Behavioral Portfolio Management

I’ve just read one of the best papers on portfolio theory I’ve ever read, “Behavioral Portfolio Management” by C. Thomas Howard, a professor emeritus of finance and the CEO of AthenaInvest. You can download it here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2210032.

What really blew me away was Howard’s discussion of the failures of MPT, why volatility and risk are two entirely different things, and why the popularity of MPT has led to the failure of so many so-called low-risk strategies. “The investment industry has adopted this same volatility as a risk measure that, rather than focusing on the final outcome, focuses on the bumpiness of the ride. A less bumpy ride is thought to be less risky, regardless of the final outcome. This leads to the unintended consequence of building portfolios that result in lower terminal wealth and, surprisingly, higher risk. This happens because the industry mistakenly builds portfolios that minimize short-term volatility relative to long-term returns, placing emotion at the very heart of the long-horizon portfolio construction process. This approach is popular because it legitimizes the emotional reaction of investors to short-term volatility.” He appends to this a great footnote comparing volatility to turbulence and risk to airplane safety.

Thomas later turned this paper into a book, and the reviews of it on amazon.com are very instructive: https://www.amazon.com/Behavioral-Portfolio-Management-Thomas-Howard/dp/0857193570.

This is the only sensible alternative to MPT that I’ve come across. I think MPT is all wrong, both empirically and as a guide to successful investing, but until today I was unable to find an alternative theory of risk, portfolio management, and performance.

I’d be interested in reactions from P123 investors. It strikes me that P123 is an ideal vehicle for people who concur with Howard’s theories.

(I also think P123 should abandon volatility-based performance measures, as they result in bad investment decision-making.)

  • Yuval

Thanks. It looks like a good read and I like the behavioral aspects. From what I see in your comments and the reviews, it makes sense to me.

The use of volatility makes sense to me too, though.
Intuitively, even if one model has performed better than another up to today but with much higher volatility, it may (not will) have a lower probability of hitting my end performance goal over a predetermined length of time into the future. If I had an infinite time horizon, then yes, I would not care about volatility and only care about return. But I will most likely die in 30 years so I do care about how volatile my returns are. I need to know (some of) my money is there. But you are right, putting all of your money in cash makes no sense either (unless its interest rate into the future gives you the targeted return you desire. But we know these days that even cash return can be suspect - so no free ride.)

A higher performance but with higher std dev model may get you to your destination. I need a way to balance the two best I can.

Maybe I am misunderstanding your comments. But that is how I look at it.

But I will read the book. Sounds interesting.

Here’s what really worries me about using volatility as a measurement of anything besides, well, volatility: 1. within a single asset class, there seems to be a low correlation between past and future volatility-adjusted-returns; 2. across asset classes, low-volatility investments produce lower returns and are therefore riskier than high-volatility investments in the long run if you define risk as the probability of not meeting your investment target. Thomas has other objections as well, but those two seem pretty definitive to me.

As P123 users we are guided by empirical evidence. That’s the whole point of this service. And from everything I’ve read, there is no empirical evidence that using volatility-based performance measures has any significant positive effect on anything at all. It certainly doesn’t improve real-world results, and a system’s past Sharpe ratio is probably one of the worst measures of OOS performance–though Sortino may be even worse. If you had invested in the ten ETFs with the highest 2-year Sortino ratios and rebalanced monthly, you would have actually LOST money over the last ten years.

Well, for item 1, my guess is that the Sharp ratio for a portfolio of Defensive sector stocks is rather predictable. Staples sector stocks may be overvalued now and therefore more volatile in the short term but they are still more predictable than the highly volatile Tech sector. Have you seen some data on lack of consistency of volatility for different sectors (for instance). I have not researched it so don’t know. That does not feel right, though. I think that volatility is somewhat consistent over say a 50 yr timeframe…

Yuval:

Having been employed in a variety of capacities with well-known firms in the investment industry since the early '80s, as well as being a partner in a fund and a newsletter publisher, I know first-hand why “the industry… builds portfolios that minimize short-term volatility.” The reason is that they have discovered their clients abandon ship when volatility gets high! Being in the business of making money from the funds that everyday people deposit with them, ‘the industry’ is financially incentivized to keep portfolio volatility low and thereby retain their client’s funds. (Not to mention that pesky fiduciary responsibility.)

Your point is quite valid; risk and volatility are clearly two separate things. Most of the members of p123 are here because they recognize the fact that MPT is generally hogwash. The concept that the market is partially efficient but with regular opportunities created by ubiquitous human behavioral biases is now widely accepted by most academics, professional money managers, and many rogue individual investors like us.

