If you went to your financial advisor and asked him to allocate your stock, bond, or fund investments, there is a good chance the allocation generated will come from an academic model called portfolio theory. It is the Nobel Prize winning model that is taught in university finance courses, and used by the mainstream financial industry worldwide.
Determinants Of Your Portfolio Allocation
Put simply without the math, your portfolio is determined by 2 main factors: Historical data, and your risk tolerance. Historical data here refers to the price behavior of your investments in the past, and risk tolerance is a mathematical calculation of how risky your portfolio should be based on personal preferences, age, and so on.
For example, if you are in your 20s and have voiced high risk appetite, you would invest more in “risky” assets like stocks, and more on bonds. The exact number is also based on an optimal risk-return combination that relies heavily on historical data.
History May Not Equal Future
The first limitation of this approach is that historical returns may not repeat themselves in the future. Just ask anyone who invested in crude oil before last year, or stocks before the 2008 crisis. Yet relying on historical returns in both examples would lead to a rude shock for investors.
Some may argue that such historical assumptions hold up better across the long-term (eg. decades), but imagine yourself sitting on a 50% loss – would you honestly have the patience or risk tolerance to wait it out?
Numerical Assumptions May Not Hold Up In Real Life
This theory has been widely adopted by the finance industry for one simple reason – It is simple to implement across most scenarios. It also helps that it won a Nobel Prize. However, it would help to look in closer detail at the statistical assumptions the model is making.
The first example is that it is based on a statistical assumption called a normal distribution, which is just an assumption on how prices behave, and is very easy to calculate around. Financial markets are far too complex to be described by the normal distribution.
Next, the model describes “risk” very differently from how most people would (i.e. potential loss). “Risk” in finance just means uncertainty, measured by volatility of historical prices, which changes across time. Thus, it is misleading to say that a portfolio is “low-risk” when it actually means price behavior has not been volatile. Again, a quick look at the 2008 crisis shows how fast volatility can change.
How Does This Impact Me?
Portfolio theory has its merits as an elegant solution to portfolio allocation, but it cannot be relied upon 100% completely. It would help to understand its real-world limitations when using it in your investment portfolio, and also incorporate your own future views on how prices will move.
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