Taking MPT to the Next Level: The Tendency of Prices to Trend and the Importance of Exit Points

Abstract

From the painful unwinding of the S&L crisis to the onset of the most recent recession, equity and bond-friendly secular declines in interest and inflation rates gave the investing masses license to stretch Markowitz’s Modern Portfolio Theory beyond its contextual foundations and to extrapolate investment practices bearing little relation. Non-acknowledgement of autocorrelation in asset prices (i.e., that prices tend to trend) and strict adherence to assumptions regarding perpetually “full-in” capital deployment carry deeply profound implications for the foundations of portfolio theory and, more importantly, for related practical applications. For most of the last two decades portfolio theory and related practices followed a relatively narrow evolutionary path which, not surprisingly (given the persistence of key interest and inflation rate elements of the macro backdrop), left these critical aspects of portfolio theory largely unquestioned and unchallenged by mainstream Finance. Formal acknowledgement of the tendency of asset prices to trend – to express autocorrelation – in combination with recognition of market participation as an elective act, which further can be made conditionally, enables a more clear, concise and broadly applicable framing of portfolio risk. Methodologically, this is addressed through disaggregation of capital at risk along risk cleavage lines encompassing the heretofore-lacking dimension of market participation. Operationally, this process of risk decomposition necessarily precedes established practices that generally position asset class allocation and/or active/passive management considerations as singular or first-order drivers of portfolio risk assessment exercises and associated prescriptive outcomes. Here we turn the page to the next chapter in the evolution of portfolio theory and related practical applications.