Modern Portfolio Theory is for Nitiots

December 21, 2012
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In the following paragraphs, we shall defend the assertion that Modern Portfolio Theory is for Nitiots.

To begin, let us define our terms:

Modern Portfolio Theory (via investopedia): “A theory on how risk averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.”

Nit: In poker parlance, an über-conservative player who constantly folds and only enters pots with “premium” hands.

Nitiot: The player who is so fearful of risk,  he (or she) will make terrible decisions to avoid it – laboring under the mistaken assumption that volatility and risk are the same thing.

At the poker table, the Nitiot plays timidly as a rule, which creates two bad results: 1) the tendency to get pushed out of pots, and 2) the inability to get paid off with premium hands (because the rare display of strength sticks out like a sore thumb).

In markets, the Nitiot makes supposedly “conservative” decisions — guided by the conventional wisdom of MPT — and often winds up poorer for their efforts.

The Nitiot’s central failing is also a central plank of Modern Portfolio Theory: The wrong-headed notion that volatility equates to risk.

In contrast to what ivory tower types and passive investors believe, winning poker players, winning traders and winning investors all have something in common: They understand that the presence of volatility means opportunity, not risk — so long as it is handled in the proper context.

John Maynard Keynes (no slouch of a trader himself) put it simply:

“It is largely the fluctuations which throw up the bargains and the uncertainty due to fluctuations which prevents other people from taking advantage of them.”

Warren Buffett — a value investor who knows a thing or two about markets — further agrees with his mentor, Ben Graham, that risk is the potential for permanent capital loss, which has no necessary correlation to volatility at all.

Which market environment was “riskier,” for instance, from a value investor’s perspective: March 2007, when volatility was at rock-bottom lows with market valuations sky high… or March 2009 (the nadir of the global financial crisis) when conditions were exactly reversed?

Or, to illustrate it in poker terms:

You are in a deep-stacked No Limit Texas Hold ‘Em poker game. You call a multiway $500 preflop raise with the Ace-King of hearts. The flop comes Q-J-T of hearts. Your first opponent bets $2,000. Your second opponent raises to $5,000, dramatically increasing the volatility of the hand.

You have a royal flush – the ultimate nuts. Has the presence of volatility somehow increased your risk? Are you supposed to be unhappy about this?

All truly robust (long-term profitable) poker, trading and investing strategies must endure “drawdowns” — periods of adverse volatility excursion, i.e. dips and troughs in the equity curve. The strategies that appear to be flawless (drawdown free) wind up being Ponzi schemes, blow-ups in waiting, or both. (Investors in the Bear Stearns High Grade Structured Credit Strategies Enhanced Master Fund — try saying that three times fast! — saw silky-smooth returns of 1% per month for +40 months in a row before it all went kablooey.)

In a strange way, then, the presence of equity curve volatility (and carefully managed drawdowns) can actually be a positive, to the degree that survival signals robustness. A methodology that undergoes routine “stress testing,” yet continues to grind out new equity highs, is far more desirable than a “perfect” methodology that has never been tested at all.

What’s more, as Keynes alluded earlier, the presence of volatility in and of itself creates opportunity, via the ability to make superior decisions.

Why? Because trading and investing, like poker, are minus sum games. It is statistically impossible for a majority to outperform (though a majority can certainly underperform), and everyone pays the vigorish (slippage, commissions, rake and tokes etc).

In a minus sum game, the winner must have an “edge” over his or her collective opponents — a means of making superior decisions (higher expected value decisions) consistently over time.

Volatility thus creates opportunity not just by throwing up bargains, as Keynes suggested, but also by highlighting skill differentials: In a volatile environment, the less-skilled are more likely to make mistakes than the highly skilled. These mistakes, on balance, transfer profit from one group to another.

On a related point, for the trader or investor who wishes to improve, the only way to close this skill gap is by enduring volatility and learning how to handle it. (As the saying goes: “A calm sea never made a skilled mariner.”)

