(Modern) Modern Portfolio Theory (EP.193)

Today on Rational Reminder we take a deep dive into the evolution of modern portfolio theory. We kick the show off with some updates and reviews on some of the brilliant shows and books we are watching right now. A key item from this selection is Stolen Focus: Why You Can’t Pay Attention and the points it makes about the value of flow state for learning and creativity. After this week’s news stories, we get into the main topic, and Ben starts with a breakdown of portfolio theory as it was laid out by Harry Markowitz in 1952. From there we talk about research that shaped the current understanding of portfolio theory, exploring the distinction between the mean-variance efficient portfolio and the multi-factor efficient portfolio, and how they theoretically combine to make the market portfolio. One of the biggest takeaways here is that your financial asset portfolios can look the same in terms of asset allocation but the person with more macroeconomic risk in the remainder of their financial situation is taking on more risk. Additionally, even if somebody is the perfect candidate to be the mean-variance investor and they could theoretically tilt toward value, it doesn’t necessarily mean they have to. We wrap up our conversation by inviting our good friend Larry Swedroe onto the show to speak about his love of reading and share his methods for incorporating what he learns from books into his work and thinking.

Key Points From This Episode:

• Updates: Shows, books, upcoming guests, reviews, and our reading challenge. [0:00:22]
• A review on Stolen Focus: Why You Can’t Pay Attention. [0:11:00]
• News stories for the week: Wealthfront offers thematic ETFs and more. [0:18:47]
• Moving onto the main topic for today: How modern portfolio theory has changed since 1952. [0:23:00]
• Lessons to be taken away from Markowitz’s 1952 portfolio theory. [0:25:09]
• How the math changes when you have a risk-free asset in your portfolio problem. [0:26:59]
• The capital asset pricing model: the other foundational portfolio theory principle that comes from the mean-variance model. [0:29:08]
• Portfolio advice that stems from mean-variance optimization. [0:32:46]
• Building a tangency by expressing information beliefs. [0:36:06]
• Findings from Michael Jensen’s 1967 application of the CAPM. [0:37:04]
• Why diversification is important according to Markowitz’s portfolio theory. [0:38:02]
• Why the CAPM does not accurately reflect the relationship between risk and expected return. [0:39:49]
• The origins of multi-factor thinking and examples of multi-factor models. [0:41:10]
• How the allocation of the multi-factor efficient portfolio creates a third dimension. [0:49:29]
• How the theory predicts how people behave in aggregate. [0:52:44]
• Takeaways from today’s discussion to keep in mind when building your portfolio. [1:00:00]
• Larry Swedroe joins us to talk about the importance of reading. [1:03:32]
• The many subjects that Larry reads about. [1:04:12]
• How Larry’s reading habit works. [1:05:12]
• How to capture ideas you read for later use. [1:05:57]
• Larry’s storage system for all the books that he reads. [1:08:38]
• The effectiveness of making a public commitment to read more. [1:12:13]