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#40 | ||
Senior Member
Join Date: Nov 2006
Posts: 1,431
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![]() Quote:
Math wasn't those guys problem. It was the economics. They were using math but you can't say what they did was just math. They made some assumptions about the way the world should behave (all of which seemed pretty reasonable). In late 1998 the world didn't behave that way at all. Making assumptions about behavior and modeling how people behave is economics. Quote:
That said base portfolio theory can go wrong as well, but not because of the math. It would go wrong because of the economics. The economics of portfolio theory is that investors care about return and standard deviation is the right measure of risk. If those are bad assumptions then, while the math of portfolio theory is right, its not very useful. You have to buy into those basic economic assumptions. Once you do buy into those assumptions is just math: specifically its quadratic programming. Finally, there are implementation issues (I highlighted one of those early) that can cause problems. Also, note that because its "just math" portfolio theory doesn't necessarily have strong implications. You can only get so far with relatively benign economic assumptions. At some point you have to take a stand to get strong predictions like, for example, beta being a good measure of risk. Portfolio theory would never by itself give that implication (portfolio theory implies the risk of a security is the following: cov(r_i,r_p) where i is some security and p is your portfolio, which implies the risk of a security may be different for every person because everyone may be holding different portfolios overall). Portfolio theory is just a framework and because it doesn't make strong assumptions it doesn't give precise implications. That's both a strength and a weakness. Last edited by pelagius; 08-05-2008 at 05:04 PM. |
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