Mini-Case; Strategic Portfolio Theory, Black Swans, and [Avoiding] Being the Turkey

Mini-Case; Strategic Portfolio Theory, Black Swans, and [Avoiding] Being the Turkey

454 CHAPTER 16 international Portfolio Theory and Diversification return of (and zero expected risk), and moves out along the security market line until reaching portfolio DP. This portfolio is defined ‘as the optimal domestic portfolio because it moves out into risky space at the steepest slope—maximizing the slope of expected port- folio return over expected riskrwhile still touching the opportunity set of domestic portfolios. The optimal international portfolio, IP, is found by finding that point on the capital market line (internationally diversified) which extends from the risk—free asset return of Rf to a point of tangency along the internationally diversified efficient frontier. 3‘13 The investor’s optimal international portfolio, I P, possesses both higher expected portfolio return and lower expected portfolio risk than the purely domestic optimal portfolio. The optimal international portfolio is superior to the optimal domestic portfolio. Risk reduction is possible through international diversification because the returns of different stock Put another way, investors are more volatile than invest— ments. Economic reality governs the returns earned by our businesses, and Black Swans are unlikely. But emotions and perceptionsethe swings of hope, greed, and fear among the participants in oarfinancial system— govern the returns earned in our markets. Emotional factors magnify or minimize this central core of economic reality, and Black Swans can appear at any time. "elohn C. Bogle, Founder of The Vanguard Group.2 Modern Portfolio Theory (MPT), like all theories, has been subject to much criticism. Most of that criticism is focused either on the failings of the theory’s fundamental assumptions, or in the way the theory and its assumptions have been applied. Ultimately, it has been accused of failing to predict the major financial crises of our time, like Black Monday in 1987, the credit crisis in the United States in 2008, and the current financial crisis over sovereign debt in Europe; markets around the world are not perfectly positively correlated. 7555 Because of different industrial structures in different countries and because different economies do not exactly follow the same business cycle, smaller return correlations are expected between investments in different countries than investments within a given country. The overall picture is that the correlations have increased over time. Nevertheless, 91 of the 153 correlations (59%) and the overall mean (0.46) were stilibelow 0.5 in 198771996. The answer to the question of “are markets increasingly integrated?” is Yes. However, although capital market integration has decreased some benefits of international portfolio diversification, the correlation coefficients between markets are still far from 1.0. There are still plenty of risk—reducing opportunities for international portfolio diversification. Portfolio Theory, Black Swans, and [Avoiding] Being the Turkey1 Criticisms of Modern Portfolio Theory Modern portfolio theory was the creation of Harry Markowitz in which he applied principles of linear programming to the creation of asset portfolios.3 Markowitz demonstrated that an investor could reduce the standard deviation of portfolio returns by combining assets which were less than perfectly correlated in their returns. The theory assumes that all invesa tors have access to the same information at the same time. It assumes all investors are rational and risk averse, and will take on additional risk only if compensated by higher expected returns. It assumes all investors are similarly ratio- nal, although different investors will have different trade-offs between risk and return based on their own risk aversion characteristics. The usual measure of risk used in portfolio theory is the standard deviation of returns, assuming a normal distribution of returns over time. As one would expect, the criticisms of portfolio theory are pointed at each and every assumption behind the ‘Copyright © 2012 Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only and not to indicate either effective or ineffective management. 2“Black Monday and Black Swans,” Remarks by John C. Bogle, Founder and Former Chief Executive, The Vanguard Group, before the Risk Management Association. Boca Raton. Florida, October 11,2007, p. 6. 3H.M. Markowitz, “Portfolio Selection," Journal ofFinance, volume 7, March 1952, pp. 7779f theory. argues 1 some or access t some it larly be mathert deviatic or whet Man history, 1987, n purveyi markets are not deviati< distribu Work of revolve exhibit: fact she event, ( curve or to ever past, p( future. ‘ The with the is typic: from t1“. does no Any theo. jinn; wror Ofga call t Black : Nassim Fooled. of the b ; “For a to Risk, Rn ‘ 5Benoitl ; “Nassim ‘ laterexti 1 Honse,2 vely rent not turn :s in ,iven have 153 were stion L has folio ween tty of tfolio rowitz to the bat an rtfolio rfectly inves- ime. It 1d will nigher ’ratio— ie-offs ‘ersion -rtfolio iormal theory 1d the :l H. etore International Portfolio Theory and DiverSiflcatlon £3 theory. For example, the field of behavioral economics argues that investors are not necessarily rationalwthat in some cases, gamblers buy risk.

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• What are the primary assumptions behind modern portfolio theory?,
• What do many of the MPT critics believe are the fundamental problems with the theory?
• How would you suggest MPT be used in investing your own money?