Tuesday, April 12, 2011

What is Living and What is Dead in MPT

I was hunkered down over my computer too late the other night when I heard a scratching at the glass patio door.  It was my old friend Investo!  I hadn't seen him since the late 80s when he disappeared just after the RJR Nabisco LBO.  He wasn't looking good: his beard came down to his beltbuckle and he seemed to have some kind of bird's nest in his hair.  I brought him and gave him a blanket to warm himself, along with a cup of cocoa.  After a bit of chit-chat, I divined that he had wandered into a cave in the Adirondacks and fallen asleep one day in early 1991, and had only just now awakened.

The cocoa worked its beneficent mind-clearing magic and in no time he was his old self.  Naturally, once he found his footing, he wanted to talk about his investments.  In particular, he asked me to bring him up to date on what had become of Modern Portfolio Theory.  Was it still, for example, modern?

We fell easily into an extended conversation--so intense that I barely noticed that Investo was making notes in some sort of weathered steno pad.  Hours passed without my being conscious of the time, but as the sun began to break through on the horizon,  I could see Investo start to shake his head as if to help focus on the world,  "I have to go," he said, "but this is for you"--whereupon he ripped out what was to all appearances a carbon copy of the notes he had taken. Before I could offer him breakfast, he slipped out through the door and into the early dawn.

I laid the carbon aside and forgot about it as I turned my attention back to my own life. But later in the day I noticed it and gave it a quick skim.  Here is the first page:
MPT 20 years later:

 Markowitz diversification: Still largely true, made into a Godzilla by securitization but then completely undercut by tranching.  

 Sharpe Beta: Dead, and getting deader, except perhaps in old-fashioned textbooks and  in the training manuals of second-tier salesmen.

 Tobin separation: Actually, still alive and healthy insofar as it underlies index funds and such, but everyone has pretty much forgotten the name.

 Fama ECMH.: Oh dear.  Nobody believes Fama ECMH any more, not even Fama.  It tells you nothing about bubbles and crashes, and it doesn't alert you to the notion that we may all be irrational in systematic or predictable ways.  Yet  it's still true that the market is not for amateurs, and that if you go into a strange poker game, you look around for the sucker and if you don't see him, you get out because you're it.  

Black Scholes Option Pricing:  This may be a  two parter.  Black Scholes taught everybody that options traffic in risk, and that you can slice and dice risk into a million pieces (and no, don't pretend you knew that all along).  But Black Scholes was more or less vaguely based on the notion that outcome distributions are "normal" and we have learned to our dismay that  they are nothing of the sort.

 Modigliani Miller Leverage Irrelevance: Kinda sorta true, as we come to grasp that there is no clear line between debt and equity, between "owners" and "lenders;" all are just claimants against the asset pool.

 Modigliani Miller dividend irrelevance:  True if you believe that managers maximize shareholder value.  And that pigs will fly.
 Did I say all this?  Was it true, I wonder?  Will he come back and explain to me what I could possibly have been thinking?

Oh, and one more thing: down at the bottom of the page: note to self, must check on my investment in Lehman Brothers.  


Ken Houghton said...

Short version: MPT is still empty. Or even emptier than whenever Malkiel started using that cartoon in editions of A Random Walk....

"that you can slice and dice risk into a million pieces (and no, don't pretend you knew that all along)."

We knew that in 1991--we just couldn't find anyone who was willing to pay for doing it. (First attempt to solve that problem was the Structured Note market, which then graciously seized up in 1994--but the world, or at least the Summers administration, ignored that.)

"But Black Scholes was more or less vaguely based on the notion that outcome distributions are "normal" and we have learned to our dismay that they are nothing of the sort."

More problematic--and also common knowledge in 1991--is that Black-Scholes really fails miserably when you try to apply it to long-term options. And long-dated in this context means just about every traded option that you can't synthesis in the liquid part of the LIBOR/Forwards market.

I'm not discussing dividend irrelevance, because that's how economists deluded themselves into believing there was an "equity premium"--especially compared to the time during which government debt rates were capped--and they still haven't recovered from biting that particular apple, determining instead to rape and pillage "defined contribution" retirement funds in the name of theory.

chrismealy said...

If I remember correctly the Fisher Black bio says that Black Scholes wasn't as good as what traders were doing before, but after a while it caught on and Black Scholes became a self-fulfilling prophesy. You know, an engine not a camera.

The one thing I've never understood (and I got an A+ in finance) is how anyone ever thought variance was a good measure of risk, or why anyone would ever think beta in the past would tell you anything about the future.

Anonymous said...

I am neither an investor nor an economist, but this seemed odd to me: Modigliani Miller Leverage Irrelevance

It always seemed to me that the relevance of this was that the equity-holder got first-claim at the winnings, but the bond-holder got first-claim at the losing end of the stick.

This always seemed like a mug's game for the one providing loans to the leverager because they don't get to fully profit from a win but still take a hit on a loss.

Ken Houghton said...

chrismealy - Habit formation abides. And historic data is easier to get that future data.

Anon - It made sense because (1) higher yield was supposed to compensate for risk and (2) at least you got something if the business collapsed. But what also happened in the past 30 years is that the courts shifted power toward equity holders.

Buce said...

I believe the following to be a correct statement of the law in the Second Circuit, and in Delaware: the allegation that management's behavior impaired the value of debt--that allegation standing alone--does not state a claim for relief.