Posts Tagged ‘Modern Portfolio Theory’
Thursday, May 24th, 2012
by Daniel Morillo, PH. D., Head of Investment Research, iShares
As minimum volatility investments gain popularity, clients are asking me if investments that track minimum volatility indexes can be used as a tool to “time” exposure to the equity market during risk-off periods. While it’s an interesting question, I think it overlooks the real benefit of this kind of exposure in an investment portfolio.
To me, the value of a relatively low-risk investment like a minimum volatility portfolio is not its low risk, but how its returns can compare with those of a capitalization-weighted equity portfolio, or a so-called market portfolio. I would argue that a minimum volatility portfolio of equities potentially offers a better way for long-term investors to invest in equities – even if they have no interest in the lower risk that these portfolios provide.
Yes, I know. To many readers, this might seem like a bold statement. After all, according to modern portfolio theory, the market portfolio (aka the cap-weighted equity portfolio) is generally considered to be theoretically “efficient” in that it should provide the best possible trade-off between risk and return.
Let’s look at the traditional “portfolio frontier” chart that can be found in almost every introductory finance textbook.
The chart shows that over the long run, equity markets are expected to reward riskier assets with higher returns. In this case, the market portfolio (the cap-weighted equity portfolio) is expected to provide the highest level of return for its level of risk, while the low risk minimum volatility portfolio should provide commensurately lower returns.
The problem with this picture is that a wide range of empirical studies have found that the market portfolio does not appear to deliver enough additional return to compensate an investor for the additional risk it takes compared with the minimum volatility portfolio.
Let’s look at this modified chart:
This chart shows that, contrary to standard finance theory or assumptions made by many asset allocation tools used by investors, the market has not appeared to appropriately price risk. In academic literature this has been called the “low risk anomaly” – higher risk does not always translate into higher returns. Significant academic work, including our own, has gone into pinpointing explanations for this anomaly, which I will delve deeper into in the next installment of this blog.
For the purpose of today’s blog, however, I’d point out that there is strong empirical data that equity investors should consider minimum volatility as a strategic holding, not just a tactical play. Minimum volatility portfolios can potentially deliver similar returns to those of the cap-weighted equity portfolio but with lower overall risk, in effect providing a possible replacement for the traditional market portfolio in a buy-and-hold strategy.
 See for example, the following references:
Baker, Bradley and Wurgler (2001), “Benchmarks and Limits to Arbitrage,” FAJ, Vol 67, Number 1
Ang, Hodrick, Xing an Zhang (2006), “The Cross-section of Volatility and Expected Returns,” Journal of Finance, Vol 61, Number 1
Clarke, de Silva, Thorley (2006), “Minimum-Variance Portfolios in the U.S. Equity Market,” Journal of Portfolio Management, Vol 33, Number 1
Copyright © iShares
Tags: Bold Statement, Empirical Studies, Gain Popularity, Introductory Finance, Investment Portfolio, Investment Research, Investments, Ishares, Market Portfolio, Modern Portfolio Theory, Nbsp, New Approach, Portfolio Frontier, Portfolios, Risk Investment, Term Investors, Textbook, Time Exposure, Traditional Portfolio, Volatility Indexes
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Thursday, April 12th, 2012
by Rich Weiss
Senior Vice President and Senior Portfolio Manager,
American Century Investments
Weekly Market Update,
In this issue of Weekly Market Update, we present the latest installment in our occasional series on diversification. Here we look at diversification as a tool to help address many classic investor failings identified by the science of behavioral finance.
Earlier, in Diversification 101, we explained the rationale behind diversification and how it can be used as a framework for structuring a portfolio to help manage risk and maximize risk-adjusted performance. We also provided an Introduction to Alternative Investments meant to highlight the broad types of alternative strategies that can be used to diversify a traditional balanced portfolio of stocks and bonds. In future months we’ll address such topics as the state of diversification in a post-Financial Crisis world, and when and what types of diversification strategies make the most sense.
One intriguing aspect of diversification is that it is born of modern portfolio theory, which assumes that the market is composed entirely of dispassionate, rational actors. In practice, however, investor behavior tends to be anything but rational and utility maximizing. This has given rise to an entirely new field of research termed “behavioral finance.”
