Nobel laureate Harry Markowitz’s Modern Portfolio Theory (MPT) will celebrate its 70th anniversary this year. It has revolutionized the finance industry by formalizing the principle of diversifying an investment portfolio and taken up much of the computing time of the world’s powerful financial computers and the minds of managers for decades. It’s the free lunch of finance.

Today, we tackle this mountain by proposing a new slope in which to climb it: The Intelligence Portfolio Theory (IPT).

The difference between MPT and IPT is ontological. The first focuses on the statistical effects of randomness; the second focuses on the self-organizing intelligence of interacting systems.

Randomness, as we shall see, is a mathematical convenience of ignorance, and this convenience presents many false noses.

Cette lettre est la première d’une série qui prolonge, étape par étape, la Théorie Moderne du Portefeuille. Elle s’adresse aux gérants de portefeuilles financiers et aux risk managers.

Nous commençons par un morceau de choix : la corrélation interne d’un portefeuille. C’est la variable clé qui détermine le risque de crash financier.

Depuis Harry Markowitz, les gérants de portefeuille pensent connaître la solution pour leurs investissements. Choisir des titres les plus diversifiés possibles. En d’autres termes, zéro coopération, zéro corrélation.

Mais comment mesurer la corrélation ? Et surtout, comment la mesurer en temps réel ?

This letter is the first in a series extending step-by-step the Modern Portfolio Theory. It is aimed at financial portfolio managers and risk managers.

We start with a choice piece: the internal correlation of a portfolio. This is the key variable determining the risk of financial crash.

Since Harry Markowitz, portfolio managers think they know the solution to their investments: choose the most diversified assets possible. In other words, zero cooperation, zero correlation.

But how do we measure the correlation? And furthermore, how do we measure it in real time?

Last Friday, the COVID-19 omicron variant from southern Africa awoken loudly under the horns of the media, and European stocks lost nearly 5% in the day. Bad surprise!

The financial market seems to have been invented to surprise managers, more specifically to dispel the surprise, and managers generally do not like this too much.

What are the market consequences of surprises?

A Minsky moment resembles a snake attack: a sudden and violent destructive move, much like a stock market crash. It originates in a slow psychological process according to economist Hyman Minsky, namely a gradual weakening of the financial system through mounting debts in periods of irrational euphoria.

Can we verify this hypothesis? And is the Minsky moment actually unpredictable?

Ahhh, the simple scientific world of René Descartes! Single cause, single effect. In the economic world however, this unfortunately is not the case. One cause can even bring about two opposite effects.

A devaluation, for example, usually produces a deterioration in the external accounts first and then an improvement second. Economists call this phenomenon the “J-curve.”

However for more than 20 years, the financial policies of developed economies have turned the page upside down. The “J” has become an “η.” Immediate relief and pain for tomorrow.

The tapering in view of the US Federal Reserve now raises the question: Would “tomorrow” be the end of the summer?

Are there laws in economics as well as in physics? We say yes, absolutely. Just like gravitation, classical mechanics, thermodynamics, and even quantum mechanics.

To understand this phenomenon requires a bit of imagination. In particular, a new status of law, which does not find its foundation in an external Platonic world but rather the self-organization of individuals. Here, we state a new scientific law governing a living society: rats in a cage, or «The Law of Diving Rats.”

This example introduces Econophysics.

Our previous publication, The Mason’s Strategy, underlined the longstanding and intriguing forecasting power of behavioral finance. Today, our masons go back to the university to study macroeconomic sciences and specifically where stock markets go. This time, they want to know in a purely objective manner.

Will they succeed?

Notre dernière publication, La Stratégie du Maçon, dévoilait la surprenante puissance prédictive de la finance comportementale. Aujourd’hui, nos maçons retournent sur les bancs universitaires pour étudier les sciences économiques. Ils veulent découvrir, cette fois de manière purement objective, où vont les marchés.

Vont-ils réussir ?

To check the horizontality or verticality of a wall, masons still use an ancestral instrument today known as the “Spirit Level”. Now, let us use this instrument to measure the psychology of the equity markets to warn us when they start to tilt in the wrong direction, at the risk of collapsing the edifice.

Pour vérifier l’horizontalité ou la verticalité d’un mur, les maçons utilisent encore aujourd’hui un instrument ancestral : un Niveau à Eau. Nous allons utiliser cet instrument pour mesurer la psychologie des marchés actions et pour nous avertir quand ils commencent à pencher du mauvais côté, au risque d’écrouler
l’édifice.

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