Stop Maximizing Your Returns Using Modern Portfolio Theory
Money For the Rest of Us
J. David Stein
4.5 • 1.4K Ratings
🗓️ 7 November 2018
⏱️ 32 minutes
🧾️ Download transcript
Summary
#229 Why modern portfolio theory is a defective way to build out an investment portfolio. This episode explains a better approach to asset allocation.
For show notes and more information on this episode click here.
- [0:11] What is modern portfolio theory?
- [4:29] There are many downfalls to relying on this theory while investing
- [7:05] We should prepare for the worst possible outcome when investing, not the average positive outcome
- [14:08] The true goal of investing should be about “minimizing your maximum regret in the meta-game”
- [18:34] There isn’t the best “right answer” with your portfolio
- [25:15] Maximization of anything doesn’t work in today’s environment
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Transcript
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| 0:00.0 | Welcome to Money for the rest of us. This is a personal finance show on money, how it works, how to invest it and how to live without worrying about it. |
| 0:10.0 | And we host David Stein today as episode 229. It's titled Stop Maximizing |
| 0:17.8 | your portfolio and your life. As you know, used to be an institutional investment advisors. I |
| 0:27.2 | was that for what 17 years or so. I worked mostly with not-for-profits at a number of college endowment clients, |
| 0:39.3 | and when they would hire me and my firm, we would produce an asset allocation study using Modern Portfolio Theory. |
| 0:51.2 | Modern Portfolio Theory is a theory developed by Harry Markowitz. Back, really it started in the |
| 0:59.6 | early 1950s and he eventually won Nobel Prize for his efforts and the idea to what you need to do an |
| 1:11.8 | asset allocation study with modern portfolio theory is you need an estimate of the return for different asset classes, be it stocks, bonds, real estate, and others. |
| 1:24.5 | You also need an estimate for volatility, which is how modern portfolio theory measures risk. Risk. Risk is the ups and the downs. How a portfolio differs in terms |
| 1:39.3 | of its average expected return. An asset class such as stocks that can have large |
| 1:44.8 | deviations from its expected return is more volatile and hence more risky. |
| 1:50.2 | Asset classes that are more risky are more likely have a greater likelihood of suffering |
| 1:57.0 | a loss. So you need an estimate of volatility for each asset type, and then you need something called correlation. How to do |
| 2:06.2 | different assets move together. Do they move in lockstep? In which case it would be |
| 2:12.0 | perfectly correlated, or perhaps one is more volatile, so moves |
| 2:16.8 | up a lot while the other maybe moves in the opposite direction or it just doesn't go up as |
| 2:21.5 | much. So you kind of need that correlation. So with those |
| 2:26.2 | inputs there are optimization models and what the model does is it will generate a series of portfolios that maximizes the return |
| 2:39.8 | for a given level of volatility and there's a line a plot of each of those |
| 2:49.1 | portfolios which is called an efficient frontier. |
| 2:52.8 | So for a given level of volatility, |
| 2:55.8 | you maximize the return. |
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