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Modern Portfolio Theory

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Modern Portfolio Theory refers to the idea that each investment ought to be selected in consideration of how it will interact with other assets in one's portfolio.  Modern Portfolio Theory is the basis for Mean Variance Optimization.

Harry Markowitz, "Portfolio Selection," Journal of Finance, March 1952 Vol 7, pp. 77-91 (603kb).  Also here.  This paper laid the groundwork for Modern Portfolio Theory, which earned Dr. Markowitz a Nobel Prize.  The paper suggests that, instead of asking the question, "What is a good investment?", you ought to be asking, "What is a good investment for my portfolio?"  It turns out that the answer is heavily dependent on what else happens to be in your portfolio.  All else being equal, it is more beneficial (from the standpoint of maximizing your risk-adjusted return) to take on an investment which is likely to have low correlations with other elements of your portfolio than to take on an investment which is likely to have high correlations with other elements of your portfolio.  Thus, investment selection should involve getting maximum diversification benefit (with respect to the rest of the portfolio) from each investment.

James S. Ang, Jess H. Chua, and Anand S. Desai, "Efficient Portfolios versus Efficient Market," Journal of Financial Research, Fall 1980, pp. 309-319. This paper tested whether constructing "efficient frontier" portfolios based on past information resulted in superior performance.  The conclusion was that it did not, thus confirming the weak form of the Efficient Market Hypothesis (note the two different uses of the word "efficient").  This also proves the imprudence of blindly using a Mean Variance Optimizer (using historical data as inputs) to construct a portfolio based on past data.

William J. Bernstein, "The Appropriate Use of the Mean Variance Optimizer," Efficient Frontier, January 1998. An excellent discussion of how this tool can be used and (as is more usual) misused.  "Can you use an MVO to help you shape your portfolio? Yes, but you've got to be very careful. An MVO is like a chainsaw. Used appropriately, it is a powerful tool for clearing your backyard. Used inappropriately it will send your local surgeon's kids to college. Same thing with MVOs. Want to wind up in the financial version of intensive care? Just throw in some historical (or even plausible) returns and believe what comes out the other end."  "So, what use is the thing? Well, first and foremost an MVO is a superb teaching tool. Play around with one for a few hours and you will begin to acquire a grasp of the rather counterintuitive way in which real portfolios behave."  "... you have to realize that the chances of your allocation, no matter how skillfully chosen, winding up exactly on the future efficient frontier are zero."

David G. Booth and Eugene F. Fama, "Diversification Returns and Asset Contributions," Financial Analysts Journal, MayJune 1992, pp. 26-32. This paper provides a means for estimating the compound return contribution of a particular asset to a portfolio containing it.  Basically, it suggests subtracting one half of the asset's covariance (with the portfolio) from the asset's arithmetic mean return.  The resulting compound return contribution can then be weighted with those of other assets in the portfolio to obtain the portfolio's compound return.  This takes into account the asset's diversification benefit to the portfolio.

Gregory Curtis, "Modern Portfolio Theory and Quantum Mechanics," Journal of Wealth Management, Fall 2002, pp. 7-13 (536kb). An interesting discussion of the limits of MPT.

Frank J. Fabozzi, Francis Gupta, and Harry M. Markowitz, "The Legacy of Modern Portfolio Theory," Journal of Investing, Fall 2002, pp. 7-20. A good discussion of the impact of MPT.

Paula H. Hogan, "Portfolio Theory Creates New Investment Opportunities," Journal of Financial Planning, January 1994, pp. 35-37. A very basic summary of MPT.

Malcolm Mitchell, "Is MPT the Solution — or the Problem?," Investment Policy, July 2002. A bit long, but this paper is a very readable critique of Modern Portfolio Theory.

John Rekenthaler, "Strategic Asset Allocation: Make Love, Not War," Journal of Financial Planning, September 1999, pp. 32-34. Also here.  This article criticizes blindly following Mean Variance Optimizer (MVO) outputs during strategic asset allocation decision-making.  We agree with the criticism.  MVO is an interesting tool, but the results are extremely sensitive to the inputs.  The inputs are either guesses about the future or facts about the past.  Either way, we know that the data inputs are extremely imperfect predictors of the future, which causes decision-making based on them to be significantly less optimal than may appear to be the case.  Dr Eugene Fama on optimizers: "They're junk.  You're wasting your time with an optimizer, but if you have a lot of time to waste, go ahead."

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