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.

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).

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.

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.

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.

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.

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.

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.

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