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I don't really understand the equation. Plugging in an average stock market performance (over last 20 years): Return: 8% Standard Deviation: 17.72% Risk free

by j7ake 9y ago

I don't really understand the equation. Plugging in an average stock market performance (over last 20 years): Return: 8% Standard Deviation: 17.72% Risk free rate: 3% (guess) This gives f = 1.59. This means the optimal strategy is to be putting 159% of your money in an ETF index? This strategy is in stark contrast with the typical 70%-30% allocation of investments. How do we reconcile this? Intuitively, the function of your age needs to be included in this equation (I think somebody commented on this already).

forinti 9y ago
It also doesn't take into account the cost of that extra 59%.
- zhte415 9y ago
  It includes risk-free rate, the cost of financing. And it's 259% of funds, 159% borrowed + 100% of own funds. For a consumer, the rate of funding would be higher, however.
dmichulke 9y ago
Isn't risk-free currently more like 0%? Alternatively, where can I get my 3%? No ICOs please ;-)
- clairity 9y ago
  yah, 3% is a high assumption for the risk-free rate. but if it were 0%, you'd be losing money to inflation over time (treasuries are only proxies for the theoretical construct that is the risk-free rate). no single security provides the risk-free rate but perhaps a (small) portfolio of securities could get you the risk-free return.
- ThrustVectoring 9y ago
  You can find FDIC insured bank accounts at 1.25% nowadays. There's also I-bonds at 1.9% inflation-linked, with a purchase limit of $10k/yr and a 1-year redemption lock-out. 3% is more accurate for the cost of margin loans or the opportunity cost of pre-paying a mortgage.
stevenmays 9y ago
Risk free rate = treasury bills (1.43%) Putting 160% would mean using a leveraged S&P 500 ETF.
- PantaloonFlames 9y ago
  meaning, the investor just buys the leveraged ETF, rather than borrowing money at the t-bill rate to purchase SPY. Amiright?
ThrustVectoring 9y ago
Maximum expected value isn't the same thing as best distribution of results. The levered portfolio does better in expectation, but at the cost of being in for a really bad time in a bear market. Plus, many investors can't stomach the losses of a 100% equities portfolio, let alone something levered up. >How do we reconcile this? Intuitively, the function of your age needs to be included in this equation (I think somebody commented on this already). Age is a proxy for funding amount. A lot of investment goals aren't just "maximize the amount of money I get". They often care about things like "I need to spend $X/yr in retirement". So your investment goal should also put some weight on how likely it is to sustain that, and a higher bond percentage at higher investment amounts will do that.

by j7ake 9y ago

forinti 9y ago

It also doesn't take into account the cost of that extra 59%.

zhte415 9y ago
It includes risk-free rate, the cost of financing. And it's 259% of funds, 159% borrowed + 100% of own funds. For a consumer, the rate of funding would be higher, however.

dmichulke 9y ago

Isn't risk-free currently more like 0%? Alternatively, where can I get my 3%? No ICOs please ;-)

clairity 9y ago
yah, 3% is a high assumption for the risk-free rate. but if it were 0%, you'd be losing money to inflation over time (treasuries are only proxies for the theoretical construct that is the risk-free rate). no single security provides the risk-free rate but perhaps a (small) portfolio of securities could get you the risk-free return.
ThrustVectoring 9y ago
You can find FDIC insured bank accounts at 1.25% nowadays. There's also I-bonds at 1.9% inflation-linked, with a purchase limit of $10k/yr and a 1-year redemption lock-out. 3% is more accurate for the cost of margin loans or the opportunity cost of pre-paying a mortgage.

stevenmays 9y ago

Risk free rate = treasury bills (1.43%) Putting 160% would mean using a leveraged S&P 500 ETF.

PantaloonFlames 9y ago
meaning, the investor just buys the leveraged ETF, rather than borrowing money at the t-bill rate to purchase SPY. Amiright?

ThrustVectoring 9y ago

Maximum expected value isn't the same thing as best distribution of results. The levered portfolio does better in expectation, but at the cost of being in for a really bad time in a bear market. Plus, many investors can't stomach the losses of a 100% equities portfolio, let alone something levered up. >How do we reconcile this? Intuitively, the function of your age needs to be included in this equation (I think somebody commented on this already). Age is a proxy for funding amount. A lot of investment goals aren't just "maximize the amount of money I get". They often care about things like "I need to spend $X/yr in retirement". So your investment goal should also put some weight on how likely it is to sustain that, and a higher bond percentage at higher investment amounts will do that.