The tension between efficient market and behavioral finance theorists makes for one of the enduring debates in financial and academic circles. But one thing they can both agree on is the tremendous benefit of diversification for investors—modern portfolio theorists because it creates more “efficient” portfolios; behavioralists because it puts structure around investor decisions and can help reduce the frequency and magnitude of mistakes. “Efficiency” in investing terms is defined as maximizing return for a given level of risk, and that investors can effect change in their portfolios’ risk-and-return profile by adding or subtracting uncorrelated assets to their portfolios.
In this regard, it’s instructive to look at market research firm DALBAR’s 2012 Quantitative Analysis of Investor Behavior. DALBAR devotes a portion of its new report to nine key behavioral errors, highlighting ways in which investors behave irrationally consistently and repeatedly over time. Behavioral finance topics in general, and DALBAR’s report specifically, make for fascinating reading. The biases they highlight influence investor behavior in a number of important ways. Here let’s focus on just one behavior—poorly timed buy and sell decisions—and look at how diversification can help mitigate the negative impact on investor performance over time.
One well known investor sell mistake is to react badly to market events, eliminating equity investments and moving entirely to cash, effectively abandoning their investment strategy. Studies of investor behavior refer to this as the “abandonment rate,” or proportion of investors that simply throw in the towel when equity market volatility becomes too great to stomach. Our own analysis of academic and industry literature suggests that investors are prone to bailing out of portfolios that have incurred one or two years of losses.
To be clear, an appropriately diversified portfolio should carry just enough market risk to achieve an investor’s return objectives—and no more. Investment risk is something that should be measured, managed, and carefully considered up front in an investment plan—not something to react to after the fact, in knee jerk fashion.
Poor Timing, Poor Performance
Similarly, a number of studies indicate that the average equity investor dramatically underperforms the market as a result of poor market timing decisions. Indeed, DALBAR’s data show that in the 20 years ended in December 2011, the average equity investor dramatically underperformed the market (as represented by the S&P 500® Index). This is directly attributable to poor market timing decisions—a pitfall more diversified investors tend to avoid.
Staying the Course
Here is where diversification comes in—based on available research, it turns out that investors in well-diversified asset allocation and target-date portfolios have lower abandonment rates1 and do better2 than those outside of such portfolios. In an analysis of investor behavior in retirement plans in the aftermath of the 2008 Financial Crisis, Morningstar found that those in well-diversified target-date funds “bucked a fund-industry trend in which investors tend to pull their money at market lows and chase investments close to their peaks.”3 Essentially all the research we have seen on this topic supports the conclusion that well-diversified portfolios encourage shareholders to stay the investing course despite the vagaries of the market.
To put a finer point on it, reacting to market volatility by selling in the face of volatility or bad news means that the average investors does not remain “invested for sufficiently long periods to derive the benefits of the investment markets,” according to DALBAR. Further, the report says that:
“The result is that the alpha created by portfolio management is lost to the average investor, who generally abandons investments at inopportune times, often in response to bad news. In 2011, as in years past, [systematically diversified] asset allocation (including target-date funds) fund investors have remained invested in their respective funds longer than equity or fixed-income investors. Investors’ tendency to hold asset allocation funds longer is a strong case for their inclusion in an investor’s portfolio.”
To be clear, we talk here about investor behavior in asset allocation strategies and retirement plans as a proxy for diversified and non-diversified portfolios. We cite these reports because they contain the most recent and objective data on the subject.
Whether you build your own portfolio of uncorrelated assets or choose a professionally managed and diversified asset allocation fund is up to you. The point is not how you get there. After all, your portfolio is likely to be a unique reflection of your own goals, risk tolerance, and other life cycle and financial considerations. The point is simply that effective diversification in the manner discussed in Diversification 101 can mean better risk-adjusted performance; a less volatile return pattern; better cumulative returns over time, other things equal; and lower abandonment rates and greater likelihood of sticking with an established investment plan. We believe that is a strategy worth striving for.
