Portfolio Theory is Dead, Now What?

Earlier this month, Quantivity ran a post that compiled a large list of studies refuting key components of modern portfolio theory. It is a decent resource for anyone academically-oriented:

Readers often ask what Quantivity thinks of long-term quantitative strategies, and thus corresponding relevance of modern portfolio theory and asset allocation (strategic and tactical). In short, Quantivity is not a fan.

That said, holistic understanding of how and why these theories are wrong is insightful and relevant for both short- and long-term quantitative strategies. This perspective is informed by standard institutional and retail portfolio management as exemplified by Grinold and Kahn and Faber, along with academic background in both economics and finance.

Despite intellectual tradition, the mountain of contrary evidence is simply too overwhelming:

  • Decades of counterexamples to CAPM
  • Increasing cross-asset correlations worldwide, dramatically reducing diversification efficacy
  • Two market bubbles, amply validating behavioral finance to those working in tech and finance
  • Quantification across many marketplaces, rapidly accelerating since 2007
  • Rise of “volatility” as a proposed asset class, going back to Derman in 2003

Even Kahn was moved to comment last year in Quantitative Equity Investing: Out of Style?

All these speak to arguably the fundamental conjecture of financial economics: accepting incremental “risk” demands compensation by commensurately higher return. Or, in jargon: the risk premium is non-negative and increasing. This conjecture underlies justification for mean-variance optimization, diversification, benchmarking, index investing, and thus much of modern retail investing.

Yet, evidence strongly indicates this conjecture is false.

Read the full article here.

Talk to Frank about Modern Portfolio Theory