However, as an individual investor there is a big difference between understanding on paper that volatility doesn’t matter in the long run – and actually watching your brokerage account shrink by half or more in a matter of months. Will you still be determined to steadfastly hold to your new ‘to hell with volatility’ investing principle when your account is bleeding red, you’ve lost more than half, and the media is calling for the end of civilization as we know it (as was the case in late-2008)?

The fact is that 99% of investors don’t have the temperament or conviction to stay with their (or someone else’s) program through much more than a -15% drawdown. When the market gets wild and hairy (as is likely coming very soon), will you stay with your losers when your portfolio system says you should? Or will you second guess it and pull the plug?

That is the question that separates a Buffett from the rest of humanity. Just sayin…

/Chris

Great point Chris. Even building my own portfolio just for myself I have to know that I will stick with it. A Man’s got to know his limitations.

Yuval. That having been said I think you are right. I will read the paper and the book (I haven’t yet). But I believe a good return is the most important mitigator of risk.

For those starting out I would recommend starting with a pretty large number of ports. Once you are ahead of your benchmark and have good out-of-sample results you can narrow the number of ports according to your risk tolerance and your confidence in the better performing ports. This also means getting rid of the ports that are just too volatile.

The house money bias will allow you to tolerate a little higher volatility. People that have won money gambling will take (tolerate) more risk with the house’s money.

Don’t expect great results to start with. If you are keeping up with the benchmark using a diversified portfolio and getting out-of-sample experience you are doing great! Even if you are only keeping up with the benchmark after getting rid of a couple bad ports from you original selection you are doing good and are headed in the right direction.

Chris -

I think your points are great and I need to be reminded of this once in a while. I’ve been through big drawdowns and I have the stomach for them, but I realize a lot of investors don’t.

What I found so wonderful about the article is that there’s a difference between “recognizing that MPT is generally hogwash” and being able to talk about risk and drawdowns and volatility from a theoretical perspective that ISN’T hogwash.

  • Yuval

Actually, outside of the classroom, MPT has been long known to be an intriguing body of theory but useless in practice. I first bashed it in my MBA thesis back in late 1979. Over the years since then, the most colorful characterization I’ve seen of it has been as an “error maximization” model, and another famous one, Black Litterman (the same Black as in Black Scholes), was created to try to fix it but it, too, doesn’t really do the job. The only way to makle MPT work in the real world is to, cough cough, fake it, as Wealthfront does with the extremely tight manually-derived constraints it puts on permissible weightings, that being the only way they and others like them could possibly market the results of their MPT efforts to the public without being laughed out of business.

And yes, the definition of risk is a problem. In a Forbes article last month (http://www.forbes.com/sites/marcgerstein/2016/07/18/vanguard-robos-diversification-and-kurt-vonneguts-monkey-house/print/), I characterized the notion of defining risk in terms of standard deviation, volatility, correlation, etc. as “conveniences adopted by quants to enable themselves to participate in markets.” Of course this is an incorrect definition of real-people risk. In that article, I went on to quote and work from the Merriam Webster definition. To be more historical, statistical concepts like this have nothing to do with investing or markets but reflect what has now been labeled the “physics envy” craze that swept supposedly “soft” academic fields post Sputnik, when lots of money was plowed into research in physics and the like to cope with the onset of the space race. Other departments wanted money too, but to get it, they had to dress themselves up in scientific guise. Finance did it. Psychology did it. Sociology did it. Etc. In terms of finance, MPT is the most famous creation to come out of the physics envy craze but by no means the only one.

That said, we have to recognize that for better or worse, the vocabulary of physics envy is now well entrenched in finance, and it may take many many years to clean it out, if that can be done at all (as behavioral finance people are working to do, along with maverick but increasingly loud financial folks who write about physics envy and publicly bash empirical research, data mining etc. One of the more prolific and colorful of these writers nowadays is Michael Edesess, who’s missives are often published on adviserperspectives.com. Also, academically, there may be a civil war of sorts brewing as accounting departments have been stepping in to fill the void in usable financial research left by math-crazed finance departments and p123 is not necessarily a spectator here; professors that use us tend to be in accounting departments.

So essentially, the ground under the feet of finance is in the process of shifting. It’s not quite as newsworthy as “Feel the Bern,” “Brexit,” or “Make America Great Again.” But it’s happening, and it’s getting easier to envision a future in which future finance professionals look back on things like MPT the way doctors today look back at use of therapeutic application of leeches.

