Monday, November 03, 2008

The Father of Modern Portfolio Theory on the Crisis


"You, Harry Markowitz, brought math into the investment process with your 1952 article and 1959 book. It is fancy math that brought on this crisis. What makes you think now that you can solve it?”

This objection fails to distinguish between my contribution, portfolio theory, and a later development, financial engineering. A typical application of portfolio theory chooses a portfolio similar to a 60-40 or 70-30 or even 80-20 mixture of stocks and bonds, but more sophisticated, combining more asset classes in a way that minimizes risk for a given level of return on the average. Financial engineers create new financial instruments from old. This can be a good thing—not all financial engineering is always bad—but the layers of financially engineered products of recent years, combined with high levels of leverage, have proved to be too much of a good thing.

Neither my own portfolio, nor those which my clients supervise or advise nor, to my knowledge, any of the large institutional investors (e.g., pension funds) who apply portfolio theory in a generally accepted manner, have suffered excessively from the crisis of the last thirteen months. Most have lost of course. It is part of a risk-return view of portfolio selection that if you want more return on average, and you proceed efficiently, you will have to accept greater fluctuations in the short run.


How to avoid more such crises? Politicians need to learn a lesson. "If the choice is requiring mortgages for people who don't qualify or keeping the banking system sound, we should learn to opt for sound banking every time," Harry Markowitz says. Also, since "financial engineers seem to get their necks chopped off periodically," they shouldn't get bailed out when it happens.

The father of modern finance knows how badly correlated portfolios create risk instead of controlling risk. Mr. Markowitz deserves a hearing from policy makers for his insistence that they focus on restoring information and transparency to the credit markets, making losses clear and resetting prices accordingly. To put the issue in probability terms, the odds are between very remote and nonexistent that the economy can recover until these basic steps are taken.

5 Comments:

At 11/03/2008 9:15 AM, Blogger juandos said...

Hmmm, I wonder what Harry Markowitz would think about the following (courtesy of the Washington Times): Student, car debt quietly added to bailout plan...

 
At 11/03/2008 10:28 AM, Anonymous Anonymous said...

"Mr. Markowitz deserves a hearing from policy makers for his insistence that they focus on restoring information and transparency to the credit markets, making losses clear and resetting prices accordingly."


I suggest that the environmental markets also need a lot more transparency and information. We are making or proposing long term invetments based on risk factors that are poorly understood and unevenly applied.

Hydra

 
At 11/03/2008 12:08 PM, Anonymous Anonymous said...

So-called Modern Portfolio Theory has an internal inconsistancy which has made it useless.

MPT purports to use Random Walk, ie, 'past history is no guide to the future' as a mantra. But MPT's 'portfolio optimizations' are just correlations based on past price movements.

 
At 11/03/2008 12:29 PM, Blogger juandos said...

"MPT purports to use Random Walk, ie, 'past history is no guide to the future' as a mantra"...

Hey anon, are you talking about what was written back in May at the Capital Spectator: RETHINKING MODERN PORTFOLIO THEORY

If so it was in my opinion a good call on your part...

 
At 11/03/2008 6:42 PM, Anonymous qt said...

Juandos,

Doesn't MPT deserve to be reconsidered in less extraordinarily volatile circumstances when even sound investments are currently caught in the downdraft?

No argument on the basics of value investing and analysis of the financials although Graham's Security Analysis is woefully inadequate when one is analyzing modern financial reports.

Can anyone recommend a more up-to-date reference?

 

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