Hello JY,
Thank you for engaging with this 'embarrassing' content. I appreciate the time you have taken to elaborate your thoughts. In response...
I am not sure asking investors to define risk and to consider risk as every other person on the planet does - including, and especially, the insurance industry - is embarrassing. More embarrassing is that our industry continues to believe that because something can be measured statistically, that is the best and only way to predict or anticipate that thing in the future. As the comment thread here suggests, even Markowitz has abandoned the foolishness, of at least, standard deviation as a proxy for risk.
As for your claim that I am promoting my firm, a quick bit of due diligence on your part would reveal that my firm is CFA Institute. Another part of due diligence on your part would reveal that less than half of our members make their living as active managers; approximately 40%, in fact. Our Charter is held by over 300 job titles, including many who I know support your point of view. But a part of the beating heart of the CFA charter is principled disagreement. Ironically, CFA Institute is routinely lambasted for its defense of MPT. So your comments are, in some ways, really nice to receive, and an indication that these articles are in service to our mission.
I sense in your response a rejection of the article because it does not proffer data. Correct? In my Alpha Wounds series I linked to my masters thesis work in which I demonstrated that when active equity and active balanced funds are evaluated, with Sharpe ratios that the classic result holds: two-thirds of active managers underperform. Yet, when downside volatility is included in the denominator instead that the reverse result holds, two-thirds out-perform.
Next, as was mentioned in this thread previously, we concede the historical point. We offer a diagnosis for some of the ways active management went astray, and then offer prescription. This prescription is based on data, and in our series we have repeatedly linked to it. Both Tom and I acknowledge that we are making philosophical points. Your contributions for how to help end clients are welcomed. In fact, that is one of the lovely things about The Enterprising Investor: we encourage our readers and authors to engage with one another.
As for the 'jump' you refer to...from my above responses it should be less jarring for you as most of the connections are laid more bare. I believe volatility does not measure risk, but instead is a weighted average around a mean. Break out a calculator and do this by hand and you will see this is not supposition on my part, but mathematical reality. Use of standard deviation made the math easy circa 1950-1985, but we no longer need to rely on such metrics. If you insist on describing risk quantitatively, then ensure that your measure measures what you believe it does. But, for me, and based on my experience as a former portfolio manager of some success, risk is better evaluated the way business leaders evaluate risks. Also, is there language in this article that indicates to you that we ask for a final verdict? Instead, Tom and I have routinely said, "What the industry is doing doesn't work for end clients. How can we make it better?" In other words, we value your opinion.
I am not a believer in false absolutes, like the one that you use, "no matter how you try to spin it, active managers...will in the future under perform." The reason is that to do so is a misunderstanding of the meaning of the word and concept of 'absolute.' I think you are making, instead, a probability argument, and you mean there is a high probability of active management failure. Yes?
Do you believe that some business leaders can better steer their businesses than others through their intelligence, wisdom, and efforts, or is business performance also random? And do you believe that publicly traded securities prices will eventually reflect the performance? If so, then why would it be impossible for a person to identify superior management engaged in executing business plans in a superior way? And to Tom's points here and over the years, so you think there is predictability in securities price volatility? If so, then good predictions of volatility would be a good basis for constructing portfolios, too. If, on the other hand, and this is important for you to acknowledge, you believe that securities price volatility (measured by standard deviation) is random, then why would you use it as a risk measure, or to evaluate the performance of investment managers? Otherwise it is a tacit admission that managers should not be held accountable for it, since the results are random. You cannot have it both ways. If securities returns are random, then the time series of standard deviation for securities and portfolios must be, too.
Yours, in service,
Jason