David -

While volatility may be somewhat constant, the Sharpe ratio takes into account average short-term excess returns AND volatility, leading to very misleading conclusions. A couple of links on this point:

http://www.fplcapital.com/pdf/Can-Sharpe-Ratios-Predict-Returns.pdf

Improved Sharpe Ratio, using log returns (the top half of the page explains exactly what’s wrong with both the numerator and denominator of the Sharpe ratio)

In addition, since you’re not like Chris’s clients, you want to minimize long-term risk (of underperforming your target), not short-term volatility. Using the Sharpe ratio will paradoxically increase the risk of long-term underperformance. I suggest you ignore it.

I’ll look at those papers, thanks. BTW, the book is cheaper on the Apple iBooks store than Amazon.
I agree that Sharpe itself is not the end all.

Your comment “minimize long-term risk (of under-performing your target), not short-term volatility”. Right now, I have a very low goal (I think) of 7% per year for my overall portfolio performance. My overall goal is to exceed SPY say in a 3 year time-frame for my overall port (which has 5 models and ~75 stocks). If I cannot beat SPY, then no reason to do any of this.
For short term volatility, I keep a couple of years of expenses in cash.

So my risk is missing my 7% target. You are right, my goal is not a particular Alpha or Sharpe number, it is the Return. I am focusing on Return and not risk adjusted return. I am keeping money in cash to ride me through the tough periods. But at the same time, I am consciously investing in models that select less volatile companies (larger ones with lower betas that mostly pay dividends). I stay away from (mostly) from small caps now.

One can easily argue that my selecting more stable, less volatile companies increases my ‘risk’ of not hitting the 7% number. But I am setting my bar pretty low for Return so hopefully these ports will get me there. And investing in more stable companies allows me, and more importantly, my spouse, sleep at night.

That makes sense, David.

Here’s how I sleep at night. Instead of saying, “How much money has my portfolio lost today/this week/this month,” I say “How much money have I gained and what’s my CAGR since I started using this strategy?” Those numbers may go up and down quite a bit, but if I’m investing well, it won’t be a big cause for worry.

I jot down all my investment inputs (cash in, expenses) with a date into an Excel sheet and every day I input my new total at the bottom with today’s date. The XIRR function gives me my CAGR. This really helps me keep my focus on returns rather than daily volatility. If I lose 5% of my money in a really bad day, or 20% in a really bad few weeks, my CAGR will be lower, but not lower by 5% or 20%. It’ll still be a nice enough number to build dreams upon.

Good advice on focusing on the long term.
I trade with Vanguard. It has a nice utility that shows me my overall returns since I started all of this and it uses IRR so it smooths things out as well.
This too helps me not to freak out…

So I downloaded C. Thomas Howard’s Book “The New Value Investing” onto my Kindle.

So far all he has talked about is reducing short-term volatility. By investing in 10-20 stocks minimum from at least “half a dozen” sectors. Oh, and 25-50% of your portfolio should be in international ETFs.

To his credit, I think he is making Chris’ point. It seems that Mr. Howard may not think that short-term volatility is too important but he wants the reader to be able to stick with the strategy.

Still 50% of my portfolio in international ETFs (not value ETFs or selected stocks expected to outperform) just to diversify? Wow! He really believes in diversification!

I’ll keep looking for something new or different.

Edit: I am not very far into the book. But so far there are several things I like. I can probably recommend it. But not because it has any radical recommendations regarding portfolios. His main points so far regarding evaluating a portfolio is that he looks at the excess returns compared to the benchmark over 5 years and that he thinks other than the great depression volatility is just noise.

thanks again for the lead on the book. Well worth the price. Interesting to see another perspective on what drives short term volatility, contrarian ideas about risk, use of histograms to describe why staying committed to the market is the best idea (instead of just an equity curve) (I do wonder about that though, from a Japanese market standpoint. It would have been good for him to analyze some markets that have done poorly over the last 20 years too), Schiller’s ‘noise’, asset allocation, MPT/CAPM/APT, bucket strategy for retirees, how fund managers typically construction funds, and general comments about why large funds fail. A good read.

All:

 Some quick comments:

      1)  Volatility is not what I dread; it's drawdown. Upside volatility is just fine.

      2)  A lot of ETF's sounds like "diworsification" - never the path to superior returns.

      3)  The trick is to have some decent systems that have enough smarts to know when they're going to make it.

Bill