Really Modern Portfolio Design Becomes Available

Posted on September 8th, 2009 by admin in Quant

The investment advisory industry finally seems to be taking reality into its design and construction of portfolios. In today’s Wall St. Journal, we read this:

The new assumptions present a far different picture of risk. Consider the 60% stock, 40% bond portfolio that fell about 20% last year. Under the fat-tailed distribution now used in Ibbotson’s tool, that should occur once every 40 years, not once every 111 years as assumed under a bell-curve-type distribution. (The last year as bad as 2008 was 1931.)

Insulation from extreme market events doesn’t come cheap. Allianz SE’s Pacific Investment Management Co., or Pimco, which systematically hedges against extreme market events in several mutual funds launched last year, says the hedges may cost investors 0.5% to 1% of fund assets a year. Pimco uses a variety of derivatives and other strategies to hedge the funds.

You can read the whole article here: ( “Some Funds Stop Grading on the Curve”, 8 SEPT 09 ).

In many ways, this new approach to portfolio optimization incorporates the barkings of Nassim Taleb, of Black Swan fame, who has been incessantly warning of the dangers of designing portfolios assuming the “thin” tails of the Gaussian probability density, rather than using a more realistic “fat tail” model. Fat tails more accurately, and usefully, account for extreme bad outcomes, such as we recently experienced in the credit and real estate markets.

We expect in one to two years the large investment and broker-dealer firms will routinely offer Fat Tail-based portfolio design as well as special mutual funds incorporating these ideas.

Finally,  as we noted in our post of 15 JULY 09, this knowledge has been available for 20 years. So it is quite stunning that the financial industry, which usually is amazingly fast to adopt good ideas, has avoided the fat tail approach until now.

Leave a Reply

More News