Modern Portfolio Theory, pioneered by Harry Markowitz in 1952, uses past returns and volatility to construct a portfolio that maximizes returns and minimizes risk. The idea is that while individual stocks are volatile, an uncorrelated portfolio of stocks will be much less risky and less volatile. What problems are there with Modern Portfolio Theory? Dr. Data is here to detail some of the problems and provide explanations.
The theory implies that a rational investor will choose the portfolio with the superior combination of risk and reward. Sometimes though “expected” returns are more “desired” returns. Another problem is that things change. International markets were not very correlated to the US market. A table showed how that is no longer true with most markets close to a 0.80 correlation or higher. “The World is Flat”. Correlations rarely remain stable. A 10 year graph of the rolling monthly correlation of the S&P 500 and the Bonds was displayed as an example. The graph showed that this correlation does not remain stable and went from a -1 to a +0.5 over the years. During normal environments the correlation of many equities with the S&P 500 is positive but varied. When the market makes a large down move and Implied Volatility (IV) increases that correlation becomes much higher.
The over-reliance on Beta (Beta is the concept behind beta weighting) was the final point Mike made. Beta measures how much a stock would move in relation to the move of some index, usually the S&P 500. Stocks with a Beta above 1 are considered more risky and those under 1 less risky. Mike demonstrated how useless Beta is without the context of correlation. Beta by itself can paint a false picture. The example of Viacom with a Beta of 1.4 but a correlation of only 0.4 made his point.
Watch this segment of the “Skinny on Options Data Science” with Tom Sosnoff, Tony Battista and Dr. Data (Michael Rechenthin, Ph.D) for a fascinating look into Modern Portfolio Theory and the weaknesses in it.
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