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Modern Portfolio Theory | Beta Baloney | Monte Carlo Analysis

Efficient Frontier Analysis.mp3

Of all of the so-called modern investment tools, Efficient Frontier Analysis software is certainly the most evil because the person who would use it and should know better cannot possibly know or understand the nature, the value, the seriousness, and the importance of investment advising and investing.

The Efficient Frontier Analysis story, though compelling, is absurd because the basis for Efficient Frontier Analysis and the proposed course of action it generates has absolutely nothing to do with the variables that determine investing outcomes.

Worst of all, innocent, unsuspecting investors who have worked hard to accumulate capital respond to it and depend on it.

Efficient Frontier Analysis

The Efficient Frontier is the line on a risk-reward graph comprised of all efficient investment portfolios; portfolios that provide the greatest expected return for a given level of risk or, for any expected return, the ones that will have the least volatility. 

Efficient Frontier

All portfolios on the vertical dotted line above have the same risk. Of all the portfolios for a specific level of risk, such as the portfolio represented by the blue square at the intercept of the vertical and horizontal dotted blue lines, offers the greatest expected return for that level of investment risk; therefore, all portfolios for that level of investment risk that are below the blue square must be changed to the most efficient portfolio; the blue square, the Optimum Portfolio.

Wow, that was easy! So that is all there is to investing?

The portfolio points on the illustration are determined by three factors while most often using historical information:

• Expected Returns: The expected or average rate of return of an investment.

....Based on past performance.

• Volatility: The degree of random variability.
  
  
  • An investment that fluctuates widely over time has high volatility.
    
    
  • An investment that tends to be stable in price over time has low volatility. 

 

....Based on past performance.

• Correlation: The extent to which two investments tend to track one another.
  

• Stock prices and bonds tend to go in the opposite direction. They are negatively correlated.
  
  

• Auto parts stocks and auto stocks tend to go up and down together. They are positively correlated. 
  
  

• Reduce risk and the possibility for return of a portfolio by investing in negatively correlated investments; both stocks and bonds.
  
  

• Increase risk and the possibility for investment return by investing in positively correlated investments; auto parts and autos.

 

....Based on past performance.

Yet, plastered on every investing document in the world the words, 'Past performance is not an indicator of future investment results,' which, as anyone who has spent more than a nanosecond in the financial markets would know, should know to be absolutely true.

This poorly misguided and misleading aspect of Modern Investment Theory has occurred because Ph.D.s have applied the science and certainty of mathematics to the artistry and chaos of the financial markets:

• The development of Efficient Frontier analysis is based on easy to obtain historical data and not the hard to determine data; what the economy/company will do in the future data.

• Its value for making future investment recommendations depends on the incorrect assumption that the investment past will probably repeat itself with the same order, level, frequency, and duration in the investment future as it did in the investment past. However, as with any predictive analysis there must be an underlying order and connection of the associated variables (not necessarily completely understood) in order for known behaviors, levels, or results of some variables to be used to predict future behaviors, levels, or results of the unknown variables in any type of analysis.
  
  
• The investment past is not connected to the investment future other than coincidentally.

• Efficient Frontier Analysis does not, cannot by definition and program design, answer the critical investment question of which investments will be on the Efficient Frontier in the future!

Efficient Frontier analysis is used because it has spawned new avenues to justify portfolio change without justification, it is easy to compile and present, it does not require an instant of investment insight or forethought, and, most of all, the presenter can scare the wits out of an investor to convince him/her to change from portfolio B to portfolio A based solely on the relative positions of dots on "yesterday's" Efficient Frontier illustration:

I can hear it now...

My investment advisor said that the investments he is recommending did well in the past (he said that's why she picked them) and so they should do well for us in the future — I'm not sure if he said effervescent or efficient frontier?

In any event, when we review our account with him, if updated, Efficient Frontier Analysis historical investment performance data indicates that we might do better if we were to sell our current investments that were selected based on an earlier Efficient Frontier Analysis, we will have several options:

As much as one may wish to invest based upon compelling Efficient Frontier analysis illustrations, investment results will be based on the future, not the past, and your present understanding of it!