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Old 08-04-2008, 10:23 PM   #31
pelagius
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I am not arguing against "modern portfolio theory". I am saying it is one discipline that can be followed, but not necessarily "the" discipline to be followed.
Under certain conditions I might possibly agree with this but before this advice becomes credible one needs to show an actual problem with portfolio theory (and not some over-stylized version of portfolio theory). Of course, you haven't even shown a problem with the overstylized version of portfolio either (you just said you thought it was diversification on steriods which may or may not be a problem).

There are problems with portfolio theory, but nobody has brought any of them up in this discussion.

Last edited by pelagius; 08-04-2008 at 10:33 PM.
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Old 08-04-2008, 10:35 PM   #32
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There are problems with portfolio theory, but nobody has brought any of them up in this discussion.
Well don't be coy, what are they?
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Old 08-04-2008, 10:44 PM   #33
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Well don't be coy, what are they?
I will highlight one.

The strongest assumption of stylized portfolio theory is that an investor knows the expected returns, variances, and covariances of the securities she is invests in. However, this is far from the truth. Estimating these things using historical data is very difficult and imprecise (expected returns more so than covarances). A non-stylized version would incorporate this source of uncertainty. One implication of this uncertainty is that you won't have precise weights as an implication and a range of weights on different securities are all potentially optimal given an investor preferences and parameter uncertainty. This is one reason why BYU71's statements are entirely consistent as opposed to inconsistent with portfolio theory (on the other hand I can write down a form of portfolio theory that was consistent with BYU71s statement and relied on parameter certainty).

The other option is to move beyond portfolio theory to equilibrium models such as the CAPM or APT type models. This is essentially what Jay has done. You get precise implications and solve the estimation issue in terms of portfolio holdings but at the expense of stronger assumptions.

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Old 08-04-2008, 10:52 PM   #34
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I will highlight one.

The strongest assumption of stylized portfolio theory is that an investor knows the expected returns, variances, and covariances of the securities she is invests in. However, this is far from the truth. Estimating these things using historical data is very difficult and imprecise (expected returns more so than covarances). A non-stylized version would incorporate this source of uncertainty. One implication of this uncertainty is that you won't have precise weights as an implication and a range of weights on different securities are all potentially optimal given an investor preferences and parameter uncertainty. This is one reason why BYU71's statements are entirely consistent as opposed to inconsistent with portfolio theory (on the other hand I can write down a form of portfolio theory that was consistent with BYU71s statement and relied on parameter certainty).

The other option is to move beyond portfolio theory to equilibrium models such as the CAPM or APT type models. This is essentially what Jay has done. You get precise implications and solve the estimation issue in terms of portfolio holdings but at the expense of stronger assumptions.
Thanks for that. On further review, I guess coy works for me.
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Old 08-05-2008, 01:24 AM   #35
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Thanks for that. On further review, I guess coy works for me.
I don't won't to be too hard on people but I guess I would also emphasize that what most people call portfolio theory really isn't. Its stuff that builds on top of portfolio theory.

Really, the primary implication of portfolio theory is that optimal portfolios can be described as follows: an optimal portfolio has the highest expected return given the desired standard deviation of an investor. If someone believes that the risk of their portfolio is captured by standard deviation then portfolio theory is the right framework (yes, one can argue that standard deviation is not a good measure of risk and that is another potential shortcoming of portfolio theory). Portfolio theory provides a framework for thinking about what optimal portfolios look like. An optimal portfolio doesn't necessarily have 1000s of securities in it (although under certain assumptions it always does). An optimal portfolio can have only one stock in it.

Warren Buffet, for example, often says he doesn't follow the implications of portfolio theory. This is true in the sense that he doesn't follow the implications of portfolio theory as often presented to undergraduate students or MBAs. However, I have seen nothing from Buffet that is inconsistent with the idea that he his creating a portfolio that for a given level of standard deviation has the highest expected return possible. He just believes that the expected returns, variances, and covariances that he observes are different than and superior to other people's estimates (note, this implies that his optimal portfolio may look very different than mine even if we have the same preferences for risk and both may be consistent with portfolio theory). Portfolio theory allows for such differences (complete agreement and market efficiency are imposed in models like the CAPM that build on portfolio theory). Buffet's portfolio may be optimal or statistically indistinguishable from optimal (in the full sense of modern portfolio theory) given his estimates and taking into account parameter uncertainty, transaction costs, price impact, etc.

P.S.

These issues aside I generally think that Jay gives pretty good advice when it comes to portfolio allocation ... he may not always be diplomatic ... but his advice is pretty sensible.

Last edited by pelagius; 08-05-2008 at 03:59 AM.
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Old 08-05-2008, 02:07 PM   #36
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I don't won't to be too hard on people but I guess I would also emphasize that what most people call portfolio theory really isn't. Its stuff that builds on top of portfolio theory.

Really, the primary implication of portfolio theory is that optimal portfolios can be described as follows: an optimal portfolio has the highest expected return given the desired standard deviation of an investor. If someone believes that the risk of their portfolio is captured by standard deviation then portfolio theory is the right framework (yes, one can argue that standard deviation is not a good measure of risk and that is another potential shortcoming of portfolio theory). Portfolio theory provides a framework for thinking about what optimal portfolios look like. An optimal portfolio doesn't necessarily have 1000s of securities in it (although under certain assumptions it always does). An optimal portfolio can have only one stock in it.

