SmartETF

Relative Returns By Equity Asset Class

Thank you for sharing; always nice to see performance from a multiple time-frame perspective!

A Practical Demonstration of the Value of Portfolio Theory

Good effort but you are still trying to squeeze blood from a turnip. You have made assumptions about asset allocation that are very outdated. Have you every wondered why: 1) you don’t see outliers (black swans) in your models; 2) your models aren’t able to respond to current market conditions, or 3) your Monte-Carlo models are ineffectiveness at avoiding major sell-offs (thus being down so much in the time frame you examine)?

First and foremost is you are assuming a normal distribution in your analysis. Sharpe and Mandelbrot rebuke normal (arithmetic) distributions in favor of stable (logarithmic) distributions. In a normal distribution the odds of a 5σ (std. Dev.) event is one in 7000 years when in reality its one in every 3-4 years (as seen in a stable distribution). Any model using a normal distribution is blind to the real world and the results are merely academic.

The second major flaw is your attachment to Mean Variance Optimization (MVO). Who cares what the recommended asset mix is when its averaged over a long historical time frame. You can be in a bullish of bearish state for 20 years. To assume MVO works is akin to assuming a broken clock works because it properly tells time twice a day. Add three months of new data to an MVO model and tell me if it changes your recommended allocation. It doesn’t because what can 3 months of data do to a model when averaged with decades of information? Had you elected to use the works of more recent Noble laureates (not those from the 1950’s) you would come across the GARCH models (awarded in 2002). MVO is to the Farmer’s Almanac as GARCH is the Doppler radar.

The final obvious flaw is using Monte-Carlo in conjunction with MVO. What good is it when it relies on long-term data that has been averaged over time? Try using M-C simulations on Stable Student-t distributions combined with GARCH and you would find yourself at the start of this year in 50% 1-3 year Treasuries and other risk adverse securities after enjoying a banner 2006 & 2007. The worse thing to happen is that ‘old schoolers’ will call you a market-timer as you laugh your way to the bank.

I suggest you read ‘The (Mis) Behavior of Markets” by Benoit Mandelbrot to get you out of the 50’s and upgrade yourself to the 21st century.