Beyond the 60/40 Rule: How Merton’s Theory Optimizes Asset Allocation

A brilliant article by The Economist explores probabilities, risk management, and investment strategies for your hard-earned savings. In a simple, insightful, and compelling way, it revisits a half-century-old investment theory by Robert C. Merton, based on his paper "Lifetime Portfolio Selection Under Uncertainty: The Continuous-Time Case." Merton’s model challenges the traditional 60/40 portfolio rule, instead advocating for an optimal asset allocation based on an investor’s individual risk aversion. Using the Constant Relative Risk Aversion (CRRA) utility function and your risk aversion, his framework determines the ideal split between high-risk assets (stocks) and safe assets (bonds) to maximize returns. In essence, Merton suggests that the percentage allocated to risky assets should be equal to their excess expected return over the risk-free alternative, divided by both personal risk aversion and the square of the risky asset’s volatility. This approach leads to a more dynamic asset allocation, adjusting as these variables change. Take a few minutes to digest this—I'll need more than a couple myself. While the theory offers a sophisticated and theoretically sound approach, applying it in practice is not straightforward. It requires precise estimations of key variables and may involve positions that some investors are unwilling or unable to take (such as short-selling). Additionally, one must be aware of and willing to accept the underlying assumptions and trade-offs. Interestingly, studies suggest that this investment strategy has stood the test of time, potentially delivering a significant premium over the conventional 60/40 approach. I must admit that, despite holding an MSc in Finance, I had never come across this theory before. It has certainly piqued my interest, and I plan to explore it further to see if it can be applied to my portfolio management. Hope you enjoy the article as much as I did! (text revised by a LLM) How much happiness does money buy? https://www.economist.com/christmas-specials/2024/12/19/how-much-happiness-does-money-buy from The Economist

- Pedro

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What Must Be True: Strategic Thinking for Managing Risk

Roger Martin, former Dean of the Rotman School, has written a fascinating and insightful article about risk management, emphasizing that a robust strategic process is the only effective way to approach it. Martin argues that, in most cases, risk management conducted by corporate boards often amounts to little more than box-ticking to comply with the Sarbanes-Oxley Act (S-OX) Section 404. This requirement, enacted after scandals like Enron and WorldCom, has become a lucrative exercise for consulting firms but provides little real value to management or investors. Instead of addressing critical risks, these efforts often generate exhaustive lists of potential risks (as seen in typical 10-K filings), which serve as "safe harbor" statements for management rather than actionable insights. A more effective way to approach risk management is by applying the Rumsfeld Risk Matrix (as illustrated in the accompanying graphic). This matrix divides risks into four quadrants: 1.Known Knowns – Risks we are aware of and understand well enough to measure and manage. 2.Known Unknowns – Risks we recognize but do not fully understand. 3.Unknown Knowns – Risks we are unconsciously aware of but fail to identify as risks. 4.Unknown Unknowns – Risks we are entirely unaware of. The ultimate goal of risk management is to increase awareness, turning unknowns into knowns, and improving precision by addressing uncertainties. This involves identifying key risks that are not fully understood, assessing their material impact and likelihood, and investing in understanding them better. It also requires implementing systems to monitor risks that might not be obvious and to uncover entirely new risks. So how is this achieved? The answer lies in a strong strategic process. A well-designed strategy explicitly considers what must be true (WWHTBT) for success and potential derailment, addressing factors such as industry dynamics, customer behavior, organizational capabilities, competitor actions, vendor dependencies, and technological advancements. By conducting thorough internal (IFE) and external (EFE) factor evaluations, along with a comprehensive SWOT analysis, organizations can identify key risk factors, enhance awareness, and improve their ability to detect unknown risks early. This article offers valuable insights and is highly recommended for anyone interested in strategic risk management. (text revised by a LLM) https://rogermartin.medium.com/risk-management-strategy-59869afd3558

- Pedro

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Hermanos Gutiérrez - Musica

Mi ultimo descubrimiento musical! Son buenísimos! https://open.spotify.com/artist/73mSg0dykFyhvU96tb5xQV?si=T9FfR1yVTu27j2VWVOipcw

- Pedro

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Books read throughout 2024! not a bad year

Throughout 2021 I’ve read 21 books, 5.745 pages and my average rating was 3.5 on Goodreads. The full list was the following: 1.Disciplina sin lágrimas 2.Até ao fim 3.The BlackSwan 4.A brief history of time 5.Raving Fans 6.Price and peace 7.Obvious Adams 8.Fascim 9.Os Ratoneiros 10.The secret language of competitive intelligence 11.Do dice play God 12.Strategy beyond the hockey stick 13.How to take smart notes 14.How to decide 15.The pyramid principle 16.12 rules for life 17.Deus na escuridao 18.The tipping point 19.Value-Based pricing 20.Win, keep, grow 21.Sobre la brevedad de la vida Hope 2025 i will make it to 25, but the most important is that i pick good ones, learn and enjoy myself in the journey. https://www.goodreads.com/user/year_in_books/2024/71159677