But getting back to Nitiots: On top of wrongly equating volatility with risk, these folks make an even nuttier mistake. The MPT Nitiot assumes skill has no bearing on outcome… perhaps the most fool-headed assumption academia has ever put forth!

According to these goofballs, factors like asset valuation, supply and demand, entry and exit prices, and basic risk management — all of which require skill to assess — don’t matter to the process at all. All that stuff is skipped in favor of “asset allocation,” where the chief decision is whether to (passively) accept a mix of 60 percent equities, 40 percent bonds or what have you.

This ivory tower nonsense was popularized in a 1985 book by Charles Ellis titled “Investment Policy: How to Win the Loser’s Game.” According to Nitiots, the way to win the “loser’s game” is not to become a winner yourself (by studying other winners and developing a skillset)… it’s to pretend skill is somehow irrelevant and choose to play the game blindfolded!

But it gets worse, oh yes…

In the futures trading biz, all money managers are forced to prominently disclose that “PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.” And yet this is exactly the crumbling edifice that Modern Portfolio Theory is built on — the dangerous notion that the future (in terms of asset class performance) will look reliably like the past.

MPT advocates love to cite long term studies — the “Ibbotson Study” one of the most popular — as justification for both their passive market approach and optimistic assumptions as to future stock and bond returns. In other words: The blindfold method worked great for the last X decades, so why not expect more of the same?

The trouble with this is sheer lack of sample size. From a statistical validity perspective, the 20th century — a period of unprecedented USA prosperity — offers a sample size of one!

Will the next twenty-five year period look just like the last one, in which we saw the build-up of a “debt supercycle” alongside one of the greatest equity bull runs of all time? There is ample reason to believe it won’t be the same at all… and while passive investing Nitiots “hope” it will, is hope really a strategy?

Blatant dismissal of valuation — whether an investment is high or low priced relative to historic benchmarks, cash flows etcetera — is another serious issue. For example: According to MPT logic, US real estate was just as attractive an asset class in late 2006 / early 2007 (near the peak of the housing bubble) as at any other time — or perhaps even more so, because the track record of rising home prices was longer!

As for the fact that housing bubble warning signs (remember condoflip.com?) and countless valuation metrics (price-to-rent, rent-to-income, LTV ratios, the California 50-year mortgage) had gone Screaming Mimi vertical? Meh… such counted as skill-based assessment, and was thus completely ignored.

MPT valuation blindness, and its follow-on gross overexposure to uber-crowded areas such as private equity, was a big reason many university endowment funds plunged into the abyss in 2008. The Nitiots thought they were being prudent, while inhaling risk by the lungful!

Meanwhile, as of this writing, MPTers are setting up their portfolios for another valuation-based massacre, this time in “safe” government bonds. To borrow a James Grant quip, US Treasuries have migrated from “risk free return” to “return free risk.” But once again, such an assessment is skill based… requiring the ability to turn one’s head and see the freight train coming down the track… and thus for Nitiots not allowed.

Modern Portfolio Theory has yet another, more cynical element in our view. It is a tool used to sucker the hapless retirement investor.

Most skill contests are understood to be dangerous, in respect to adverse consequences if you don’t know what you are doing. If a novice sits down at a high stakes poker game, or opens up a futures trading account, and proceeds to get educated at the cost of all his dough, few will feel sympathy. “You pays your money and you takes your chances.”

But when it comes to retirement investing, tens of millions of Americans — and tens of millions in other countries too — have little choice in the matter. By dint of amassing a pool of savings to live on in old age, these individuals, who may have never analyzed a stock or bond in their lives, with no desire to start now, are nonetheless forced to “sit down at the table” that is markets. It is either that, or see their purchasing power cruelly eaten away by the ravages of inflation.

For Wall Street, this gigantic pool of forced retirement savings creates a juicy dilemma. There are nowhere near enough truly skilled managers to run all that money properly… but there is plenty of incentive to run it poorly!

