Portfolio Theory, and practice

Even though "Modern" Portfolio Theory is pretty old, and holds a lot of false assumptions around market completeness and diversification, it could be applied practically for a portfolio of positively expected strategies instead of simple assets vulnerable to systemic risk.

Original thoughts
So the original assumption around increasing the number of asset holdings is to lower the standard deviation of return, i.e. "unsystemic risk" (see below).

This is pretty easy to do by simply taking positions in index ETFs.

So what's the deal with the "Undiversifiable or Market Risk"? That includes things like credit risk, counter-party risk, basically everything that shows why buy & hold does not turn out well.

Actual application

Replacing asset holdings with trading strategies that exploit fundamental inefficiencies where systemic risks become opportunities for profit, and all of sudden portfolio theory becomes practical for the real world. It's like running a casino, to minimize swings in revenue, hosting a whole bunch of games helps the Law of Large Numbers kick in just a bit sooner; and everybody's happy.

Fortune's Formula book review

This has got to be one of the most practical and entertaining books I've gone through. It involves crazy smart mathematicians like Claude Shannon, John Kelly, Van Thorp working with gangsters like Longy Zwillman.

A few key concepts worth noting and still practical in today's markets,

1) Statistical arbitrage

Thorp started with Warrents (still traded over the ASX today), convertible bonds against underlying stocks. The average return of these guys in the 80s BEAT Warren Buffet's track record. There still exists plenty of other opportunities today.


2) The Kelly Criterion

where:

• f* is the fraction of the current bankroll to wager;
• b is the net odds received on the wager (that is, odds are usually quoted as "b to 1")
• p is the probability of winning;
• q is the probability of losing, which is 1 − p.

While making returns more volatile, with a positive expectancy this formula guarantees the highest possible return over time while keeping risk of ruin minimal.


3) Shannon's Demon
Claude Shannon was a freaking genius, and this is his version of a "balanced portfolio", where as long as the traded instrument IS indeed stochastic, a positive expectancy is guaranteed. So it can fit into the category of statistical arbitrage.