Most Popular ArticlesJune 30, 2009
The Efficient Frontier lies at the top-left portion of the graph where most green squares reside. This means that MAC’s annual returns are generally higher than those of buy-and-hold at the same level of risk. The undesirable portions of the graph (bottom and right) are mostly occupied by red squares. All except one of the extremely high volatility years are in red. If Markowitz favors investments at the Efficient Frontier, then he would surely prefer the MAC system to the buy-and-hold approach.
Doesn’t Modern Portfolio Theory call for absolute correlations between return and risk? Hence any investment offering high returns with low risks must be flawed. On the contrary, Modern Portfolio Theory does not postulate that high intrinsic risks are an inherent characteristic of high-return investments. Rather, it simply points out that rational investors would logically ask for additional risk premium to compensate for the extra risk they are taking. The performance of the MAC system is theoretically sound.
Based on the risk-and-return tradeoffs presented in Figure 3, no rational investor would subscribe to the buy-and-hold scheme as it offers no adequate risk premium to compensate for its enormous volatilities.
Monthly performance comparisons
The monthly performance comparisons between the MAC and the buy-and-hold method are best illustrated with a histogram. Again, I show only the 6-month MAC to keep the graph legible. The horizontal axis in Figure 4 shows different increments of monthly percentage change. The vertical axis tabulates the number of occurrences of each of these increments in 1,659 months.
On the positive-return side of the distribution, green squares capture all the winning months of the markets, including the few unusually strong rallies of 10 to 30 percent. When the markets are bullish, the MAC system does not miss the best months.
On the negative-return side, there is a sizable gap between the two systems. The MAC system is able to elegantly sidestep the markets during most of the losing months. Proceeds from all these bad months are safely kept in cash as reflected by the single green square floating at the very top of the vertical axis. Many red triangles suffer worse than fifteen percent losses, while green squares rarely incur losses of more than five percent.
Figure 4 illustrates graphically how the 6-month MAC system beats the markets. There is no fairy tale if a system can consistently avoid the losers but stay with the winners 1,659 times over 138 years.
Holy Grail or fairy tale?
I am not trying to persuade anyone that the MAC system is the Holy Grail. Indeed, I discovered MAC’s limitations when evaluating its decadal performances, which I will discuss in Part 3. Stay tuned!
What I have tried to convey is that all claims should be treated as hypotheses until they are proven by objective evidence - even a claim as sacred as the eminent passive investment doctrine. Perhaps the generally accepted buy-and-hold investment principle is only a fairy tale!
Theodore Wong graduated from MIT with a BSEE and MSEE degree. He was General Manager of several Fortune-500 companies designing sensors for satellite and military applications. He started a hi-tech company via a LBO in partnership with a private equity firm. He now consults on management and investment best practices. While studying for his MBA, he discovered his true passion was in investment research. He combines engineering analytics with econometrics modeling to enhance quantitative investment analysis. He seeks absolute returns by active risk management in both up and down markets. He can be reached at .
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