Of course, you can’t admit to Mr. and Mrs. Pensioner that your plan is to toss their savings into the maw of a faceless, bloated, fee-generating mediocrity machine. So instead, you explain to them why skill doesn’t actually matter… why “asset allocation” is the holy grail… why stocks always go up “in the long run” and so on… thus making Amalgamated Juggernaut Advisors the best choice.

Modern Portfolio Theory is wonderfully enabling for all this, emphasizing, as it does, the mass allocation of gigantic sums in robotic fashion, as if skill (and maneuverability) did not matter at all.

In a final word to MPT Nitiots, we offer the perspective of Robert L. Bacon, author of the 1956 classic “Secrets of Professional Turf Betting:”

I don’t want to be like Pittsburgh Phil and win a million dollars at the races. I’d just like to grind out $25 a day for myself without any risk!

How many times have you heard something like that from turf fans who were trying to be “conservative” at racing? …Oh Brother! You can add this “grind” idea to the long list of other unsound notions held by the public play…. One sure thing that a smart player engraves deeply into his skull, is the fact that you MUST speculate at the races. You CAN’T grind!

The player at the races can’t grind or chisel because [that girl] is taken. The racetrack has all grind and chisel privileges! The mutuel take and the breakage add up to a percentage that continually grinds and chisels the betting money… The grind privileges are spoken for and taken, so the professional bettor must speculate. The mutuel grinding only goes one way – against the bettor. But any percentage can be overcome by enough winners at fat enough prices!

Fortune favors the speculator over the grinder because of the plain old arithmetical percentages. The speculator has a percentage chance to win. The grinder has no chance.

To beat the percentage of the mutuels, the player must ALWAYS have an overlay. He must always have an extra percentage in his favor, to counteract the “take” percentage. Forget about this idea of “grinding out a day’s pay.” If you want to make a day’s pay at the races, get a job watering horses, or pitching manure into trucks. But never try to grind it out of the mutuels.

You Must Speculate — You CAN’T GRIND!

“Speculate” is a dirty word in conventional investment circles. But there is a difference between smart speculation and foolish speculation. We humbly suggest that trusting one’s savings to Modern Portfolio Theory – i.e. being a Nitiot – is the most foolish speculation of all.

JS (jack@mercenarytrader.com)

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19 Responses to Modern Portfolio Theory is for Nitiots

  1. Mike C on December 21, 2012 at 3:37 pm

    I partially agree from a certain perspective, but I think you are overstating the case against MPT, and sort of throwing out the baby with the bath water.

    I think it is important to distinguish between “investing” and “trading/speculating”. They aren’t the same, and I think it bears mentioning that for example a $200 billion pension fund can’t really pragmatically be run as a trading fund such as guys like yourself or Peter Brandt do. Obviously, the liquidity doesn’t exist to move that much money in and out, and obviously at all points in time someone has to hold the asset.

    It can get tricky to distinguish the two, but simplistically I see investing as holding an asset for presumably some intrinsic property of long-term appreciation:

    http://pragcap.com/u-s-equities-long-term-real-returns

    Whereas trading/speculating is about capturing some short-term price variation. Since I both trade and invest, I guess I can see the potential positives with both. I think trading the way guys like you and Peter do it obviously has much higher upside, but I think the downside is higher as well. It certainly isn’t practical to have millions of people with their retirement accounts being active traders.

    So I don’t think there is anything that wrong with an approach that basically says we have asset X that generates A returns over many decades, and asset Y that generates B returns over many decades, and they are correlated with C, and really the best we can do is combine them together in some way. Is that optimal? Or even preferable? Of course not, if you can trade your way to 10-20% CAGR with minimal drawdowns, but I’m learning myself that isn’t an easy task when you have 1-2 big losers or 8 stop outs in a row. In contrast, buying and holding assets X and Y for 20 years and rebalancing periodically might get you 4 or 6 or 8% annually with a bit wilder ride.

