2. Nobel laureate economist Robert Merton decades ago did the math to create the formulas you or I can use to appropriately size portfolio risk. (A simplified version of the formula for people with low risk aversion: Take the equity risk premium and divide by variance. This is called the Merton share.)
My problem with the various risk management/optimization strategies is that risk is also calculated based on past performance. For example, the "efficient frontier" in modern portfolio theory requires past return and past variance to calculate. Thus VTI (with high return and high volatility) and bonds (with lower return and lower volatility) would both be considered part of the efficient frontier, but international stocks (similar volatility to VTI but lower historical return) are 'inefficient'. However, the US is currently about 60% of global market cap. Will it keep growing to 70%? 80%? 90%? And how do I calculate my own level of 'risk aversion'? I might think I'm all in at 100% stocks, but next time there's a market crash, will I really stick to my allocations? If it were so easy to calculate risk, why isn't everyone wildly successful in their investments?
I share some of these thoughts, specifically:
1) When is a market or economy so structurally, legally, technologically, culturally, and demographically different that it is no longer comparable to historical data? To what extent are 100,000 Monte Carlo simulations better evidence for a strategy than, say, a set of 50 years of actual results from the 19th century? To what extent is a Chinese stock a very different kind of asset than a UK stock or a US stock?
2) Are there cases where short-term volatility does not indicate long-term riskiness? For example, a business model with inherently variable or cyclical revenue flows, but reasonably assured long-run success? E.g. there is a store in my town that sells pool tables. They might make 3 sales in one month and 8 sales in another. If they were a stock, the stock price might be all over the place. Yet they're apparently not risky. They've been around for something like 40 years and they have a local monopoly.
3) Does the optimal point or points on the efficient frontier move around in reaction to market pricing action to an extent it is no longer useful? For example, 20-year treasuries have gone from yielding 4.5% in September 2023, to 5.25% in October, to about 4% in late December, and back to 4.5% now. These moves must have caused a significant change in the optimal asset allocation. Was it practical for a retail investor to change their AA this quickly, in reaction to the swinging market prices? And if you're changing your AA, are you no longer rebalancing? Also, the advice is to buy and hold. See what I mean?
4) Efficient frontier studies based on historical data don't seem to incorporate factors which could change the riskiness of equities, such as the introduction of liquid markets for hedging, lower corporate tax rates, or changing financial regulations. Specifically, I'm thinking about the average
debt-to-equity ratio, which is now
lower than it was in the 20-teens and much lower than in the booming 90s. If stocks were over 2x more leveraged in the past than they are today, then are they really the same asset?