Education, MPT…..and the law of compensating assumptions

What is education?

Is it the learning of something without question, i.e. the solution and the process that defines the solution?

Or, is it the learning of the fundamentals of the problem and possible solutions to that problem, bearing in mind the strengths and weaknesses of the solution given the nature of the problem?  A solution has to be arrived at through an assessment of balance, and without an awareness of balance there can be no effective solution.

Without an awareness of weakness, there can be no structural integrity, because you are unaware of those moments at which your structure is exposed.   This is part of the law of compensating assumptions: any structure must have assumptions which compensate for its weaknesses.

Take MPT structures which are statistically derived: given that they will often fail to accurately reflect the risks and return relationships at a given point in time they are exposed to significant out of equilibrium moments.  Just like any statistically drawn conclusion, they are averages, based on an assumption of normal relationships.

These are the weaknesses: its strength is that it can be implemented with virtually zero cost to the investor, as can the underlying asset allocation.   The weakness is overcome by its strength (lower costs) in this perspective, but it is not optimal.  Its lack of optimality is discounted by its pricing providing it with a significant margin of error. 

In other words, rules of thumb diversification and withdrawal management depend on next to nothing to implement and manage.  As soon as you incorporate fees and other costs of personalised wealth management, the inherent weaknesses of the structure open up.  A failure to grasp these weaknesses is a bigger weakness than an assumption that it has no weaknesses at all.

You need compensating assumptions at the heart of any wealth management system.

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