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James Montier Debunks Traditional Asset Allocation Theory
James Montier's latest white paper on the flaws of modern portfolio theory in general, and traditional asset allocation in particular, is a must read for anyone who manages even one dollar of capital in our increasingly manipulated, centrally planned and inefficient capital markets.
I Want to Break Free, or, Strategic Asset Allocation ≠ Static Asset Allocation
h/t Stefan
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The 'prudent investor' theory cannot explain what has transpired in the last 18 months. Ergo, there were no 'prudent investors' involved.
(other than taking the other side, and that was a bruised and battered lot until a couple of weeks ago)
Lots of wisdom here. Heck, I've seen (very good actually) long term value equity managers hugging their Bloombergs and spitting out second-by-second performance: "We're 2 bps behind!...now we're 1 bp ahead!" The disease is pervasive.
Even when the stock market was showing 11% annualized returns ince the 30's there were huge swaths of time where it was flat to down...I guess part of modern portfolio theory includes being born at the right time too.
More support for Taleb's strategy: sock away most (90%, 95% or more) of your portfolio into whatever the safest store of value is and then place bets on low likelihood/high impact outcomes with the other, very small percentage.
I agree. No one should ever lose money on their investment. EVER.
If you lie down with anyone, you become like they are.
Great piece.
What strikes me as odd in the 'official' investing world is that the concept of bull and bear markets seems to be non-existent.
Detrended stock prices display a more or less sinusoidal distribution of prices. Consequently, they have a U-shaped probability density curve rather than a bell curve. But MPT, and even the classical Black & Scholes option pricing formula, assume a normal probability curve. John Ehler's has a good paper on this. Yves Smith also discusses weaknesses of MPT in her book "Econned" though she did not appear to know about the U shaped PDF of stock prices in that book.
More generally, although CDOs were seen as a way of eliminating risk and therefore permitting higher valuations of essentially junk (the mezzanine tranches), they did not take into account systemic risk. The meltdown that occured was due to a phenomenon known as phase-locking. Stephan Strogatz in his book on differential equations has a good discussion of this. He looks at how the random signaling of fireflies in SE Asia gradually falls into a synchronized pulsing pattern.
The luncheaters (Dmitri Orlov's term for the CEOs) of the major financial firms were undoubtedly not familiar with these ideas. Not to worry, it is well-established in the business world that executive skills are the same whether you are running a sausage stuffing enterprise or Merrill Lynch.
Escapeclaws:
Brilliant! A breath of fresh air.
Economic academia ( Example Merton and Scholes with their Nobel prize) led the economic community down a garden path with the assumption that standard statistics could be used to model financial risk.
Setting up a Chemical Engineering curriculum I ask a professor why a statistics was not included in the math offerings. A counselor (who might have been H.C. Van Ness while at Purdue ~1954) said something like ~”A coin flipped has no memory”. Or perhaps it was about the roll of a die. I got the message that statistics was a “soft” science; that there was only time in the curriculum for coverage of the physically determinant math.
Much later in life I was in a situation where reliability analysis was very important in projecting engine component failure rates (warranty). Standard statistics works perfectly; never wrong, when correctly used. But humans are communicating, rememberiing animals who modify their tendencies. Standard statistics cannot be reliabily use to predict decision making processes.
Thank you for the post.
That “U” shape distribution also applies to on-off controllers with a high-low setting
Escape,
Interesting! Glad to find another Strogatz reader. His book "Nonlinear Dynamics and Chaos: With Applications to Physics, Biology, Chemestry and Engineering" is a fine read-- I have been wanting to apply some of the material he discusses to finance.
I am curious about your reference to the U-shaped PDF... Any particular texts discuss with more detail?
This is what I'm talking about.
Every asshole investment adviser follows this "efficient market/modern portfolio" bullshit like its gospel. (Trust me. I've been one for 20 years.) Braindead fuckers.
All of it assumes that tomorrow will be just like today, which is nonsense. Every industry disclaimer touts that "past performance is no indicator of future results", but all the lazy SOB "advisors" confidently lead their clients off the cliff by pretending that past performance IS some type of indicator. Obviously, too, the term "efficient market" has become an oxymoron like jumbo shrimp or government assistance.
If you're going to protect your clients, and maybe even make them a little bit of money, throw all of this traditional shit out the window and think for yourself. Use your brain. Observe what's happening and act on your own conclusions.
I like that!
In other words, "Past trends are irrelevant, but, hey, look at these graphs which show how much money we can make based on past performance!". Sometimes the obvious is revelatory.
