“Any intelligent fool can make things bigger, more complex, and more violent. It takes a touch of genius—and a lot of courage—to move in the opposite direction.”
Einstein is right. In general, complexity implies opacity, and is often a calling card for a manager who is trying to charge excessive fees for a strategy that is easily replicable. One example where we see a healthy dose of complexity in the financial services industry is in asset allocation. The dominant paradigm utilized by massive institutional investors and professional investors is modern portfolio theory, which involves the use of optimization procedures that seek to maximize expected return for a given level of risk. The telltale sign that a manager is using modern portfolio theory is the classic risk/reward graph that shows the “efficient frontier” and the capital allocation line, as set forth in Figure 6.1.
This all sounds great in theory, and Wes and Jack still teach advanced college-level courses on the subject; however, as practitioners and not students-in-training, we are less focused on complex mathematical solutions, and more focused on pragmatic tools that work. We must ask the question, do complex asset-allocation strategies grounded in modern portfolio theory even work? To address ...