Once we recognize that our portfolio modelling efforts have an R-squared of less than 1.00, we must accept the possibility that optimism based upon portfolio optimization is necessarily misplaced. When the R-squared is less than 1.00, the crucial element in the decision at issue is not the likelihood of being right and what we get out of it, it is the consequences of being wrong. As the great Peter Bernstein put it: “There is no certainty. Rational people do not bet the ranch on a model with an [R-squared] of less than 1.00, that works out only for the most part. And God forbid it works out only for the minor part! Consequences, not probabilities, determine the decisions that matter.”
In the real world, outcomes are inherently uncertain, but we still have some control over what is going to happen or at least some control over the consequences of what is going to happen. Dealing with such inherent uncertainties is what risk management is all about. The current environment for guaranteed income isn’t great. But don’t be too quick to bank on portfolio optimization to save the day. As the Roman Stoic Seneca expressed it, “Our minds should be sent forward in advance to meet all the problems, and we should consider not what is wont to happen, but what can happen.”
I hope you’ll read the full article as well as the entire issue of the magazine.