Warren Buffet, for example, often says he doesn't follow the implications of portfolio theory. This is true in the sense that he doesn't follow the implications of portfolio theory as often presented to undergraduate students or MBAs. However, I have seen nothing from Buffet that is inconsistent with the idea that he his creating a portfolio that for a given level of standard deviation has the highest expected return possible. He just believes that the expected returns, variances, and covariances that he observes are different than and superior to other people's estimates (note, this implies that his optimal portfolio may look very different than mine even if we have the same preferences for risk and both may be consistent with portfolio theory). Portfolio theory allows for such differences (complete agreement and market efficiency are imposed in models like the CAPM that build on portfolio theory). Buffet's portfolio may be optimal or statistically indistinguishable from optimal (in the full sense of modern portfolio theory) given his estimates and taking into account parameter uncertainty, transaction costs, price impact, etc.

P.S.

These issues aside I generally think that Jay gives pretty good advice when it comes to portfolio allocation ... he may not always be diplomatic ... but his advice is pretty sensible.

What would be interesting would be to take Jay's breakdown, 50% domestic, 30% international, 10% RE and commodities and 10% bonds. Take randomly 3 10 year periods and 20 year periods and compare the return to a good equity manager who claims to beat the S&P by 2-3 percent. My guess would be the numbers wouldn't be that much different, especially over the 20 year period.

Either method is fine as long as the results are good. Go through the mental girations and follow the formula or find someone who is getting results and just let them manage the money for a fee.
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Old 08-05-2008, 02:25 PM   #37
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Just for kicks I took the last 10 years and applied the formula.

50% S&P 500 index (2,88%)

30% World International Index (4.65%)

10% Gov't Bond Index (5.70%)

5% Commodity Index (15.5%)

5% Reit Index (10.64%)

Yield for portfolio over last 10 years through June 30th is 4.71%, beats S&P by around 2%



During same period good ole well managed Mutual fund like Growth Fund of America did 9.18%. Take even 2% a year out for fees and net of 7.18% is pretty good.

I am in no way here giving or suggesting anyone make any type of investment in anything. My main point is that Jay's contention that "any" financial advisor who claims to beat the S&P by 2-3% is probably incompetent or dishonest is pure bull crap.

Invest your money in whatever way you feel comfortable whether it be the efficient portfolio or researching for good advisors to do it for you. There is no "only the right way" to do it.

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Old 08-05-2008, 02:25 PM   #38
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What would be interesting would be to take Jay's breakdown, 50% domestic, 30% international, 10% RE and commodities and 10% bonds. Take randomly 3 10 year periods and 20 year periods and compare the return to a good equity manager who claims to beat the S&P by 2-3 percent. My guess would be the numbers wouldn't be that much different, especially over the 20 year period.

Either method is fine as long as the results are good. Go through the mental girations and follow the formula or find someone who is getting results and just let them manage the money for a fee.
We know the answer to this empirically. Its has been looked at extensively in the finance literature. Once we adjust for risk or style, Jay's strategy does a little better on average. A funds past performance has almost no predictive power for future performance (see, for example, Carhart's 1997 Journal of Finance article that examines something very close to this question). Thus ex ante, our best estimate of how funds that performed the best in the past will perform going forward is the following: after controlling for risk they will do little better than a passive allocation before costs and slightly worse after costs.

Second Jay's breakdown, while sensible, is not necessarily an implication of portfolio theory. Its consistent with portfolio theory, but active management can be consistent with portfolio theory. Jay's view essentially adds an assumption called complete agreement and an assumption about market efficiency to get to a portfolio allocation recomendation.

Last edited by pelagius; 08-05-2008 at 02:30 PM.
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Old 08-05-2008, 02:31 PM   #39
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We know the answer to this empirically. Its has been looked at extensively in the finance literature. Once we adjust for risk or style, Jay's strategy does a little better on average. A funds past performance has almost no predictive power for future performance (see, for example, Carhart's 1997 Journal of Finance article that examines something very close to this question). Thus ex ante, our best estimate of how funds that performed the best in the past will perform going forward is the following: after controlling for risk they will do little better than a passive allocation before costs and slightly worse after costs.

Second Jay's breakdown, while sensible, is not necessarily an implication of portfolio theory. Its consistent with portfolio theory, but active management can be consistent with portfolio theory. Jay's view essentially adds an assumption called complete agreement and an assumption about market efficiency to get to portfolio allocation recomendation.

Finance literature probably written by academians (sp). Anyway, it has been a fun discussion. May everyone make a lot of money using their favorite method.
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Old 08-05-2008, 02:44 PM   #40
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Finance literature probably written by academians (sp). Anyway, it has been a fun discussion. May everyone make a lot of money using their favorite method.
Of course, its written by academics. If you think the studies are flawed then bring up problems with the studies. Just stating that they are written by academics is not a criticism. Point out flaws in the empirics.

Second, I have no problem with active management. Its fine ... its not going to make a huge difference on average. On average passive will beat active by a little not a lot and active has more chance for upside (someone may get very lucky and choose funds that happens to do fantastic). Of course, it also has a greater chance of a worse downside relative to the benchmarks since passive by definition is basically the benchmark. In fact in aggregate we can prove passive beats active under the following two assumptions:

(1) Passive in aggregate holds approximately the market portfolio

(2) Active is higher costs then passive

If passive holds the market (which seems to be true empirically in aggregate) then by definition active also must be holding the market in aggregate because by definition passive plus active adds up to the market. If active is higher costs then by definition they must do worse because in aggregate the holding are the same portfolio: the market.

Of course, in any given period some active managers do way better than passive even controlling for risk. I have always agreed with that. However, that really good performance in a given period is not usually a good predictor of future performance.

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