Understanding Modern Portfolio Construction
Cullen O. Roche (Orcam Financial Group)
February 22, 2016
Over the last 75 years there have been great strides in modern finance, portfolio theory and asset allocation strategies. Despite this progress the process of portfolio construction remains grounded in many theoretical concepts that can result in inappropriate or unrealistic frameworks. In this paper we provide an overview of the development of these ideas, construct a general foundation for understanding portfolio construction and produce a framework for simplifying, systematizing and streamlining the process in an attempt to establish a realistic and suitable process for portfolio construction.
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● U.S. jobless claims hit 5-mo low as labor mkt strengthens | Reuters
● US consumer confidence remains steady in 1st week of Mar | Bloomberg
● US services firms show resilience during mfg recession | WSJ
● ECB’s Draghi plays his last card to stave off deflation | Telegraph
● UK inflation expectations fall to 1.8%, below BOE target | MNI

Recent economic data for the US suggests that the stock market’s hissy fit this year has been a false signal for anticipating a new recession. That’s not surprising—the short-term noise in equity prices is a constant challenge for business-cycle analysis and so it’s not uncommon that market volatility will lead us astray at times. That’s always been the case and nothing’s changed. Looking to markets in isolation of hard economic numbers is a dangerous game if real money is at stake. The challenge is finding a happy medium. The good news is that there are several choices for relatively reliable signals.
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● Revised GDPNow model estimate for US Q1 growth holds at +2.2% | Atlanta Fed
● US wholesale inventories rose in Jan as sales tumbled | Reuters
● Faltering US economy leads global slowdown | Markit
● Is Passive Investment Actively Hurting the Economy? | New Yorker
● How To Be Wrong As An Investor | Wealth of Common Sense
● Who Gets the Blame for the Slowing Economy? | NY Times
● Google’s AI program beats GO grandmaster | Wired

The Federal Reserve will leave its Fed Funds rate unchanged at the current target range of 0.25% to 0.50% at its policy meeting next week, writes The Wall Street Journal’s John Hilsenrath–reportedly one of the most “well-connected” journalists on Fed matters. Supporting evidence for anticipating that the central bank will stand pat includes the recent numbers on key Treasury yields, the Effective Fed Funds rate and the market’s inflation expectations.
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● US small-business owners’ confidence eases in Feb | MarketWatch
● US Redbook Retail Sales Index up 0.7% in the first week of Mar | MNI
● Are Central Banks Really Out of Ammunition? | Project Syndicate
● Fed Likely to Stand Pat on Rates, Keep Options Open | WSJ
● UK industrial production ticked up in Jan | MarketWatch

Failure isn’t an option, but it happens. Modeling the possibility that a portfolio strategy will stumble isn’t exactly cheery work, but it’s a productive and necessary exercise for stress testing what the future can do to the best-laid plans for investing. The good news is that there’s a rainbow of options for estimating the potential for trouble. But it’s usually best to start with a basic framework before venturing into more exotic realms.
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● Federal Reserve’s US employment yardstick sours in Feb | MarketWatch
● US Consumer Spending Up Slightly in Feb | Gallup
● Fed officials set battle lines on rate hikes ahead of FOMC meeting | Reuters
● While market debates commodities bottom, inflation warnings rise | CNBC
● China Exports Plunge In February | RTT
● Japan Q4 GDP Slump Revised Up Slightly; Spending Remains Weak | MNI

Risky asset roared back to life last week, led by a surge in surge in equities in emerging markets, based on a set of ETF proxies for the major asset classes. For the third straight week, there was a risk-on bias for the five trading days through Mar. 4.
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