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Old 12-06-2013, 10:34 AM   #21
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We are all "curve fitting" when we say stocks work in the long run, and whenever someone says "stay the course".

MVO is reserved to describe the method by Markowitz. About MVO method overfitting data and its sensitivities to data perturbations, see the following by Bernstein: http://www.efficientfrontier.com/ef/497/mvo.htm.
Has anyone read the article above by Bernstein? The article is entitled "The Thinking Man Ouija Board", and has this as conclusion.
Financial analysts and investors have been conned by MVO's complexity and elegance. It's [sic] failure is reminscent [sic] of communism's. Marx's system fails because of the flaws inherent in human nature: Markowitz' system fails because of the flaws inherent in economic forecasting.
Bernstein sounds either skeptical or disillusioned with the method that promised the "efficient frontier" in investing. I wonder what happened.
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Old 12-06-2013, 10:56 AM   #22
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Bernstein sounds either skeptical or disillusioned with the method that promised the "efficient frontier" in investing. I wonder what happened.
Reality.
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Old 12-06-2013, 01:37 PM   #23
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Bernstein sounds either skeptical or disillusioned with the method that promised the "efficient frontier" in investing. I wonder what happened.
He started to talk this way after the 2007-2008 crash. I agree with some other posters here: He saw his clients get frightened and sell, and recognized that any plan that disregarded this behavior was not realistic, and a plan that is not realistic is not optimum (regardless of what the backtesting shows). So, he started to talk about annuities and the need for absolute safety for enough of the portfolio to pay for minimum essential spending. Which may not allow a person to actually retire at all, and may not be required based on what the US market has produced historically, but it makes the life of an investment advice writer or FA much less stressful ("the frightened calls keep coming!) if markets take a downturn. As a result, I don't think, at this point, that his interests are exactly congruent with mine.

This is one area where we (in general) have an advantage over an FA or someone running a pension fund, etc. We are building an individual plan just for us. If we "know ourselves" we can build a better plan (for our needs) than a "one-size-fits-all" approach--the plan doesn't need to "protect us" from behavior that we are not prone to. No advisor can ask a few questions about risk tolerance and really understand what a client will do when the market goes south. Conversely, only by building the plan can "the client" fully appreciate the assumptions that underpin it. That's valuable knowledge when hard times hit.
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Old 12-06-2013, 01:57 PM   #24
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Samclem, that was certainly the reason Bernstein now advocates people putting the principal for essential expenses into something safe, and only invest the left-over in the market. That portfolio is far from the Efficient Frontier.

However, back to the problem with MOV method by Markowitz, in my opinion, is that it tries to build an elaborate formal Gaussian model from skimpy back data, then runs an optimizer on this delicate model that is highly susceptible to spurious data points. In the end, you would want to take an MOV-derived portfolio back to a historical simulation to see how it would work. On the other hand, an optimizer based directly on a historical simulation is its own back-tester. It is a lot simpler to understand than the elaborate math behind MOV, which may be equivalent to curve-fitting a 12 degree polynomial to 10 data points.

Of course, anytime you base a future prediction on past data, you are betting that history will at least rhyme, if it does not exactly repeat, to borrow from Mark Twain.

And by the way, I used a lot of engineering optimal theories and methods in my career, but I dealt with inanimate objects that generate very true-to-theory Gaussian noise. I can also collect many hours of data from sensors that have sampling rates in the hundred to kilo samples per second to build error models. That's millions of samples, and then we also need to collect data at different temperatures, sensor orientations, etc... Sometimes there are still unknown variations that are called turn-on-to-turn-on random errors that we could not identify the cause.

It's a far cry from the 142 years of stock market data, which constantly evolves with historical and political events.
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