Well, no. That's wrong. Past performance does tell you a lot about future results. It doesn't tell you exactly what the returns will be for any asset class, but it does help you set probabilities and probability boundaries on the future behavior of the market.
"Past performance is no indicator of future results" is a disclaimer, nothing more.
It really should be "past performance can tell you a lot about future results, but it's highly unlikely that this fund manager is capable of interpreting it correctly."
Saying that it doesn't tell you anything about future results is like saying the markets are random, when we all know well that they are only partially so.
"Performance" is bullshit. Lots of jokers have great "Performance" for 3 years, even 5 years - then Bom Blow UP - All Gone!!
So how to judge a manager? Only way is by knowing the individual, the philosophy and process. has to match your own philosophy. Hmmm- then WHY not do it yourself. I mean - its hard work and still imperfect and risk prone to find a professional manager who shares your philosophy , risk profile , time horizon and general comfrt level with an investment approach. The best person to invest on that basis is YOU!!
No need for professional managers - No need to pay them fees.
"The QWERTY keyboard was designed specifically to slow typists down. Letters that frequently occured close together in words were space irregularly on the keyboard, causing the typist to pause, thus reducing the likelihood of jamming hammers" Bullocks. That erroneous statement made me stop reading the paper right there. The QWERTY layout itself reduced typebar entanglement. There was no need to slow down the typist since the keys themselves were layed out in a way that would reduce the probability of typebar wedging.
A very smart move. You judged the paper based on the only thing that was not related to the subject. Trust me (and all the others) read the rest. It is very good. Why would you care about a couple of lines on the QWERTY...smart is possibly to much to ask?
Erronious assertion due to lack of research on a known topic might indicate a shallow research on the whole. But, IMO, the author could skip the QWERTY bit and say "We hold these truth's to be self evident."
It appears you are right about the keyboard.
http://home.earthlink.net/~dcrehr/whyqwert.html
However, I don't see how that one problem (a common misconception) caused you to discount the entire post. To each his own, as they say.
The QUERTY keyboard is actually optimal, at least for the the vi and Vim text editors used in software development. The design of these editors locates the more common single-keystroke commands along the QUERTY finger row. The most common commands are concentrated on keys under the right hand on that row. As a heavy user of Vim, I say keep QUERTY QUERTY !
The simple fact is that when the debt bubble began to deflate, it didn't matter where your money was. Even the safest bet, money markets, damn near imploded and had to have a massive government backstop to stay afloat.
Asset allocation, or the pie chart with magical properties. To diversify risk (not really) by reducing returns (increase in costs, fees). A plausible use of diversification (only on the surface). A sophisticated con? Yes, a way to take cream off the top between corporate america and wall street. The new fashionable wave of retirement theft.
Asset allocation, a somewhat plausible scam perpetrated on the uneducated 401(k) investor to line the pockets of mutual fund managers and financial firms. The goal, maximize fee income. Benefits to the customer, who cares, just as long as money under management is maintained.
Financial people who have been in the business for a while can describe much of this activity as a way to inflict fees. The justification takes several forms, and is largly based on historical trends in indexes or sectors. However, the results do not justify the costs.
But, really for the small investor, this is all they can afford anyway. Right!
Got ya, the mental justification, welcome to the world of financial advise.
Its much easier to produce a portfolio based on diversifying risk (less return), than one that targets specific companies in different sectors based on business performance or intrinsic value. The former is statistics based and you can defend your position based on historical trends, which by their very nature, provide justification no matter what happens and is usually reinforced by movement of the herd. So it is relatively safe when you tell clients they have just lost money, and surprisingly they let it ride. But, this is not really investment money management. Especially in terms of goals. Because if retirement is the goal you maust have a return, and in the last decade performance does not justify being long. It is in being selective.
Mark Beck
"so how should we measure you", its a simple question and with a complicated answer, and using benchmarks is a easy way out. However, an alternative can be suggested, wherein the primary goal is preservation of wealth (created over time) and not just preservation of capital. What do we mean by this - wealth preservation in simple terms is the maintaining purchasing power of said wealth, using appropriate asset allocation. If an asset manager can guarantee an annuity stream with an assured purchasing power in today's $$, it would more than suffice than meaning less indexing, as this is a relative method which is a tool most if not all fund managers use to hide their own ineptitude. -IB
long on explanation...short on how to manage the cycles. For instance, what about value traps? Also is there not a new school of thought that argues investment trends, which used to work in 7 year cycles, are being compressed by technology and modern trading techniques.
I'm wondering if derivatives and cds have altered the fixed income world. Similarly, have ETF's made stocks obsolete?
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