Welcome to the ETF GPS blog! The launch of this blog corresponds with the launch of my investment management practice. Communication and education for all who wish to know more about ETFs, the financial services industry, and portfolio management are my goals for this blog. I hope to post at least once per day on timely topics. What prompted me to start this blog let alone my own business? Strap yourself in you may be surprised.
A Little History Lesson
The financial services industry that most investment advisors (myself included) have cut their teeth on has been building portfolios and making investment decisions based on 1950s research. That in and of itself is troubling but the story behind why it is still used is also troubling.
The 1950s research is affectionately known as Modern Portfolio Theory (MPT). MPT is what you will find at the heart of all the glossy charts and graphs your financial advisor whips out when he talks about diversification. In 1952, while studying at the University of Chicago, Harry Markowitz pioneered work in MPT and eventually won a share of a Nobel Prize in 1990 for his work in economics. Markowitz wrote a book titled Portfolio Selection that really propelled his work. Simplistically, the central idea in MPT is that one can reduce risk in a portfolio simply by holding a properly diversified portfolio. Basically stated that diversification is good. I agree that diversification is good.
Half a century later the financial services industry and financial periodicals still make a tragic mistake that was set in motion by Markowitz himself. The mistake, wait for it… how we define risk. In his book Markowitz even outlines the better way to evaluate risk in a portfolio. Here are a few quotes from his book:
Page 77
“One of the measures considered, the semi-deviation, produces efficient portfolios somewhat preferable to those of the standard deviation. Those produced by the standard deviation are satisfactory, however, and the standard deviation itself is easier to use, more familiar to many, and perhaps easier to interpret than semi-deviation.”
Page 193
“Variance is superior with respect to cost, convenience, and familiarity. For example, roughly two to four times as much computing time is required (on a high speed computer) to derive efficient sets based on semivariance than is required to derive efficient sets based on variance.”
Page 194
“Analysis based on semivariance tend to produce better portfolios than those based on variance. Variance considers extremely high and extremely low returns equally undesirable. An analysis based on variance seeks to eliminate both extremes. An analysis based on semivariance, on the other hand, concentrates on reducing losses.”
So, in English the above is telling you that instead of standard deviation (variance) as a measure for risk semi-deviation (semivariance) is more preferable. What is the difference?
Standard deviation (variance) is a statistical measurement of historic volatility (volatility in not risk) while semi-deviation (semivariance) evaluates the fluctuations in returns below the mean.
Semi-deviation (semivariance) provides an effective measure of downside risk. It’s similar to standard deviation, but it only looks at periods where the portfolio’s return was less than the target or average. This approach allows investors to see how much loss can be expected from a portfolio, instead of only looking at its expected fluctuations.
Why Old Ideas Survive
Fast forward 50 plus years and with all the computing power today why is the financial services industry still using a less desirable method of building portfolios? Well, for the same reasons Markowitz did – time and money. The financial services industry is driven by marketing and not technology. Standard deviation makes nice, easy to understand charts and graphs and tons of money has been spent on the software to generate those charts and graphs.
The even scarier point is that it is probably safe to say that the vast majority of investment advisors have never read Markowitz’s book but most think they understand and have a grasp of his theory. Had they read his book they would take a second look at what they are doing for their clients. Not only have I questioned – I am acting. I have discovered Post Modern Portfolio Theory and you should too.
