including large/small and value/growth, but no net exposure to anything but the single factor, market beta. The argument over whether TSM is diversified or not basically crystallizes people’s different concepts of diversification. So by my measure, TSM is highly diversified in the sense that it minimizes diversifiable single stock risk. And not at all diversified in that it has net exposure to only one of the known drivers of equity returns.

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Re: Ignored Risks of Factor Investing

Post by vineviz » Fri Dec 07, 2018 5:17 pm

stlutz wrote:
Fri Dec 07, 2018 4:38 pm
packer16 wrote:
Fri Dec 07, 2018 4:21 pm
I agree that the most diversified portfolio may not be the efficient portfolio. Is not the goal of diversification to get an efficient portfolio with the highest risk adjusted return (Sharpe ratio)? What is the point of getting a more diversified portfolio if it provides you less risk-adjusted return than a market portfolio?

Packer
Diversification is not fundamentally about return. It's about managing risk. The *most* diversified portfolio will not provide the highest risk-adjusted return--it's not even seeking that.
Precisely.

Moreover, two crucial risks that diversification can help manage (either explicitly or implicitly) are estimation risk and approximation risk. A mean-variance optimized portfolio is constructed using expected returns and expected variance, but our ability to precisely estimate and approximate those expectations is flawed at best. One goal of portfolio diversification is to dramatically ameliorate the potential impact of these errors.

See, for example, https://www.windhamlabs.com/insights/estimation-error/

Also, the field has developed much greater insights in the investor utility functions than Markowitz had available. In addition to the first two moments (mean and variance), for example, investors also care about the third and fourth moments (skewness and kurtosis) in their portfolios.

On mathematical and statistical grounds, the fact that the CAPM doesn't effectively predict stock returns means that mean-variance efficient portfolios often tend to end up being highly concentrated (see the recent worry about FAANG stocks, for instance) so an intentional focus on diversification can reduce the risk associated with that concentration. Add in the fact that investors are not homogenous in their preferences and the whole thing gets wonky fast.
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Re: Ignored Risks of Factor Investing

Post by vineviz » Fri Dec 07, 2018 5:20 pm

cheezit wrote:
Fri Dec 07, 2018 4:51 pm
Having multiple ways to quantify diversity is in some ways worse than having exactly one way to quantify diversification, because it means there are multiple distinct things that can be referred to by the same name :( If you had to pick one measure of diversification, what would it be? Looking at the wiki here and also the entry at Investopedia, I don't see a single formula.
It's not as if the particular measure changes the fundamental discussion. I've posted several times about diversification measures (like the diversification ratio and Shannon entropy), but I probably should consolidate some of it into the Wiki.
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Re: Ignored Risks of Factor Investing

Post by stlutz » Fri Dec 07, 2018 5:30 pm

vineviz wrote:
Fri Dec 07, 2018 5:17 pm
...the fact that the CAPM doesn't effectively predict stock returns means that mean-variance efficient portfolios often tend to end up being highly concentrated (see the recent worry about FAANG stocks, for instance) so an intentional focus on diversification can reduce the risk associated with that concentration...
In return I'll agree with you as well. :sharebeer

The market portfolio is not the maximally diversified portfolio simply because the portion of the economy that is represented by the public stock market is not maximally diversified. The "most" diversified portfolio would deviate significantly from the market.

That said, I find the total market to be "good enough" for my purposes.

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