Modern Portfolio Theory and investing in 10 shares

[Brendan Burgess]

<!--EZCODE ITALIC START--> Originally posted by Darag as part of another thread<!--EZCODE ITALIC END-->

About a year ago I came across this site and found it
educational to say the least.

It opened my eyes to the importance of having an
active and selfish interest in your personal finance.
More importantly I learned how ignorant I was and have
made an effort to educate myself on the general
subject of finance and investment. I now actually
believe this stuff should be taught in school such is
its importance for an individual's general wellbeing.

More recently, in the last few months, I've started to
study the subject a bit more seriously by reading some
of the classic works such as Ibbotson and Brinson's
"Global Investing", Malkiel's "A Random Walk Down Wall
Street" and Graham and Dodd's "Security Analysis".
These are all a bit heavy - as an introduction I'd
recommend the online book
www.fee-only-advisor.com/.../index.cfm

One thing that strikes me is that Brendan's advice to
invest in 10 big Irish shares would be considered to
be very poor advice by most investment experts. I
recall some heated discussion on this in some topic in
the past and I believe that the guide should be
changed to reflect the fact that this advice is
considered controversial. Current state of the art
investment theory seems to be based on Modern
Portfolio Theory and from what I know this advice
would be considered overly risky for the expected
return; in other words by selecting a better
portfolio, an individual can achieve an equal return
with less risk (or a higher return with equal risk).
Since I haven't heard MPT (Modern Portfolio Theory)
mentioned here before, I suggest people start reading
the above online book as an introduction.

 

[Brendan Burgess]

Hi Darag

I am currently rewriting the Chapters on Why you should invest in the stockmarket and How to invest in the Stockmarket. The revisions will reflect the discussions on Askaboutmoney. That was a major point of publishing the book online - to get comments and alternative views.

<!--EZCODE BOLD START--> Modern Portfolio Theory<!--EZCODE BOLD END-->
I was really impressed with MPT when I first came across it about 10 years ago. The maths was nice. It was comforting to be able to measure risk. Wasn't it just wonderful to be able to get the same level of return for less risk?

But the great flaw of MPT is that risk is not the volatility of a share or market over a one year time period, unless you are investing all your money in the stockmarket today with a view to withdrawing it in 12 months' time.

Have a read of Buffett on MPT. He completely ridicules it.

Brendan

 

[tyoung]

Risk/Volatility

This probably belongs on the "Letting of Steam" board but I find it really bothersome when some academic/ professional patronises us with this risk/volatility thing.
It's really easy to look at a 10 year chart of a stock or
index and say (with the benefit of hindsight) that it wasn't risky -it was just volatile. That's not much help in the here and now. I bet there were many Japanese investors who took comfort in the market's volastility as they doubled up in their market's great slide.
How about Elan? Was it risky to buy it at 80 euros or it just be volatile? Or how about the Nasdaq? Was it risky to buy when it was at 5000 or is this just a prolonged bout of volatility?
It"s just another example of how hindsight can make investing look deceptively easy.

 

[Bearish]

Risk

tyoung,

unfortunately this risk/volatility thing is important for 99.9% of investors. The problem with risk is there are so many different measures of what constitutes risk. On top of that, risk is personal, some people are willing to take on more than others irrespective of the projected return. However risk plays a huge role in the financial markets and you ignore it at your peril.

Darag,

while I think is good that you are reviewing MPT, it has a lot of faults, namely its assumption of a normal distribution curve and its focus on total volatility rather than just downside volatility. Unfortunately most fund managers worship the theory as its the main theory thought in any security analysis class.

Finally, I think it foolish for any investor to ignore market psychology. Its easy to be an objective academic when looking at investment strategies, but when your job's on the line as an investment manager's is, everytime he/she puts in a bad performance following the herd rather than going it alone can look awfully attractive.