    I know this was a long comment….sorry, I could go on further but I think bottom line you’ve got an apples to oranges comparison here. Trading is trading, and most people probably can’t make money let alone even stay flat from active trading so for a hundred billion dollar pension fund or Joe – Sixpacks IRA some logical way of portfolio construction has to exist beyond buying a few hot stocks that probably will get killed

    • Jack Sparrow on December 22, 2012 at 11:49 am

      Your perspective has merit… there is a lot of nuance with this stuff. Whole books could be written on the topic, which means any article (even one that runs a few thousand words) will necessarily generalize some deeper points.

      With that said, I still question whether MPT has validity as a “this is the best we’ve got” type solution to a serious problem. It is true that the average retiree has no real ability or inclination to trade / invest their own funds. It is also true that investable alternatives for the average retiree are very thin on the ground. But does a bad problem necessarily warrant a bad solution? Perhaps the retiree with no access to skilled management should not be in markets at all. Perhaps there are radically different alternatives worth exploring – say, for example, finding ways to pool savings locally and invest in one’s community.

      I don’t recall the stats off the top of my head, but the average US baby boomer has something like less than 30K saved up for retirement. A good portion, if I remember rightly, is even worse off than that, with close to no savings at all. And of course hundreds of millions of Americans are up to their ass in debt. This also presents a serious head scratcher of a question: Why are these people being encouraged to invest in retirement accounts, when they would be far better off paying down debts and building up their emergency cash cushions in the first place? If you have credit card debt at 12 percent interest, let alone 18 percent interest, it makes no sense to put money in a retirement fund instead of redirecting those funds towards paying off debt. Paying off the card is like a guaranteed tax free 12 or 18 percent etcetera. And if your cash cushion “rainy day fund” for general life adversities is less than six months, that should be beefed up too (most Americans live paycheck to paycheck).

      All of this combines to convince me that, more or less, the majority of Americans should probably not be investing in the stockmarket at all, or even investing in anything outside getting their cash balances and debt levels to where they should be. Then on top of that, there is no reason retirees can’t educate themselves a little better and do more due diligence in terms of where it makes sense to put their funds. It may be an elitist bias of yours truly, but it is hard to feel sorry for the average joe who “worries” about retirement and such yet watches an average four to six hours of television per day (again I don’t recall the exact number, but it’s something horrific).

      Basically MPT is a “best of a bad situation” type solution that winds up shearing a lot of sheep. And even if one accepts that pensions will always have to figure out how to run hundreds of billions, certain established Wall Street practices – like a myopic focus on benchmarking, with the crazy notion that benchmark deviation is more of a risk than permanent capital loss – are toxic through and through. The sheep will keep getting sheared as long as they lack the guts and gumption to recognize how the system is tilted against them, and, sheep being sheep, it may be that this never really changes. But with that said, from a theoretical and / or individual perspective at least, it is quite possible to do better.

      • Mike C on December 23, 2012 at 4:22 am

        Thanks for responding. You sort of have two separate issues here that I think makes sense to keep very separate and not mix together in the thought process. There is overall financial responsibility and then there is the question of what to do with investable assets.

        I absolutely agree that the question of what to do with investable assets takes a backseat to first eliminating debt, and then building an emergency fund. The question of whether or how to “invest in the stock market” is unimportant until those two things are in place. It is kind of silly to worry about how to invest 20K if you’ve got 40K in credit card debt and are living paycheck to paycheck otherwise.

        All that said, once you have investable assets, you have to make some choices. The Rush quote is applicable:

        “If you choose not to decide, you still have made a choice”

        In our financial/monetary system, over the long-term holding cash is a recipe for losing purchasing power. And now central banks have made it tougher with ZIRP policy. I think many people would be best served not investing in the stock market, but aggressively saving and sticking to bank CDs, but unfortunately the Fed has made that a pretty shitty option, and who knows how long that could be the case.

        So once you’ve paid down debt, and have an emergency fund, and have some excess capital, you’ve got to do something. There is probably .1% if even that of people who have the mental aptitude and discipline to actually trade actively and be successful. It might actually be closer to something like .001%. The truth is mostly passive portfolios of various asset classes are probably best for the vast majority of people because they are least likely to really harm themselves.

