
How standard portfolio theory changes when assets are technologies - mrleiter
https://arxiv.org/abs/1705.03423
======
ericjang
My eyes glazed over at the vast number of priors introduced in this work. Why
should I believe the assumptions hold?

In Machine Learning, the standard expectation of research papers is to
empirically demonstrate the increased statistical power of the model over
benchmarks, and I wish the authors demonstrated that their model aligns with
historical reality.

I attended a talk recently by Aswath Damodaran where he explained that there
are two types of investors, most often lying in disjoint sets: 1) number
crunchers and 2) story tellers. Perhaps the success of tech companies (e.g.
AMZN, GOOG, FB) can be explained in aggregate via the Wright model, but my
feeling is that the majority of 'optimal portfolio distortion' these companies
caused is mostly idiosyncratic to those specific companies, e.g. the "story
tellers" have more information in the long-term behavior of a company.
Consequently, aggregate modeling captures statistical correlation rather than
causation, which can still make money but is not robust to long tails.

I think number crunching is only useful for short horizon portfolio selection.

~~~
soVeryTired
Mathematical finance as a field has gone down a deep, dark, weird rabbit hole.
The point of papers in the field is rarely to make a statement about how to
invest, or how markets work. The point is to do a load of funky maths, showing
off how clever you are, and then claim a tenuous link to finance.

If anyone doubts what I'm saying, they should look up the definition of "No
free lunch with vanishing risk" [1] and tell me how it relates to the real
world.

[1]
[https://en.wikipedia.org/wiki/No_free_lunch_with_vanishing_r...](https://en.wikipedia.org/wiki/No_free_lunch_with_vanishing_risk)

~~~
fapjacks
Please excuse my total ignorance, but could part of the reason for this be
some kind of personal advertising for the financial industry (e.g. "Look at
how smart I am, hire me for your quant fund!")?

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erikstarck
For a conclusion, it's very inconclusive. :)

"Crucially, we find that the nonlinearity of the problem leads to multiple
local optima, so that very different optimal portfolios can exist
simultaneously, and the global optimum switches instantaneously between them
as parameters change. This means that inside a critical region of parameter
space a small change in one of the parameters can lead to a very significant
change in the optimal portfolio."

~~~
tinco
Doesn't that just mean that it's impossible to manage a technology portfolio
in a cost efficient way? So the only way to manage a technology portfolio
would be to simply try to juggle as many as you can, eliminating them randomly
as you are resource constrained?

~~~
AnimalMuppet
It means it's very difficult to maintain the _global_ maximum for a technology
portfolio. You are at the global maximum, and at the drop of a hat that
converts to a local maximum. That could still be pretty good, though. It could
still be cost efficient - just not the best that is possible.

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jtraffic
I'm very much among the (small) camp of people who thinks that standard
portfolio theory isn't worth a whole lot even when the assets are stocks. It
just fails to describe important features of the data. To me, this ruins the
value of work that uses it as a base.

~~~
Chris2048
Which important features are missing?

~~~
jtraffic
Fat tails, long-term autocorrelation, discontinuities in price changes,
divergent variances.

Aside from missing those observable features of the data, the theory is
missing much about market agents: herding and contagion, information
asymmetries, slow convergence to equilibrium, non-normally distributed errors,
heterogeneous strategies and objectives, interaction effects, confirmation
bias.

I'm just repeating Taleb, and his mentor Mandelbrot, of course:

[https://www.amazon.com/Black-Swan-Improbable-Robustness-
Frag...](https://www.amazon.com/Black-Swan-Improbable-Robustness-
Fragility/dp/081297381X/ref=sr_1_1?ie=UTF8&qid=1494426362&sr=8-1&keywords=the+black+swan)

[https://www.amazon.com/Misbehavior-Markets-Fractal-
Financial...](https://www.amazon.com/Misbehavior-Markets-Fractal-Financial-
Turbulence/dp/0465043577/ref=sr_1_1?ie=UTF8&qid=1494426381&sr=8-1&keywords=misbehavior+of+markets)

------
rrggrr
A hedge fund manager once told me: "The only free lunch in my business is
diversification". Her fund imploded three years later. There is no free lunch
and portfolio theory is an inadequate hedge against theta decay and mean
reversion.

~~~
cheez
Diversifying using uncorrelated income streams is a good strategy, generally
and there is actual math to show that you cannot significantly reduce risk by
diversifying to more than ~20 streams.

~~~
kovek
Where could one read up more about this math showing you cannot significantly
reduce risk by diversifying more than ~20 streams?

~~~
frgtpsswrdlame
I've also heard of using 30 (not 20) stocks as a sort of rule of thumb for
sufficient diversification. I went ahead and looked it up though:

 _In 1970, Lawrence Fisher and James H. Lorie released "Some Studies of
Variability of Returns on Investments In Common Stocks" published in The
Journal Of Business on the "reduction of return scattering" as a result of the
number of stocks in a portfolio. They found that a randomly created portfolio
of 32 stocks could reduce the distribution by 95%, compared to a portfolio of
the entire New York Stock Exchange. From this study came the mythical legend
that "95% of the benefit of diversification is captured with a 30 stock
portfolio."_

[http://www.investopedia.com/articles/stocks/11/illusion-
of-d...](http://www.investopedia.com/articles/stocks/11/illusion-of-
diversification.asp)

I would really read the rest of that link though, there's some good stuff in
there.

~~~
valuearb
Ben Graham and Buffett think diversifying increases risk. How well can you
know one girl if your harem has thirty?

Statistical models are just models, not the real world.

~~~
cheez
Graham and Buffett are investors in the truest sense: they invest in the
business, not in the stock. They deal with the managers directly. That is not
what most of us do. That is why diversifying in such a situation increases
risk: you only have so much mental attention.

~~~
valuearb
No. Graham was a stock market investor. Buffett never bought a company till
nearly 20 years into his career. Buffett and Munger believe in focused
portfolios when you are investing in stocks, why put 5% into your 20th best
idea when you can put 10% in your 10th best idea?

In reality most of us should not buy public equities, we should be in index
funds.

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inputcoffee
Looking at the special features of technology investments is an interesting
idea.

I do think this paper misses an opportunity by failing to model some of the
more salient features.

I would be interested to see what the optimal strategy would be if 9/10
investments yielded 0, and 1 out of 100 yielded 100x.

Actually, the model should tune those parameters based on available data.

Now tell me the optimal investment strategy.

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valuearb
Portfolio theory is useless for the rare skilled investors. In fact it's dead
wrong. If you are skilled you want to concentrate in your best ideas, and you
want high variance to improve your purchase and sale prices.

If you leverage though, you better know portfolio theory math and your risk of
ruin.

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specialist
Nice cite, fun to think about, thanks. Will compare with NPV options based
strategy proposed in Design Rules.

Design Rules, Vol. 1: The Power of Modularity
[http://www.amazon.com/dp/0262024667](http://www.amazon.com/dp/0262024667)

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juskrey
1/n

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iliconvalleys
Charts at the bottom on this page here show asset classes and their
performance as a portfolio basket relative to the S&P which illustrates some
of these points [http://54.174.116.134/recommend/datasets/explore-
trends.html](http://54.174.116.134/recommend/datasets/explore-trends.html)

