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Is there any merit to some other portfolio theories?

Portfolio theories are a set of principles and strategies for managing investments. They have been developed over the years to help investors manage their risks, increase returns and achieve their financial goals. While some of these theories are widely accepted and used by investors, others have not gained as much traction. In this article, we will explore some of these lesser-known portfolio theories and discuss whether they have any merit.

One thing to keep in mind is that there is always merit to any theory that has been put through rigorous statistical testing. This means that theories which have been developed based on sound statistical principles are more likely to be effective than those that have not been tested. However, it is important to remember that statistical inferences are not always accurate. Sometimes, events with probability zero happen (Black Swans), and events with probability one do not.

For example, the market has predicted fourteen out of the last six recessions. This means that there have been times when bear markets have not accurately predicted or indicated a recession in the economy as a whole. Therefore, it is important to consider the limitations of any theory before deciding whether or not to use it.

One portfolio theory that has gained some attention in recent years is the Kelly Criterion. This theory was developed by John L. Kelly in the 1950s and is based on the idea that the optimal size of a bet is directly proportional to its edge. The edge is the difference between the probability of winning and the probability of losing.

The Kelly Criterion has been used in a variety of fields, including gambling, finance, and even weather forecasting. The theory suggests that investors should allocate a percentage of their portfolio to each investment based on the expected return and the risk of the investment. The higher the expected return and the lower the risk, the more money an investor should allocate to the investment.

While the Kelly Criterion has been tested extensively and has been shown to be effective in some situations, it has its limitations. For example, the Kelly Criterion assumes that investors have perfect knowledge of the probabilities of winning and losing. In reality, probabilities are often unknown or difficult to estimate accurately. Additionally, the Kelly Criterion does not take into account other factors that may affect the performance of an investment, such as market trends, political events, and economic conditions.

Another portfolio theory that has gained some attention in recent years is the Modern Portfolio Theory (MPT). This theory was developed by Harry Markowitz in the 1950s and is based on the idea that investors can reduce their risk by diversifying their portfolio across a range of assets.

MPT suggests that investors should allocate their portfolio based on the trade-off between risk and return. The theory assumes that investors are risk-averse and want to maximize their return while minimizing their risk. By diversifying their portfolio, investors can reduce the risk of their portfolio without sacrificing returns.

While MPT has been widely accepted and used by investors, it also has its limitations. For example, MPT assumes that all investors have the same risk aversion and that returns are normally distributed. In reality, investors have different risk preferences and returns are often not normally distributed. Additionally, MPT does not take into account the impact of market trends, political events, and economic conditions on the performance of investments.

Finally, there is the Black-Litterman model, which is a portfolio theory that combines the ideas of MPT and Bayesian statistics. This model was developed by Fischer Black and Robert Litterman in the 1990s and is based on the idea that investors can use Bayesian statistics to estimate the expected returns of different assets.

The Black-Litterman model suggests that investors should allocate their portfolio based on their expectations of returns and their confidence in those expectations. The model assumes that investors have imperfect knowledge of the future and that returns are not normally distributed. By using Bayesian statistics, the Black-Litterman model allows investors to incorporate their subjective views about the future performance of different assets into their portfolio allocation decisions.

While the Black-Litterman model has been shown to be effective in some situations, it also has its limitations. For example, the model assumes that investors can accurately estimate the parameters of the model, which is often difficult in practice. Additionally, the model does not take into account the impact of market trends, political events, and economic conditions on the performance of investments.

In conclusion, there are many portfolio theories available to investors, and each theory has its own strengths and weaknesses. While some theories, such as the Modern Portfolio Theory, have gained widespread acceptance and use among investors, others, such as the Kelly Criterion and the Black-Litterman model, have gained less traction.

It is important to keep in mind that any theory should be tested rigorously before being applied to real-world investment decisions. Additionally, investors should consider the limitations of each theory and their own investment goals and risk preferences before deciding which theory to use.

Ultimately, the key to successful investing is to have a well-diversified portfolio that is tailored to your individual investment goals and risk preferences. By combining a sound understanding of portfolio theory with a disciplined approach to investment management, investors can increase their chances of achieving their financial goals.

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