        In any case, the situation with Baby Boomers really is an oncoming train wreck. I really have no idea how it all works out. A lot of people are probably going to adjust to very low standards of living in their golden years.

        FWIW, I continue to benchmark my active trading versus my more passive investing that is somewhat based on MPT type stuff (in terms of diversified asset class exposure). In my investing, I buy and hold stuff like Berkshire Hathaway and Hussman Total Return Fund (there is your stock-bond diversification). I was actually ahead on trading up until 2012, but the investing has overtaken the performance of trading in 2012. I’m actually very confident that a portfolio of quality stocks, ETFs, and mutual funds diversified across different asset classes will get me to the goal in 30 years (I think there will be another secular stock bull market in that time frame). The difficult decision for me is when to abandon the shorter-term active trading based heavily on technical analysis. I believe it can work. Peter Brandt is an example. I’m sure the P/L of you guys backs that up as well. But I’ve gotten chopped up to death in 2012 with false breakouts and breakdowns, and it seemed like the signals I didn’t take would have been the winners while the ones I took all were the stop outs. Trading isn’t easy. Buying and holding a stock index is pretty easy.

        • Anonymous on December 26, 2012 at 5:01 am

          In life, as in any discipline, 95% will never cross the finish line. And if that number has not changed in last 400 years, what is the point of discussing if those 95% use MPT or EMH or some kind of portfolio insurance….

          • Jack Sparrow on December 27, 2012 at 1:12 pm

            The point is that, even if 95% of the masses are cannon fodder and forever doomed to remain so, there is a portion that can be reached – that can contemplate, evolve and grow.

  2. Experquisite on December 23, 2012 at 11:30 am

    You raise some good points, and I’d be the first to criticize the Modern Portfolio Theory, but I feel like you are conflating disdain for the financial services sector with legitimate grievances of the MPT.

    First off, permanent capital loss often usually preceded by volatility, the exceptions being those short gamma scenarios you mentioned. The vol vs risk angle is from the perspective of stocks vs bonds (held to maturity), not overvalued stocks vs undervalued stocks.

    Second, yes, it’s a shame that this burden to invest has been thrust on the undeserving populace due to governments abdicating their responsibility to uphold a basic social contract, but that in itself has nothing to do with volatility nor MPT. If only there were more honest, capable, independent financial advisors to help at a price point people can afford. I rather hope that recent tech/financial startups will help in this regard.

    Lastly, your post has a somewhat superior smarter-than-thou tone which takes away from its message. Asset allocation for amateurs is a real problem, and although perhaps the people who read and write these sorts of blogs don’t face it, millions of people cannot spend spent hundreds or thousands of hours learning the skillset necessary to “sit down at the table”. Perhaps we should focus more on proscriptive advice rather than snide backlash.

    PS Mike – ditch technical analysis, its mostly nonsense. make some logmormal random walks in excel, attach bollinger bands and MACD to them and see if you can tell the difference. it just inhibits getting into the “flow”, which is the state you want.

    • Jack Sparrow on December 23, 2012 at 6:20 pm

      “Permanent capital loss often usually preceded by volatility” – well that depends on the valuation component, doesn’t it?

      For an investor who blindly invests at dangerous valuations, the statement is almost certainly true. But for an investor who is careful to only invest at attractive valuations – always seeking a “margin of safety” – one might argue exactly the opposite, that excellent opportunities or capital appreciation are often / usually preceded by volatility (which shakes out weak hands, forces dislocations, and presents temporary bargains in the first place).

      Re, the burden to invest and the lack of honest, capable, independent financial advisors, my assertion is that if more high quality financial advisors existed, MPT would be in far less favor. This in turn is tied to valuation observations: To the degree that MPT advises long-term investing without cognizance of valuation outliers, MPT is nuts. And to the degree that smart advisors are in the game, valuation gets emphasized (which discredits MPT).