Rebalancing: Sell High, Buy Low
There is another way in which a diversified approach can improve the timing of investor buy and sell decisions, and that’s through the process of portfolio rebalancing. Step back for a second and think about diversification—at a high level, it’s a process of spreading assets within and across asset classes in a way that is likely to maximize your likelihood of sticking to your investment goals and objectives over time. You (or your financial professional) create a well-thought-out strategy weaving together all the aspects of your financial life to create a finely tuned, broadly diversified portfolio.
But as financial markets move—and in recent years they’ve moved around quite a bit—those carefully selected asset weightings and relationships get out of balance with your intended targets. Putting those weightings back in balance is called “rebalancing,” in which you sell winning assets and buy those that have underperformed. Let’s use a real-life example from 2008 to illustrate rebalancing in action. In 2008, stocks plummeted while government-backed bonds enjoyed one of their best years on record. We know from studies of investor behavior during the crisis that many equity-only investors sold stocks and abandoned their savings plan at this point.
Contrast that behavior with a diversified investor (with demonstrated lower abandonment rates and longer holding periods) who stuck with their overall strategy and rebalanced their portfolio at the end of the year. Because stocks performed so poorly relative to other investments, they would now be underrepresented in our diversified portfolio, while bonds would be comparatively overrepresented because they’d done so well. Rebalancing to predetermined weightings would mean you were selling bonds after a historic rally and buying equities after a historic sell-off. The contrast with investor behavior cited in the DALBAR and Morningstar studies could not be more stark. In no uncertain terms, then, systematic rebalancing enforces a disciplined buy-low, sell-high strategy that is central to a sound investment plan.
At American Century Investments, we believe strongly that investors would do well to adhere to a disciplined, diversified, long-term investment approach. Future pieces will address various aspects of diversification, among other topics.
Download a PDF of this post.
1 Equity Abandonment in 2008–2009: Lower Among Balanced Fund Investors. John Ameriks, Ph.D.; Jill Marshall; Liqian Ren, Ph.D. December 2009
2 Burgess + Associates, “Outcomes of Participant Investment Strategies 1997-2006,” Study Commissioned by John Hancock Retirement Plan Services, October 2007.
3 Morningstar Fund Analysts, “Target-Date Investors Stick Around, Earn Better Returns,” Fund Spy, March 16, 2010.
Diversification does not assure a profit nor does it protect against loss of principal.
This information is not intended to serve as investment advice; it is for educational purposes only.
Investment return and principal value of alternative investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Due to the limited focus of alternative investments, they may experience greater volatility than funds with a broader investment strategy. They are not intended to serve as complete investment programs by themselves.
The performance results provided here are hypothetical, and are only used for illustrative purposes.
Hypothetical performance results should not be considered indicative of any actual performance results, or any results that could be attained by clients.
The opinions expressed are those of Rich Weiss and are no guarantee of the future performance of any American Century Investments portfolio.
Tags: Academic Circles, Alternative Investments, American Century, American Century Investments, Balanced Portfolio, Behavioral Finance, Diversification Strategies, Efficient Market, Intriguing Aspect, Investor Behavior, Investor Decisions, Modern Portfolio Theory, Occasional Series, Portfolio Manager, Rational Actors, Rich Weiss, Senior Vice President, Stocks And Bonds, Stocks Bonds, Types Of Diversification
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Wednesday, June 1st, 2011
Robert Arnott recently interviewed Nobel Prize Winner, Harry Markowitz, one of the deans of Modern Portfolio Theory, to answer the question, “Did Diversification Fail?” This first part is followed by 4 additional segments 3-6 minutes in length. Given that Fundamental Indexing has been outperforming Cap Weighted Indexing in recent history, these 5 video segments make for some interesting viewing/listening.
Click here or on the image below to view this video:
In the interview, Markowitz shared these thoughts:
- 2008 was not an outlier year, as it wasn’t the worst year in markets;
- in fact, it was tied for the second worst year.
- 2008 was just short of 2.5x standard deviation move
- moves of 2x SD to the left of the curve (the bad tail risk) should only happen 2.5% of the time
- that’s one year in 40, “I’ve been in the business for 58 years, so I’ve got to expect a one year in forty move once in a while.”
