dsilisk

There’s Only One Right Way to Build a Portfolio

Bull. This is total bull. This reflects everything wrong with investors: the pseudo-mathematical games of MPT, CAPM, and VAR are a detriment to all investments, as well as a JOKE to people who understand the true math behind probability.

Modern Portfolio Theory, the way portfolio risk/return is caluclated, and Value at Risk, the risk management technique of most investment banks, are both flawed because they rely on mathematical models of probabilty distributions which are not appropriate models of the market. The market correction of March, 2007, should have happened once in 8 billion years, according to their model, but it happened again in august and its happenning again in Jan '08.

Reliance on probability distributions is only appropriate if the higher moments of those distributions are calibrated to reflect actual market performance. however, since higher moment calculation is an advanced mathematical technique, the banks aren't technologically advanced enough to use it. therefore probablistic modeling of stock returns will result in statistics that do not correlate to actual events. other models, such as factor models, catastrophe theory, and moving-average risk calculations are safer, albeit more mathematically complex, tools.

Risk is a moving target. Risk metrics should not be fixed, i.e. risk being determined by historical prices. Risk/reward metrics should be calculated within factor models which determine the correct exogenous variables which determine how much value to place on risk. Catastrophe theory, moving-average composition, and factor models MUST be developed in order to make sense of risk/return in a viable (i.e. mathematically sound) sense.

Stop lying to everyone! Stop telling them this whole "risk/reward" thing works. You finance people call variance volatility, and you call volatility risk. That is like the dog saying "All cats have four legs. I have four legs. Therefore, I am a cat." Flawed logic RULES on Wall St., I guess that is why we are in this whole housing/credit debacle in the first place.

If you want to discuss these ideas further, please do email me at daniel.siliski @ rogue-economics.com. Lets put the real math back in finance.