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Modern Portfolio Theory

In the 1950s economists started trying to build a science of market investing. Their efforts, known as Modern Portfolio Theory, have been based from the beginning on a bell curve model of market volatility, which as we've been seeing is a passable approximation to reality for long-term results, but a terrible description of the short-term. Consequently, MPT advocates with a long-term mindset have been real friends to investors, inspiring great products (low fee index funds) and providing sound advice (diversify, don't try to time the market).

But the short-term mindset has been associated with some spectacular failures, and these have seemed to follow a general pattern:

  1. You start with a (wrong) random-normal model of market volatility, that makes you believe that short-term price movements can't get very big;

  2. You amplify the error with risky trading behavior (for example involving hair-trigger automated selling systems, or huge amounts of borrowed money);

  3. You believe that it's mathematically impossible for your model to fail, so you put yourself in a position where you'd get hurt if it ever did fail;

  4. Reality disobeys your theory, your model fails, and you get hurt.

If you're influential you can spread the "hurt" far and wide. This is what happened with portfolio insurance in 1987 and Long Term Capital Management in 1998. (In 1987 automated selling programs helped precipitate the worst crash in history; in 1998 damage was contained in part by quick action by Alan Greenspan, who once said "A surprising problem is that a number of economists are not able to distinguish between the economic models we construct and the real world").

Watching geniuses fail can be a great learning opportunity for the rest of us. In this case it's an old lesson: the nature of market volatility makes it inappropriate as a short-term investment, no matter how smart you are or what you try to do. You should expect the unexpected; and never put yourself in a position where you can be badly harmed by any short-term thing the market might possibly (not "probably") do, because sooner or later it definitely (not "probably") will.

 

Value at Risk

One of the factors leading to the financial collapse in 2008 was investment firms misusing a random-normal model called VaR (for Value at Risk). It had the usual fatal flaw of ignoring the chance of catastrophic failure. What made things "different this time" is that many of the people using the model seemed to be aware of the flaw, but used the model anyway, and even misused it as a risk concealer rather than risk insurance. The attitude is like a developer building houses on top of an earthquake fault: there's money to be made in ignoring risk, at least for a little while.

 

Article Contents
Market Abnormality
Significant Outliers
Ups and Downs
Long Term Risk
Momentum & Reversion
Crashes & Recoveries
Retirement Planning
MPT, VaR
Skill vs. Luck
Books & Links

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