Tuesday, April 05, 2011

Post-Modern Portfolio Theory

Modern Portfolio Theory has proved to be too … theoretical. How better to approach the investment process? John Mauldin's Outside the Box offers thoughts from Neils Jensen in London: Confessions of an Investor.

Risk is not market volatility, Jensen asserts. Real risk (or tail risk) is losing your investment.
The smart guys at Welton Investment Corporation have studied the phenomenon of tail risk in depth…. In short, severe losses (defined as 20% or more) happen about 5 times more frequently than estimated by the models we (well, most of us) use.
An underestimated risk factor, Jensen says, is "birthday risk."
When you look at [the asset-performance charts included in Jensen's discussion], wouldn’t you just love to have retired in 2000? A solid 7.9% per year for the preceding 19 years turned $1 million in 1981 into $4.2 million in 2000, whereas those poor souls who retired in 1980 managed to turn $1 million into no more than $1.1 million during the previous 14 year period. And those who are retiring today aren’t much better off following an extremely volatile decade.
But maybe they are. Retiring at the top of a bull market can lead to delusions of grandeur and overspending, followed by worry and shrinking wealth. In 2009 Jonathan Clements made the point well. See What a Good Year to Retire, Really!

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