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Notes to myself, possibly of interest to others.
-- Bill Northlich

Sunday, April 26, 2009

Sic Transit Gloria CAPM

We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. ...CAPM: poor Harry Markowitz's Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. ...I asked him a couple of questions...he so staggered me with, "Oh, you missed the whole concept of correlation and assets. Correlations change." ...correlations in a crisis all go to one.

What money managers did was to create models that said, "If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes -- see what happens? You get long-term positive results."

And they would project that into the future. But they didn't project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

John Mauldin's 4.24 letter.

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