I went back recently to take another look at an article that Harry Markowitz wrote
in 1991 (“Individual versus Institutional Investing” in Financial Services Review l(l):1-8). The creator of Modern Portfolio Theory (MPT) was
invited to comment on financial theory as it relates to an individual vs. institutions
such as a mutual fund or a manufacturing company job shop. In the article he makes some distinctions
between individual or family finance and his original thinking on MPT for
mutual funds. He goes on to pitch the
advantages of simulation methods to capture some of the excess -- and more than
likely unsolvable -- complexity a family faces in managing its resources over a (joint) lifetime. I guess it is not surprising
that we have seen simulator type approaches go wild in financial services since
the article was published in '91 (and since the cost of computing resources has plummeted).
The quotes below in no way summarize the seven page
article. The points are merely ones that
I found interesting coming from the father of MPT:
- …an evening of reflection convinced me that there were clear differences in the central features of investment for institutions and investment for individuals,
- The “investing institution” which I had most in mind when developing portfolio theory for my dissertation was the open-end investment company or “mutual fund" [vs. a family or individual].
- For example, some economic theories find it convenient to assume that the individual is immortal, or that death is a Poisson process independent of the age of the individual. For actual financial planning, however, aging and mortality are salient facts that must be included in the model.
- The essentials of the game-of-life [simulation] is probably different for (a) the very wealthy, (b) the class of homeless that used to be called vagrants, and (c) most of my friends and relatives. I have the latter in mind as I sketch the model.
- Since future status is random, the simulated family must follow adaptive decision rules rather than a single plan as expressed on a worksheet.
- the game [of life] is complex; most likely beyond analytic techniques.
- The problem with simulation analysis is that it is not very good at finding near optimum decision rules. It takes many runs of the model to estimate the excellence of a given set of rules. Since the rules we seek may be adaptive i.e., may recommend different allocations of resources under different circumstances, and “circumstances” admit to countless variations-it will not be feasible to search for optimum decision rules.
- The exercise of building a realistic game-of-life simulator-deciding what is essential to the family planning process and incorporating it into a simulator without the severe constraint of producing an analytically tractable model should be highly educational, especially to the model builders. [ a point to which I can personally attest]
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