- There ARE daily ‘black swans,’ but so far there haven’t been annual ‘black swans’ [in the U.S., he adds].
- people say, in crises like 2008, all asset classes lose money … therefore diversification has failed [that's not quite true]
- government bonds went up
- corporate bonds went down 5% (net basis)
- the S&P 500 went down 38%
- emerging market equities went down 50%
- therefore, depending on whether you were high up in the efficient frontier in equities, or low and heavy in bonds, you got hit hard or not so hard
- that’s why its so important to pay attention to where you are on the efficient frontier.
This is followed upon by 4 more segments (click on images to view):
The Capital Asset Pricing Model
The Efficient Market Hypothesis
The Fundamental Index Approach
Tags: Asset Classes, Asset Pricing, Black Swans, Capital Asset Pricing Model, Corporate Bonds, Diversification, Efficient Frontier, Efficient Market Hypothesis, Emerging Market, Fundamental Indexing, Government Bonds, Harry Markowitz, Model Length, Modern Portfolio Theory, Nobel Prize Winner, Rob Arnott, Robert Arnott, Standard Deviation, True Government, Video Segments
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Thursday, September 23rd, 2010
WealthTrack’s Connie Mack interviewed MIT’s Andy Lo. Here for your review are the video and transcript. Lo discusses his ‘Adaptive Market Hypothesis‘ which in a nutshell, challenges Modern Portfolio Theory’s ‘Efficient Market Hypothesis.’ Lo contends that markets are not efficient, but rather adaptive.
Click play to watch.
CONSUELO MACK: This week on WealthTrack: fasten your seat belts. Our Financial Thought Leader, alternative investment manager and MIT professor Andrew Lo, says the market’s volatility and uncertainty is here to stay. Strategies for riding the financial roller coaster are next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Do you feel that the financial markets are more unpredictable and arbitrary than ever? Well it is not your imagination! Unless you lived during the Roaring Twenties and the Depression-era thirties, you have never seen anything like it, until now.
Take a look at this chart provided to us by this week’s Financial Thought Leader guest. It shows the historical volatility of a broad-based stock market index from 1926 to the present. Notice the wide and wild swings at the beginning, the twenties and thirties, followed by the relative calm for the decades in between- the historical average of market volatility is 14.5%- and then the astonishing pick up in market volatility during the last couple of years. This week’s guest says “fasten your seatbelts,” the roller coaster ride will continue.
One of the true treats of WealthTrack is our ability to talk to some of the most creative and original thinkers in the investment world. And today’s guest is right up there with the best of them. This week’s Financial Thought Leader is Andrew Lo, PhD economist, professor of finance at the MIT Sloan School of Management, director of MIT’s Laboratory for Financial Engineering, and author of numerous articles and several books, including A Non-Random Walk Down Wall Street . Professor Lo also puts his ideas to work as an investor. He is the founder and chief scientific officer of AlphaSimplex Group, an investment firm whose slogan is “adaptive strategies for evolving markets.” In recent years, the firm has introduced several mutual funds under the name of its parent company Natixis, which are designed to help investors protect themselves in these ever evolving markets by limiting their portfolio risk and volatility. We will provide a link on our website, wealthtrack.com.
I asked Professor Lo to talk about some of the biggest changes he sees in the markets, starting with what he calls internet time.
ANDREW LO: We are living in Internet time now, and I mean that not just as an analogy but literally in the sense that, because of the Internet, information is transmitted at lightning speed, whereas before it would take weeks or months for certain kinds of news to get out. Nowadays it’s reflected almost instantaneously and this has dramatic implications in how financial markets operate and how we react to those kinds of surprises. Over the last two or three years, I think we’ve been on this volatility roller coaster ride where traditional investments that offered relatively traditional kinds of risks are now really unpredictable in the kind of volatility that they provide to investors.
CONSUELO MACK: Such as which kind of investment? Stocks and bonds?
