Markku Kurtti – Diversification is a Negatively Priced Lunch (S7E7)
Apr 22, 2024
auto_awesome
Markku Kurrti, a electrical engineer turned finance enthusiast, discusses analytical models on stock underperformance, active manager strategies, and the equity risk premium puzzle. He challenges traditional beliefs on diversification numbers, emphasizing the benefits for long-term success and optimizing returns. Exploring concepts like compound growth, leverage, and Kelly criterion, he provides unique insights into the financial landscape.
Maximizing information channel capacity in finance is crucial for optimum growth rates.
Diversification premium varies for individual stocks from geometric perspective, challenging traditional portfolio diversification beliefs.
Deep dives
Learning about Finance Through Personal Investing Experiences
The guest, Marco Kratty, shares his journey from initially losing money on stocks in 1999 during the tech bubble to developing a passion for investing over the years. His interest in finance grew through reading classic investment literature and eventually pursuing a Master of Science program in finance after being inspired by a podcast discussing the Kelly criterion.
Exploring the Compounding Process Capacity Concept in Finance
Marco delves into the concept of compounding process capacity based on principles from information theory. He draws parallels between the information channel capacity in digital communications and the capacity in finance, emphasizing the importance of maximizing the signal-to-noise ratio or the Sharpe ratio to achieve optimum growth rates. Through empirical tests with industry returns data, he demonstrates how maximizing this capacity can lead to significant growth opportunities.
Understanding the Diversification Premium in Stock Portfolios
Marco discusses the diversification premium, highlighting how diversification affects geometric returns differently than arithmetic returns. He explains how the geometric diversification premium accounts for the reduction in variance track due to diversification but notes that this benefit diminishes for individual stocks when considering geometric perspectives. By analyzing statistical inputs like idiosyncratic variance, he quantifies the benefits of diversification in portfolio construction.
Challenging Traditions in Portfolio Diversification and Risk Management
By challenging traditional beliefs on portfolio diversification, Marco introduces new perspectives on optimal portfolio sizes and risk management. He argues that the traditional view of diminishing benefits beyond 20-30 stocks may not hold true when considering the diversification premium and compounding effects over time. Highlighting the importance of consistent alpha and idiosyncratic variance, he proposes that the optimal diversification level varies based on factors such as risk aversion and confidence in alpha generation.
In this episode I chat with Markku Kurtti, author of the blog Outcast Beta.
Markku is classically trained as an electrical engineer and works on receiver algorithms for mobile phones. A passion for investing, however, lead him to pursue an MS in Finance and an interview with Ed Thorp compelled him to devote his time to better understanding compounding processes.
This obsession has driven him to develop a number of analytical and numerical models that provide differentiated insights into topics such as “why do most individual stocks historically underperform cash,” “how many stocks should an active manager actually hold,” and “how does the uncertainty of uncertainty help explain the equity risk premium puzzle?”
With Markku’s work, I’m reminded of the phrase: all models are wrong, but some models are useful. His outsider’s take provides some unique insights into the benefits, and opportunity costs, of diversification.
I hope you enjoy my conversation with Markku Kurtti.
Get the Snipd podcast app
Unlock the knowledge in podcasts with the podcast player of the future.
AI-powered podcast player
Listen to all your favourite podcasts with AI-powered features
Discover highlights
Listen to the best highlights from the podcasts you love and dive into the full episode
Save any moment
Hear something you like? Tap your headphones to save it with AI-generated key takeaways
Share & Export
Send highlights to Twitter, WhatsApp or export them to Notion, Readwise & more
AI-powered podcast player
Listen to all your favourite podcasts with AI-powered features
Discover highlights
Listen to the best highlights from the podcasts you love and dive into the full episode