The Yale Endowment is the crème de la crème. Nothing beats it? Their AUM is about 25 billion. Michael evaluates and reads some of the 2016 copy of The Yale Endowment. He wants listeners to decide if it is an example of how the best think, or if it is how one of the best operations self-describes themselves. Michael ends with breaking apart an excerpt from a presentation that David Swensen gave on his portfolio management strategy.
During one of your recent podcasts, you and Wesley Gray were discussing how the academic community considers the volatility of an asset’s price to be its risk while you and Gray consider the permanent loss of the capital invested in an asset to be its risk. Many years ago, I read an interview of Harry Markowitz where he stated that he used volatility to measure the risk of an asset because “it made the math easy.” I was completely shocked. The father of Modern Portfolio Theory chose his measure of risk based on its mathematical convenience.
I searched for the interview again because I wanted to send a link of it to you so that you could read it for yourself. Unfortunately, I could not find the interview but I still remember the feeling of complete shock that I felt when I read that Markowitz chose volatility as the measure of risk because “it made the math easy.”
What is your understanding of how volatility became the primary measure of risk in finance?
I don’t believe Markowitz believed that as you state, but rather was designing for theory. As you might recall he was surprised that modern finance was built off his work. He wrote the PhD paper, and others extrapolated his work into something else. Markowitz, himself, stated that “semi-variance is the more plausible measure of risk.”
But I have also see this:
“I would’ve created CAPM around semi-variance, but no one would have understood the math and I wouldn’t have won Nobel Prize…” –Harry Markowitz
There is a common problem in finance when it comes to evaluating investment managers’ performance: the factor or skill vs. luck. When a manager performs well over a number of years, it is not clear whether the success can be attributed to the manager’s skill and strategy, or random luck. And vice versa, when a manager performs badly, it can be difficult to pin-point whether it was due to lack of skill, or simply bad luck.
Another factor that is commonly misunderstood in finance is risk. Understanding the differences between risk, volatility, and skew is essential to developing a well-performing trading strategy.
Campbell Harvey studies these phenomena. He is a finance professor at Duke university, and research associate with the National Bureau of Economic Research in Massachusetts. His research papers on these subjects have been published in many scientific journals.
In this episode, Campbell Harvey and Michael Covel discuss risk tolerance, evaluating trading strategies, Harry Markowitz’ classic paper on portfolio selection, and the importance of differentiating between volatility and skew.
In this episode of Trend Following Radio:
Survivorship bias, and not being fooled by randomness
Why people with higher risk tolerance experience much higher upsides
Understanding process vs. outcome
The difference between volatility and skew
The importance of recognizing that asset returns are rarely “normally distributed”
When it is appropriate to apply a general framework, and when it is not
The Sharpe ratio – is it always relevant?
Harry Markowitz, Jim Simons, and Nassim Taleb
“These people that are taking a lot of risk, with enough luck, will rise to the top. The person that is risk-averse is stuck in the middle” – Campbell Harvey
Today on the podcast Michael Covel talks with Harry Markowitz, the founder of modern finance and Nobel Prize winner. Markowitz also appeared in Covel’s documentary film a few years back, “Broke: The New American Dream”. Covel and Markowitz talk about Justin Fox and “The Myth Of The Rational Market”; Markowitz’s beginnings, and the Nobel Prize; Markowitz’s 1952 paper; how Markowitz felt about some of his prescriptions and ideas being interpreted into dogma; why Wall Street was not interested in Markowitz’s theories at one time; diversification for the right reason; Markowitz’s new four-volume book; advice on maintaining mental acuity at an advanced age and sounding like you’re 35 when you’re 86 years young; Markowitz’s attraction to the philosopher Hume; if it was fifty years later, if Markowitz would be a quant running a hedge fund today; Markowitz’s legacy; on being comfortable vs. being rich; the leveraged long-only hedge fund industry and being coaxed into putting your money into these institutions; Long Term Capital Management and portfolio theory. What a life!
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