- Pedro

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How Math Connects Fireflies, Clocks, and Computing

A fascinating video featuring Steve Strogatz explores the power of mathematics and how it reveals hidden patterns in the world that would otherwise remain undiscovered. In one example, Strogatz discusses a study where he and his colleagues explained why fireflies begin flashing in unison. This phenomenon, initially thought to be purely biological, was redefined as a mathematical problem. Building on these findings, engineers developed a method to synchronize small electronic clocks, demonstrating how the mathematical principles from the study extend to fields like distributed computing and sensor networks. Mathematical abstraction—a cornerstone of mathematical reasoning—strips away irrelevant details, allowing us to focus on the fundamental elements of a problem. This approach uncovers connections and commonalities across diverse phenomena and scientific disciplines. I hope you enjoy the video as much as I did! (text revised by a LLM) https://youtu.be/kV-pnbtfraE

- Pedro

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El Gran Otro: Cómo el Capitalismo de Vigilancia Moldea Nuestros Comportamientos

He terminado La era del capitalismo de la vigilancia: La lucha por un futuro humano frente a las nuevas fronteras del poder por by Shoshana Zuboff, Albino Santos (Translator) Mi valoracion - 3/5 (Qualitativa - “Me ha gustado”) Un extenso libro sobre lo que la autora define como el capitalismo de vigilancia, que representa un nuevo paradigma para la sociedad, en el cual nosotros (los humanos) y nuestros comportamientos somos la fuente principal de materia prima para este proceso. Shoshana nos guía de manera exhaustiva a través de sus orígenes, cómo funciona y la importancia del behavioral surplus (excedente conductual) como base de todo. También aborda quiénes son los ganadores de esta nueva forma de organización social y económica (las "Magnificent 7") y quiénes son los grandes perdedores (nosotros). Se nos presenta todo lo que estamos perdiendo, en la mayoría de los casos sin ser conscientes de ello. Asimismo, se explican los riesgos a los que nos enfrentamos como sociedad: el fin de la privacidad, el libre albedrío individual y la creación de un "Gran Otro" que intenta influir en todos nuestros comportamientos. Es un libro cuya lectura recomiendo encarecidamente. Sin embargo, no es para todos, ya que resulta demasiado extenso. Estoy convencido de que podría reducirse fácilmente en un tercio de sus 861 páginas actuales sin perder su valor. De hecho, creo que esa reducción aportaría mayor claridad y eficacia al mensaje. Como diría Saint-Exupéry: "La perfección no se alcanza cuando no hay nada más que añadir, sino cuando no hay nada más que quitar". (texto revisado por LLM)

- Pedro

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How Games Shaped Probability, Strategy, and Economics

An excellent Economist’s Podcast that features Kelly Clancy—a neuroscientist, physicist, and author of Playing With Reality—discussing the profound impact of games on our lives and societal dynamics. Clancy emphasizes that games are a powerful form of learning, shaping how we think and interact with the world. Games like Chess, Go, Dice, and Cards introduced humanity to the concept of uncertainty, paving the way for probability theory (via Pascal and Fermat’s correspondence) and, subsequently, modern statistics. The episode also highlights the critical role of war games, such as Chess and Go, which evolved into more complex systems like Kriegsspiel. The latter was instrumental in training military officers and predicting battlefield outcomes, particularly during World War II. Clancy then connects this history to Game Theory, one of the most significant developments in economics, pioneered by John von Neumann. Game Theory has informed concepts like nuclear deterrence and continues to influence modern strategic thinking. However, it’s essential to complement it with insights from behavioral economics to understand human decision-making fully. The takeaway? Games are not just entertainment; they’re essential tools for education and skill-building. They can influence our behavior, shape our knowledge, and enhance problem-solving abilities. For instance, Miegakure (https://miegakure.com/) challenges players to solve problems in four dimensions—a fascinating way to expand your cognitive boundaries. All of this in just 38 minutes (at normal speed)—a fantastic return on your time! (revised by a LLM) The surprising ways in which games have changed the world—an interview with Kelly Clancy https://www.economist.com/podcasts/2024/11/27/the-surprising-ways-in-which-games-have-changed-the-world-an-interview-with-kelly-clancy

- Pedro

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