      Re, smarter than thou, don’t mean to sound smug but what can you do? We are traders and speak mainly to an audience of traders, while being aware of broader long-term investing issues.

      Mainly I do not think the solution Wall Street proposes for the average man in the street is a real “solution”… as the saying goes, if you want a job done right you have to do it yourself, no one is going to look out for your assets better than you can, etcetera. The average individual should do a better job of either vetting investment opportunities or vetting the people who run their money for them. If they do neither, to some extent they get what they deserve.

      In this vein too, think about how much untapped entrepreneurial spirit is out there (or could be out there)… I was just recently reading in the Economist xmas issue about how the Nigerians living in Kibera, perhaps the largest slum on the planet, are the most entrepreneurial-minded in the world in terms of finding small ways to create business services and turn a profit. Why can’t the average American trying to figure out their retirement be more like that, or try to seed local community funds in that same vein? Broader point being, there are many better solutions than settling for the mess that is MPT.

      • Experquisite on December 23, 2012 at 8:37 pm

        A friend of mine once said, “MPT etc won’t make you rich, but will hopefully prevent you from being the outlier at the left edge of the chart.”

        • Jack Sparrow on December 24, 2012 at 12:26 am

          To which we would suggest, “If you don’t have a hope in hades of playing the game well, consider not playing at all.” Not to mention that MPT does little to guard against valuation based disasters that threaten whole asset classes (like the potential up and comer in bonds).

  3. Norman on December 23, 2012 at 2:09 pm

    Back in 1970-71 I attended a week long investment seminar at Stanford. Sharpe and someone else presented MPT. I’ve forgotten the details but in order to come up with a simple linear equation they had to throw out a cross-relationship. However, what they then come up with is a way of predicting that same cross-relationship.

    Although its taught in Biz Schools, MPT is nothing more than a sophisticated looking technical trading system like double or triple tops and moving averages, etc.

    If you think about it, MPT proports to tell you how the future will turn out, ie stocks (etc) that have been volatile in the past or various intertwined currency/bond relationships that will contimue to do so, also.

    This belies in spades their basic contention that the market is a ‘Random Walk’. If it is a RW how can they come up with an equation that unrandomizes the walk?

    And Nobel Prizes were given out for this rubbish.

  4. carl on December 23, 2012 at 7:12 pm

    Hmm well. Mpt has worked out quite nicely for me over the last twenty years of my savings and investmrnt plan. Id gladly stack it up against you trader types. Long term mos traders have horrific track records.

    • Jack Sparrow on December 24, 2012 at 12:20 am

      Sturgeon’s law: “90% of everything is crap.” Most investors have horrific track records too, as do most entrepreneurs (9 out of 10 businesses failing etc). If MPT works out for you, by all means, Via Con Dios.

  5. C on December 23, 2012 at 7:42 pm

    “ALL models are wrong….some models are useful”, goes the old saw, and MPT is no exception. MPT is useful to practitioners who know clearly how, and for what purpose to employ it, as well as its flaws. And that includes BOTH alpha generation and risk analysis. Plucking straw-men from the tails, to diss a cross-sectionally effective model is just silly. Sure, it would be sub-optimal to rely solely on MPT for trading, because all models are stupid with their attendant limitations. But the same holds true for almost any approach. MPT remains a good basis for reasonably accurate out-of-sample forecasts of risk ESPECIALLY over shorter-term trading horizons. That in itself makes most of this post provocative hyperbole at best.

    • Jack Sparrow on December 24, 2012 at 12:24 am

      Where you stand depends upon where you sit. Your endorsement of MPT is faint praise at best. The basic construct contains some serious, perhaps fatal, flaws (such as valuation blindness), and the ability of a sufficiently skilled practitioner to “work around” said flaws speaks more to cherry picking certain helpful structural ideas (for example, determining an allocation mix that is then intelligently managed based on valuation and individual stock picking or manager selection) that MPT cannot lay fair claim to. Oh, and as for the value of forecasting, have a chat with Warren Buffett or Nassim Taleb on that topic…

  6. Karim on December 25, 2012 at 9:08 pm

    The article makes constant reference to skill, which is rather similar to a unicorn as neither one really exists. I just want to see one single long-term investor who has managed a relatively large portfolio and has shown the skill to outperform the market after adjustment for risk. Those ivory tower figures at least have the audacity to present studies backed by rather rigorous statistical results. What we have hear is a lot of talk and no evidence. In other words, a lot of nonsense.

