Is the PP Compatible with CAPM?

[blackomen]

http://en.wikipedia.org/wiki/Capital_as ... cing_model

Normally, Beta is calculated with respect to the S&P500..  but just for fun, I tried calculating Beta with respect to the Permanent Portfolio instead of S&P500.

I didn't save the results but almost every equity index (including the DOW) had a PP Beta of over 2 (when using the historical data from 2007 to now.)

So only one of the following possibilites could be true:

1) An investor would require at least TWICE as much return as the PP to justify investing in equities or an equity-heavy portfolio.
2) There's no way the PP could outperform Equities in the long run in theory (but that's not true from what we've seen.)

Thoughs?

[melveyr]

I like the way you are thinking. Too often do people apply beta to only equities.

With CAPM, beta should really be measured with respect to the "optimal risky" portfolio. The "risky" portfolio is generally defined as every investment outside of T-Bills. This even includes things like your human capital, junk bonds, real estate... etc.

Now, most people don't do this in practice because it is hard to aggregate all of the investment universe, let a alone try to find the fluctuations in value of human capital. So most people use US equities as proxy for the risky portfolio.

Takeaway:
I don't think your results are in conflict with CAPM. 100% equities is not the optimal risky portfolio, therefore it is taking risks that are not compensated for. The academic community does investors a disservice when they use 100% equities as a proxy for the optimal risky portfolio, because that is not what CAPM actually says. The idea of the optimal risky portfolio is much broader than just equities. Equity returns just happen to be the easiest to measure because of data availability.

Ahh see this part of the wiki article that you posted:
"The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital...) In practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the inobservability of the true market portfolio, the CAPM might not be empirically testable. This was presented in greater depth in a paper by Richard Roll in 1977, and is generally referred to as Roll's critique.[6]"

[Pointedstick]

Out of curiosity, melveyr, what would you rate as the optimal risky portfolio?

[melveyr]

Out of curiosity, melveyr, what would you rate as the optimal risky portfolio?

Well that is a really tough question because it is the holy grail of finance. If you can identify the optimal risky portfolio (usually measured by having the highest Sharpe ratio) you can blend it with cash or leverage to dial in the level of risk/returns that you want.

If CAPM perfectly described the world (I don't think it does), the optimal risky portfolio would be a global cap weighted index of every conceivable investment outside of T-Bills. However, this assumes that every investor is the same and has the same definition of risk. In reality, we all have different human capital betas (my father is a real estate agent who's income fluctuates like equities for instance) and we all spend in different currencies so those two factors alone complicate the simple CAPM description of a single optimal risky portfolio. It is important to remember that human capital is usually the largest part of your portfolio.

The real take away is that the optimal risky portfolio is the portfolio with the highest expected Sharpe ratio. If this portfolio is too risky for you than you can simply delever it with cash, or if you are willing to take additional risk than you lever up this optimal risky portfolio to have a higher expected return.

From my observations, a blend of long duration treasuries, gold, and equities has a decent Sharpe ratio considering the transparency/simplicity of its construction. However I am always hunting for something better and I will be sure to share if I end up doing something dramatically different. TBH I am 100% Vanilla PP and overweight cash because I have some upcoming expenses. 

[blackomen]

Although I have no idea what the optimal portfolio is (or if it's dynamically changing over time) but I feel the Permanent Portfolio is not too far off from it.  The PP also has the advantage of liquidity and lower transaction costs (Try owning a 100+ asset "optimal portfolio" and rebalancing it..  I doubt the headache and transaction costs will justify any additional return unless you have tens of million of dollars.)

I don't have any meaningful raw data to support this but I highly suspect that the PP also owns several of the most widely traded liquid assets available..  so it's likely that if money is leaving one asset, it'll flow into another asset you own.

[MachineGhost]

CAPM and beta is baloney.  Only an ivory tower academic could come up with something so theoretical it doesn't exist in the real world.  CAPM is worse than the search for the holy grail or fountain of youth.  OTOH, here is the market-cap weighted global optimal multi-asset portfolio:

[align=center][/align]

Me thinks I'll be sticking to the PP.  Humans are stupid.

[blackomen]

I don't disagree with that but what I'm saying is that even for someone who speaks the "language" of CAPM, the PP clearly provides better bang for the buck (risk).

CAPM and beta is baloney.  Only an ivory tower academic could come up with something so theoretical it doesn't exist in the real world.  CAPM is worse than the search for the holy grail or fountain of youth.  OTOH, here is the market-cap weighted global optimal multi-asset portfolio:

[align=center][/align]

Me thinks I'll be sticking to the PP.  Humans are stupid.