In my comments over the months since the economic sucker punch landed, I have been reiterating that Monte Carlo simulation is not to blame for the faulty risk assessment that brought down the derivatives markets. The assumptions that went into those risk simulation models were the source of the trouble, and that’s too bad, because many versions of Monte Carlo software are flexible enough to accommodate all kinds of probability functions and timelines.
Today I came across a lucid article from IndexUniverse.com detailing just one of the ways Monte Carlo simulation can be tuned to the combined unfolding of time and risk. Tomorrow, I’ll look specifically at that variation of risk analysis, but first, today, a little background.
Since Harry Markowitz won the Nobel Prize in Economics in 1990, the Efficient Frontier has been the line in the sand under which portfolio managers wiggle their toes. The efficient frontier is a major component of his Modern Portfolio Theory, which brought him the big prize. In the 1950s Markowitz was researching the idea of the present value of investments in order to optimize the return across collection or portfolio of these, and he realized that the element that was missing from ideas about present value was risk. This insight led, eventually, to his prescriptions for diversifying investments to maximize the return and minimize the risk across an entire portfolio.
Portfolio diversification is now gospel among financial planners. But gospel doesn’t mean all investment advisors treat or even produce the same Monte Carlo Excel models of portfolio risk in the same way. Tomorrow, one investment advisory firm’s approach to Monte Carlo and the Efficient Frontier.