Phil DeMuth_

A Practical Demonstration of the Value of Portfolio Theory

Hi Roger --

Ben does not have a Seeking Alpha site, but his writings can be found all over: he's a regular columnist for Yahoo! Finance and the Sunday New York Times Business Section (available online as well). He's also a regular on "Cavuto on Business" on Fox and "Kudlow & Company" on CNBC.

A Practical Demonstration of the Value of Portfolio Theory

Hi Mark --

Thanks for your comment. The lack of conviction implied by diversification is a strategy for dealing with uncertainty. But even where one has conviction, it can be very useful. Let's say we have a strong conviction that China will dominate global markets in the 21st century. Even so, are we 100% sure? Well...probably not. China is great, but who knows what might go wrong? So let's overweight China but also keep some investments in other things that are going to still be there even if China goes down the drain. Here is where Monte Carlo can help us estimate what to add in what proportion to what plausible effect on our future risks and returns. It's not a time machine but it is as good a tool as we have at present for dealing with this kind of issue.

A Practical Demonstration of the Value of Portfolio Theory

Machine Ghost: Interesting points, thank you.

As to the Forbes 400, why exclude inherited wealth? The wealth came from somewhere; if market timing were the original source, it would be evident, or if market timing were so lucrative, then market timers would have long ago displaced the idle rich layabouts and Daddy Warbucks types still remaining on the list.

Even though people like Buffett and Zell buy low I would not call them "market timers" in the sense that term is ordinarily used. They are really doing long-term market valuation, which I would endorse, and is a skill that can be acquired by will and discipline, to use your words.

I definitely agree that hedge fund managers may use market timing (in nanoseconds, sometimes) to great profit, but these usually are frontrunning (="quantitative") strategies or market-manipulation strategies based on their ability to briefly dominate certain markets with their massive trading firepower. Just my opinion.

Whatever it is that hedge funds might be doing, it is not a strategy that can be appropriated by retail investors or anything that bears much resemblance to the brand of short-swing market timing based on technical analysis or forecasts of macro economic trends (or newsletters doing the same). I would call skill in this domain elusive. This conventional definition of market timing is what I was referring to and what Sharpe criticized. But certainly it has many devotees.

A Practical Demonstration of the Value of Portfolio Theory

Thanks to all who have responded.

Foust: The Swensen portfolio you cite was down 7.4% over the study period, and that with a 30% fixed income buffer. Is there any evidence of Swensen's long-term outperformance of the market using only liquid, publicly-traded securities? I thought these were only a small fraction of the Yale endowment, and that his track record was really based on private equity and hedge funds and illiquid securities that have little to do with the transparent and efficient markets in which the rest of us fish. I do like Swensen's Boglesque stress on low fees and indexing, though.

Big G: If you have the ability to consistently move in and out of markets as they rise and fall then I congratulate you. This skill is elusive, for all the reasons William Sharpe pointed out in his 1975 essay on market timing. As I go down the Forbes 400 list, I cannot find anyone who made his fortune in this manner. I don't know how people possessing this knack could have avoided becoming billionaires.

Mark McHugh: I agree -- anyone who can consistently pick the top-performing asset class in advance is going to outperform a diversified portfolio. Diversification is only valuable to people who can't do this.

Locke: The movie hasn't even edited into its final form; why not hold fire until you see it? I think you have been misinformed as to its content.

Smart ETF: Mandelbrot urges portfolio managers build portfolios using precisely the kind of Monte Carlo simulations we perform here ("The (Mis)Behavior of Markets" p. 267). He confesses of the people trying to apply his methods in finance, "...in truth, our knowledge is still so limited that no one has yet to report great success." (ibid, p. 256). It sounds like your experience is an outlier.

DMB: I think the 1-in-20 calculation of a 10% correction is excellent modeling. The MC-tested portfolios tend to beat market-indexed portfolios with less risk; if you have a better mousetrap then please tell how you do it.