I'll finish up Ray Dalio's quote from his paper in 2003:
"So:
a) While the ability to create an efficient portfolio of betas is limited by the limited number of them and their relatively high correlation, the confidence that you will eventually have a positive result, even if you choose poorly, is high; and
b) While the ability to create an efficient portfolio of alphas is great because of the large number of them and their relatively low correlations, the penalties for choosing poorly are large.”
Let me define a few more terms that Ray Dalio used. Ray used the term correlation several times. Modern Portfolio theory tells us that we want the asset classes we use to be as uncorrelated as possible. That way, when some of our investments are going down, others will be going up, minimizing our possible losses. We talked about this in a previous post.
As I mentioned before, Harry Markowitz, in a 1952 paper described how to find an optimal portfolio for any given level of risk. The key to a Markowitz efficient portfolio is to find the mix of assets with the lowest correlation amongst the various asset classes used. This sound complicated, but it can be accomplished with less trouble than you might think.
Ray also mentioned Sharpe ratios. A Sharpe ratio measures the excess return available per unit of risk. The higher the Sharpe ratio, the better the investment.
When picking a mutual fund for the long term, would I do best to choose the fund with the best long-term past performance?
Posted by: Anonymous | November 28, 2005 2:12 AM | Permalink to Comment