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