The Evolution of Portfolio Theory

The Evolution of Portfolio Theory: A couple of thought pieces that contribute toward evolution of process.

First Nassim Taleb was on CNBC yesterday and his two segments covered a lot of topics including his idea that I have referred to as putting 80% into various currencies (t-bills from various countries) and then going berserk (my word not his) with risk with the other 20%. While that will not be practical for too many folks it is an interesting glimpse into how he thinks about the role that risk should play.

With his interview yesterday he appears to have tweaked this slightly. Instead of various currencies he said something that protects against inflation. From the context I took him to mean TIPS not commodities but of course you may draw a different conclusion from his comments. If he did mean TIPS then his idea looks a lot like what Zvi Bodie has been writing about for a long time.

The other item was an article run at IndexUniverse by Katrina Sherrerd who is the COO of Research Affiliates. The first point of the article was about the need to keep learning or as she might put it the need to overcome ignorance. The context was investment advisors but it obviously pertains to do-it-yourselfers too.

This was particularly interesting;

The investment management industry tends to emphasize product—and its invariably linked goal of beating the benchmark—over education and counseling.

And I am sure the people who bought the Apple linked debt who now stand to get put the stock a couple of hundred points above the current market would agree with too much emphasis on product.

The article then talks at length about research from Malkiel about how difficult it is to beat the market over any period of time and the extent to which people assume they will get higher returns than they actually will. She made the point of there being limited alpha available (which I think is more of an academic concept as opposed to reality) and that advisors need to focus more on proper counseling of clients and less on trying to sell performance.

This is a productive conversation. Beating the market over any extended period is very difficult and is typically not necessary for someone with an adequate savings rate. As I say frequently being relatively close to the market and having an adequate savings rate can get the job done for someone who is simply trying to accumulate enough for retirement.

Being overly optimistic about future returns gets mentioned in just about every behavioral article that gets written and is no doubt something you have read about before. Over the course of an investment career an ordinary investor will have years that they beat the market but there will be years they lag. This is a reasonable assumption. However it is not reasonable for the typical person to think they will get 10% annualized for the next decade if the market averages 5% annualized for the next decade. If the market averages 15% per year for the next decade then expecting 10% or maybe even a little better is not so crazy, it may not happen for you but it is not crazy.

A better way to think of it is that you can only take what the market gives. You can try to predict what that might be but whether you are right or wrong about what will happen, getting 10% in a 5% world on a regular basis is an extreme long shot and I think this is a crucial point of understanding.

As far as alpha being finite, I don't agree with this. I have read about why people think this is the case but I simply disagree. Whatever time frame that someone measures performance (year, quarter, whatever), there are trades that can be done in between that can add alpha (or do the opposite). Further, there are unlimited possibilities for adding alpha with options. The point is not that you should trade options or trade more frequently just that finite alpha is an academic concept.

As far as actually adding alpha, I agree that alpha generation as a top priority is not going to be a good idea for a lot of people. In my opinion, the majority of market participants should focus on accumulating enough money for when they need it and doing it in such a way that they reduce the odds of doing stupid things like panic selling at a low, putting too much money into a fad stock at a high or buying investment products like the Apple linked notes mentioned above.

Yesterday we had a search and rescue/medical call/airlift for a patient who almost froze to death in his car after crashing way off road for two days. I was at a meeting in Prescott when the call came in so my role was to set up the landing zone, I didn't get to go to the scene but he was difficult to get to and he had to be cut out of his vehicle.

DIGITAL JUICE