    • Jack Sparrow on December 27, 2012 at 1:11 pm

      You equate skill to unicorns? Seriously? That is such a bizarre assertion it is mind-boggling. As for “one single long-term investor” – gee, let’s see, how about Warren Buffett, Seth Klarman, Stan Druckenmiller, David Tepper, Dan Loeb, Marty Whitman, Bob Rodriguez, George Soros, Michael Steinhardt… I could keep going… those came up in ten seconds flat off the top of my head… re, “no evidence,” what planet do you live on?

  7. Mike C on December 31, 2012 at 4:52 am

    Just closed out a few trades that got stopped out. 2012 was the year for me of death by a thousand cuts. In hindsight, most of them looked like valid chart setups that simply failed.

    Here is my last 30 days. Shorted the yen at .012002 and covered at .011880. Only profitable one. Went long gold at 1668 looking for bounce at 200 DMA, and exited at 1647 next day on stop out. Bought the breakout of the Euro at 1.3240 and just stopped out at 1.3201. Shorted sugar at 18.49 which looked like a breakdown of the 18.80ish support level and stopped out at 19.50. So just false breakout and breakdown one after another.

    I’m going to continue on in 2013, and continue to track technical, chart-based trading against my portfolio that is a combination of value orientation with MPT type asset class diversification (with a trend following overlay, Mebane Fabers 10 month moving average). I think I didn’t take enough trades to allow the averages to work in my favor. Looking back, I didn’t take a few on broken trendlines to the upside which would have been big winners.

  8. Druce Vertes, CFA on January 4, 2013 at 10:31 pm

    A classic misapplication of MPT is, if you use historical bond/equity returns and correlations you’re going to arrive at a certain efficient frontier. But if the current Treasury yield is < 2% then clearly that historical return distribution cannot hold going forward.

    If a big drop in say equities makes you automatically say it's more volatile and you should own less, or a long period of strong bond returns automatically makes you say you need to own more, you're just doing it wrong. You have to estimate the distribution of returns and correlations going forward.

    MPT is just a model. It may be oversimplified but it's informative if applied correctly. A lot of times, if something has a wide variation in potential future values, it's going to have a wide variation in observed prices. If you overreach or abuse your model you're gonna have a bad time. In markets, a little common sense and a decent simple model goes a long way.

    You're always going to have to make an implicit or explicit forecast. It's always going to be impossible to evaluate subjectively, even in hindsight. You never really know if you're a genius or prudently avoided risks or got lucky.

    The only thing that is going to let you outperform is a correct perception that is at variance with the market (Steinhardt).

    • Jack Sparrow on January 4, 2013 at 11:22 pm

      Many defenders of MPT (or should I say semi-defenders) give a variation of “it’s kind of limited and kind of sucks, but has merit if you use it correctly in certain limited ways.” This reminds me of the Far Side cartoon where one person says to the other, “He’s pretty handy with a gun,” in reference to the guy up on the roof nailing shingles with the butt of his revolver.

      Also, Steinhardt’s observation is valid, but incomplete / inappropriate when “only” is attached. Many traders make money without having perceptions “at variance with the market” at all. How does one even translate that statement, for example, to mechanical trend following, statistical arbitrage, yield / rebate capture, or the kind of trading Jim Simons does?

      There are useful explanations for how various methodologies and approaches make money, but there are very few universal statements as such – too many paths up the mountain. As for MPT, it may be that some folks get value out of it, but to the extent they do so by ignoring or compensating for MPT’s serious (nigh fatal) flaws, that doesn’t cancel out the qualitative shittiness of MPT on the whole.

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