In this video I discuss some of the problems with Portfolio Theory.
VIDEO SUMMARY
In this video, we are continuing to talk about Portfolio Theory. This video is all about the issues that are involved. I am going to give you the dirt on portfolio theory, because what you come to discover is that you run into some issues in practical day-to-day application. So I do not want you to get the wrong idea here, because I am a big fan of Portfolio Theory. I spend a lot of time talking about it, and the reason why I do that is because there is a lot of valuable concepts here that are useful to you. But I want to be honest in some of the problems that you need to be aware of.
The problems come from assumptions. So there is nothing wrong with this model. It is a mathematical equation and it is built on sound theory. But when you use this model, you are putting in your own assumptions. And so the results that you get out are going to be good results or bad results based on you. The model is genius, but you may or may not be a genius. I don’t know. But the results of what this model spits out are entirely based on you and how good you are at coming up with assumptions.
Assumptions are very difficult. We have talked about correlations. Coming up with assumptions about correlations is the heart of what makes Portfolio Theory work. That is really hard to do. So a correlation is how two of your investments are going to move related to each other in the future. So you are trying to predict how these two assets are going to move. How you do that is you are going to look at history, and how they have moved related to each other in history. Then you will try to infer some reasonable value for a correlation coefficient for how they are going to move related to each other in the future. Well history is no guarantee of what will happen in the future. We just saw this in the Great Recession. One of the big problems that happened was the correlations between investments were way off. They were not what people expected, and it caught people off guard. So correlations are important, but they are very difficult to predict.
So that is the first problem, is that just coming up with a future prediction is hard enough. But then what you are doing is you are layering an assumption on top of your existing assumptions. Because you come into your portfolio with a whole list of assumptions based on each individual investment. The price you paid for each one of your investments is based on your assumptions of how that investment is going to perform in the future. So you know you made an assumption on the risk of that investment. You made an assumption on how much money it is going to make. And so you come in with a set of assumptions and then you are layering on top of that another set of assumptions on the correlation between this investment and the other investments in your portfolio. That is a lot of assumptions. Not only that, it gets worse, because as the number of assets in your portfolio increase, your assumptions also increase. So the equation that I have been using in these videos is for a two asset portfolio. So you could have a portfolio with two assets that could be stocks and bonds, or they could be two individual assets and then you figure out the correlation between them, and that is your assumption, and you use that to determine your expected performance. Well most of us have more complex portfolios. So we need an equation that expands beyond two assets. The cool thing is Portfolio Theory can do that. For every asset you add to your portfolio, you just keep adding on to the mathematical formula. But the problem becomes it gets very long, very quickly, and very complex. Because you have to determine a correlation coefficient between every relationship of every asset in your portfolio. So when you have only two assets, you only have one correlation coefficient. But if you increase that number to 2, 3, 4, 5, 6, you have all of these relationships that you have to make assumptions about. That is an incredible amount of assumptions. So in my opinion, there are just too many assumptions going on here to come up with really accurate results out of this financial equation. So what do we do then?
Portfolio Theory gives us a lot of guidance because it is built on sound theoretical principles. So what I think you should take away from this is that the concept of diversification can be a valuable tool in your financial decision-making process. And you may not be able to use this equation to come up with the exact most accurate prediction for how your portfolio is going to perform, but you can infer some valuable information that diversification can have a powerful effect on how you come up with your financial strategies.
Leave a comment down below letting me know what you think! If you find these videos helpful, please subscribe to my YouTube channel.
Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.