Modern Portfolio Theory: Break free dude!
| Aug 12th, 2010 | Filed under: CAPM / Alpha Theory, Today's Post | By: AAA Staff |
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There were a series of government-sponsored television commercials in Canada in the mid-1980s that in simple yet effective terms sought to encourage young people to “break free” from smoking tobacco.
Showing teenagers at school playgrounds, on the streets and in other social settings shouting “break free!” (“Fumer, c’est fini!” en Francais) the ads (click here for a humorous glimpse at one of them on YouTube [Ed: Yikes. Holy 80's hair!]) quickly caught on as a catchphrase among the Canuck young, with the at-the-time-prerequisite “dude” tossed in at the end for good measure.
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Markowitz, says the same thing as he talks about MVO “I never ever assumed that probability distributions were normal. I never justified Mean Variance analysis in terms of probability distribution being normal.” “My basic assumption is that you act under uncertainty to maximize expected utility.” It all most sounds like he expects people to act as rational free thinking beings, and as we know this is not all ways the case, people tend to anchor to ideas and seek out answers supporting our existing beliefs. Markowitz also talks about using a “Student’s t-distributions with 4.5 degrees of freedom plus or minus a half degree as a good model of stock return”. My long winded point is I agree with State Street, MPT and MVO are not perfect in the real world. We need to act as rational investors when applying academic theory to real world asset management.
Nice to see institutional inertia being overcome a mere 20 years after the ‘discovery’ of Post Modern Portfolio Theory methods. Markowitz bashing although fashionable is also a little unfair given that his seminal work was done in the 1950’s BC (Before Computers) and he did articulate the assumptions and the fact that it was a ‘normative model’ or how investors aught to behave and not necessarily how they did behave given the assumptions of i.i.d, quadratic utility, elliptical distributions etc etc. The primary problem of diversification is its reliance on the concept of correlation which is only a limited and linear measure of association and also on the assumption that it remains constant. In the real world of time varying correlations, volatility clustering and asymmetric preferences and effects it is not that surprising that the ‘classical’ theory doesn’t work that well. Still both the largest provider of Risk Measurement softaware, also being a little unfairly
Nice to see institutional inertia being overcome a mere 20 years after the ‘discovery’ of Post Modern Portfolio Theory methods. Markowitz bashing although fashionable is also a little unfair given that his seminal work was done in the 1950’s BC (Before Computers) and he did articulate the assumptions and the fact that it was a ‘normative model’ or how investors aught to behave and not necessarily how they did behave given the assumptions of i.i.d, quadratic utility, elliptical distributions etc etc. The primary problem of diversification is its reliance on the concept of correlation which is only a limited and linear measure of association and also on the assumption that it remains constant. In the real world of time varying correlations, volatility clustering and asymmetric preferences and effects it is not that surprising that the ‘classical’ theory doesn’t work that well. Still both the largest provider of Risk Measurement software, The largest Ratings Agency, almost all 3rd party Optimisation software and most institutions continue to use the ‘normal’ assumption.
The obvious yet often overlooked truth about Modern Portfolio Theory is that it works best when uncorrelated assets are utilized. Most asset allocation models do not use truly uncorrelated assets, such as managed futures.
Those who utilize MPT or other asset allocation models would do well to consider perhaps what can be argued is the most uncorrelated asset class in history, managed futures. How the managed futures asset class remains generally ignored and mis-understood by Wall Street financial advisors remains a mystery.
[...] most popular post in August on AllAboutAlpha was Modern Portfolio Theory: Break free dude! Why was this the most popular? I’m [...]
The blog post “Ancient portfolio theory” contains my comments on this:
http://www.portfolioprobe.com/2010/09/20/ancient-portfolio-theory/