ANDREW LO: Well, yeah, for example, let’s take stocks. You know, the S&P 500 traditionally has had a volatility of around 15% per year. Well, during the fourth quarter of 2008, the volatility reached as high as 85%. At 85% annual volatility, there’s a good chance that an investor can lose all their investment over the course of a few days. I don’t think anybody could withstand that kind of a risk. Fortunately it doesn’t last very long, but for the periods where volatility spikes, it’s tremendously disruptive for investors. And that’s really a relatively new phenomenon.
CONSUELO MACK: So when you say it’s a new phenomenon- now there’s a sentiment on Wall Street, in fact, that the kind of volatility that you just alluded to in 2008, 2009, that that’s over and essentially that we’re back to a normalcy that we’ve had for the last 40 or so years. You’re not sure that’s the case though, right?
ANDREW LO: No, I’m not. I think that it is over until it’s not, and so a good example of this is what happened in the beginning of this year. It looked like we were heading to calmer waters. It looked like the market was recovering. Certainly, last year was a good year for the stock market, and things were going pretty well until April and May, and what happened then was Greece. Now, certainly people knew that Greece had a debt problem even as early as, you know, three or four years ago, but it didn’t become a public problem until April and May. And during that period of time, the market volatility spiked yet again, and so next year it may not be Greece. It may be Spain. It may be Portugal. It may be emerging market debt. It may be gold. It may be something that will cause the public to fly to quality and safety.
CONSUELO MACK: i.e., Treasuries.
ANDREW LO: That’s right.
CONSUELO MACK: Which they’ve been doing.
ANDREW LO: And in fact, Treasuries have been remarkably volatile themselves in terms of the money flowing in and out. In fact, as we know, Treasuries have had negative yield for periods of time over the last couple of years. I mean, negative yield is a remarkable phenomenon. It basically says that I’m willing to lose money over the course of the next three months in order to put my money in U.S. Treasury securities, and that’s a sign that there is genuine fear in the marketplace. When you have this kind of fear, markets are very unpredictable and moreover, the volatility of volatility becomes an important factor.
CONSUELO MACK: Listening to you, I’m getting terrified.
ANDREW LO: I’m sorry.
CONSUELO MACK: Essentially, but here you are. You’re a PhD economist, and you are a behavioral economist as well as a risk management expert. So if uncertainty like that you’ve just described is going to be part of our life for the foreseeable future- correct? Then how do we deal with the risks of uncertainty as individual investors? What can we do to protect ourselves, aside from withdraw from the markets?
Tags: China, Commodities, Connie Mack, Consuelo Mack, Efficient Market Hypothesis, Financial Engineering, Financial Roller Coaster, Historical Volatility, Investment World, Management Director, Market Volatility, Mit Sloan School, Mit Sloan School Of Management, Modern Portfolio Theory, Natural Gas, Professor Andrew, Relative Calm, Roller Coaster Ride, Seat Belts, Sloan School Of Management, Stock Market Index, Thought Leader, Wealthtrack
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Saturday, September 4th, 2010
The legendary investor Sir John Templeton had high praise for Roger Gibson, saying “he guides investment advisors through a logical process for making important asset-allocation decisions.”
Harry Markowitz, who won the Nobel Prize for inventing modern portfolio theory, says Roger’s book, Asset Allocation: Balancing Financial Risk, “presents individual investors and their investment advisors with a balanced, professional view of the investment process.”
Don Phillips, who heads fund research for Morningstar, goes even further, saying Roger is “without a doubt the best and most articulate voice on the subject of asset allocation today.”
You can hear that articulate voice by joining us for a free webcast with Roger Gibson.
Commodities have been gaining acceptance as a permanent asset class, and during the webcast Roger will show you where commodity-linked equities can fit into a portfolio to provide diversification while managing volatility.
The webcast is intended to deliver news you can use, so I hope you will be able to join us on September 9.
Diversification does not protect an investor from market risks and does not assure a profit.
Tags: Asset Allocation Decisions, asset class, Commodities, Diversification, Don Phillips, Eastern Time, Financial Risk, Free Webcast, Harry Markowitz, High Praise, Individual Investors, Investment Advisors, Modern Portfolio Theory, Morningstar, Nobel Prize, Professional View, Roger Gibson, September 9, Sir John Templeton, Volatility
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