ending the charade

A Journal of Financial Planning article urges advisors to “end the charade,” by “replacing the efficient frontier with the efficient range” (a hat tip to Michael Kitces for recommending the piece).

For some, the biggest charade is the notion of standard deviation of return as “risk,” but the article (by Meir Statman and Joni Clark) leaves that construct in place.  It does, however, provide important perspectives for those trying to connect theory and practice.

Visually, here’s the idea:

The article fits well with my April posting on the risks of “plug and play,” including the expectation that you can create a magical and “efficient” frontier out of inputs that are unlikely to fairly represent the future as it will be.

Statman and Clark raise a number of important issues, including the likelihood that financial services companies “rely on their perceptions of investor preferences rather than on mean-variance optimization as they construct their portfolios.”  Table 2 in the article shows a good example of that.

Importantly, “Harry Markowitz, the father of modern portfolio theory, noted that optimized portfolios should reflect the preferences of investors, beyond mean and variance.”  As with the Sharpe ratio, it seems that the caveats and context provided by their creators of the models are often lost by those blindly applying them.