This is the title of of Bob Veres’ piece in Financial Planning about some of the problems with Modern Portfolio Theory. He points out some of the salient problems that have come to light involving mean variance optimization and correlation. A few interesting excerpts:
Recently, we’ve seen data showing the efficient frontier is kind of a silly idea. If you draw one for every decade, using retrospective return and volatility numbers, you get a whole bunch of fishhook graphs in different parts of the risk/return space, with different shapes and slopes. Invest precisely along last decade’s frontier and you’re likely nowhere near the one that fits the current decade.
Why would modern portfolio theory inputs use single numbers for all the correlations when they clearly move around, and converge when markets do what they did in 2008?
…our investing world has developed a lot of strange taboos. “In the investment markets, we are learning that when volatility rises, it tends to stay high-what they call volatility clustering,” he says. “If portfolios are entering a period of high volatility, one might respond by taking some risk off the table.” In the enterprise risk management world, that is common sense. In the investment world, such behavior is labeled market timing.
You’ll benefit from reading the whole article. Bob Veres highlights some of the critical issues, such as the need for MPT to evolve from its original form as new data arises. He points out:
…modern portfolio theory is not very different in the way we apply it than it was when Dwight Eisenhower occupied the White House.
We’ve learned a lot since then about correlation stability, volatility clustering, and tactical asset allocation. The future of investment management is exciting, but we need to move beyond the 1950s and incorporate everything we have learned since then. I suspect that tactical asset allocation and systematic use of relative strength and value as factor returns will play a big part going forward.
Source: kunjumon.com
Until the brokerage firms get tired of selling pie charts to their clients, mph will stay in vogue.