Niels Jensen on why Modern Portfolio Theory should be junked

Long term trend watch:  On this week’s Outside the Box column, John Mauldin features a Niels Jensen column on how models that use normal distributions for risk management are manifestly false and should be junked in favor of those that use power law distributions (known as the "80/20 rule" to us mortals).

This theme was also hit on in two books that I have recently read, the Black Swan by Nassem Taleb and The Origin of Wealth by Eric Beinhocker.

The Black Swan: The Impact of the Highly ImprobableOrigin of Wealth: Evolution, Complexity, and the Radical Remaking of Economics

The net effect is that hedge funds and investment banks end up taking on too much leverage because they are lead astray by their risk management models.  Leverage itself creates high levels of correlation within asset classes during times of crisis, which are in turn exacerbated by high levels of leverage, creating a "vicious cycle" like what we saw this summer during the Subprime Crisis, but also during the LTCM collapse and the 1987 stock market crash.  This theme was well explained in Richard Bookstaber’s A Demon of our own Design.

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation

My advice at this (relatively late) stage in the business cycle: reduce leverage voluntarily, becuase not too far down the road, the market will make you do it involuntarily.

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