Rich and Co.

The Problems with MPT – from The Big Picture blog

However, before we go there, I would like to spend a moment on MPT, as I believe it is important to understand the shortcomings of the prevailing approach to investment and risk management. (Much of the following is inspired by Woody Brock.) Let’s take a closer look at three of the most important assumptions behind MPT (there are many more assumptions behind Modern Portfolio Theory. Wikipedia is a good place to start should you wish to read more about it):

  1. Risk-free investments exist and every rational investor invests at least some of his savings in such assets, which pay a risk-free rate of return.
  2. Returns are independently and identically-distributed random variables (returns are trendless and follow a normal distribution, in plain English).
  3. Investors can establish objective and accurate forecasts of future returns by observing historical return patterns. (Strictly speaking, this assumption was relaxed by Fischer Black in 1972 when he demonstrated that MPT doesn’t require the presence of a risk-free asset; an asset with a beta of zero to the market would suffice.)

Well, if these assumptions are meant to stand the test of time, then good old Markowitz (the father of MPT) is in trouble. Truth be told, none of the three stand up to closer scrutiny.

  • The concept of risk-free investing no longer exists, post 2008.  Banks are giant hedge funds which cannot be trusted and even government bonds look dicey in today’s world. 
  • Secondly, returns are clearly not random. If you have any doubts, just look at how the trend-following managed futures funds make their money. 
  • Thirdly, from 26 years of investment experience, I can testify to the fact that historical returns provide little or no guidance as to the direction of future returns.

Written by Rich and Co.

April 5, 2011 at 6:21 pm

Posted in Uncategorized

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