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Newbie question about MPT (Modern Portfolio Theory)
Old 05-09-2006, 06:59 AM   #1
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Newbie question about MPT (Modern Portfolio Theory)

Hi Everyone,

As a newbie to the board and someone who is very close to ER. This is my second attempt at ER and I want to do it right (I was burned badly during the Nasdaq 2000 crash). I have been studying MPT as the basis for my assets allocation during ER. I would like confirm my understanding from board members that my understanding of MPT is correct. That is, in the period of high inflation, one should shift more assets into stocks. The reason for my thinking is that the Expected Returns for Riskfree assets increases thereby moving the tangent point to the Efficient Frontier to the right, meaning more stocks allocation?

Thanks in advance for your feedback.
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Re: Newbie question about MPT (Modern Portfolio Theory)
Old 05-09-2006, 10:20 AM   #2
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Re: Newbie question about MPT (Modern Portfolio Theory)

I have not read the book on MPT but seen countless postings on various web sites. Maybe you could read about it in detail if that is really your question. But it sounds more like "what do I do in times of high inflation?" The current answers are only intermendiate or short term bonds, TIPS, commodities and stocks that do well during times of inflation. Commercial REITs may even work. Some folks like Brewer have more sophisticated financial investments-hedges, shorts, swaps and more, more than I can engage with. I keep pretty much to index funds, a managed Vanguard fund and a few dividend stocks. I used to like ibonds but they don't look so good right now.
I am very concerned about inflation but I also acknowledge that I do not know soon or how hard it will hit so I just shift a little so I don't get swamped if inflation hits but overall holding diversified resources.
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Re: Newbie question about MPT (Modern Portfolio Theory)
Old 05-09-2006, 10:33 AM   #3
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Re: Newbie question about MPT (Modern Portfolio Theory)

Van, I think you are missing the central point of MPT, namely that the marke already has accurate inflation expectations already priced into all assets ans that you can't expect to assimilate and make use of new info faster or better than the market. Therefore, you set up a diversified (index) portfolio that meets your risk tolerance and return requirements and go play until it is time to rebalance.

Of course, some people don't fully buy this theory (myself included), so you see many takes on what to actually do, portfolio-wise.

I think yakers gave you a pretty good run-down of the stuff that has done well in times of high inflation. As a hedge against inflation ramping up, I have settled for CPI-linked notes, commodity futures, and a few individual equities that own/control hard assets or commodities. If the Fed starts getting very lovey-dovey after tomorrow's meeting, I will be a lot more concerned about inflation.
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Re: Newbie question about MPT (Modern Portfolio Theory)
Old 05-10-2006, 07:52 AM   #4
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Re: Newbie question about MPT (Modern Portfolio Theory)

Hey Van,

If I remember my MPT correctly, an increase in the risk free rate [like Tbills], all else equal, makes the tangent line [from the risk free rate to the Efficient Frontier] "flatter".* IIRC, this is called something along the line of a "Capital Asset Line" (CAL). All this does is change where the CAL touches the efficient frontier, which changes the mix of risky assets one would mix with a risk free asset. This doesn't necessarily mean that one would allocate more to risky assets.* How much one would allocate to risky vs. risk free assets depends one where one's indifference curve then intersects with the new CAL. I would think that if one's relative risk aversion stays the same, one might allocate more to the risk free asset [given its increase in expected return] than allocating more to stocks.

Maybe its time for you to break out the formulas.* :

- Alec
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Re: Newbie question about MPT (Modern Portfolio Theory)
Old 05-10-2006, 11:29 AM   #5
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Re: Newbie question about MPT (Modern Portfolio Theory)

Van--I agree with the others about the standard inflation protection speel is:* shorter bonds, a little more equities, some TIPS, and some Commodities exposure or Natural Resources/Energy/Oil/Precious Metals. All added in small doses to a well-diversified portfolio.
My opinion is for investors to learn more until they are comfortable with the reasons why these are suggested.* Education helps you feel comfortable about your well-diversified portfolio, regardless of market flucuations.* That is the key, knowing that you can't forecast the market, but your portfolio compostion is good enough to get you to your financial goals.* You most likely won't get rich, but your hope is to have a comfortable retirement.* This is all based on* *significant savings.* Others are trying to "beat the market" to compensate for poor savings habits or previous poor investing, that is not likely to happen. The time to buy inflation protection was back when inflation was not obvious.
Joe
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Re: Newbie question about MPT (Modern Portfolio Theory)
Old 05-10-2006, 06:24 PM   #6
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Re: Newbie question about MPT (Modern Portfolio Theory)

Thank you everyone for your help with my question on MPT. I truly appreciate the details of the answers. I think Alec is right! It is time for me to break out the formulas (ha ha).

Thanks again.

Van
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Re: Newbie question about MPT (Modern Portfolio Theory)
Old 05-10-2006, 07:09 PM   #7
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Re: Newbie question about MPT (Modern Portfolio Theory)

I read a book years ago on how to invest when focusing on the 30 year bond rate.
If I remember correctly it went like this.

First the trigger interest rate was 7%
Second you need to look at the direction of interest rates - rising or falling.

So here are the guidelines.

Rising interst rates - 30yr bond below 7% - cash equlivents - treasury bills

Rising interest rate - 30yr bond above 7% - long term bonds

Top & falling interst rates - 30 yr bond above 7% - Stocks/bonds

Falling interst rates 30 yr bond below 7% - stocks

Draw a sign curve and you will get the picture.

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