CHAPTER 7
Classical
Portfolio
Construction
Modern Portfolio Theory
Recall from Chapter 4 the paradox of the optimalfand a market system’s
drawdown. The better a market system is, the higher the value forf. Yet the
drawdown (historically), if you are trading the optimalf, can never be lower
thanf. Generally speaking, then, the better the market system, the greater
the drawdown will be as a percent of account equity (if you are trading
optimalf). That is, if you want to have the greatest geometric growth in an
account, then you can count on severe drawdowns along the way.
Diversification among other market systems is an effective way to buffer
this drawdown while still staying close to the peak of thefcurve (i.e., without
having to trim back to halff, and so on). When one market system goes into
a drawdown, another one that is being traded in the account will come
on strong, thus canceling the drawdown of the other. This also provides
for a catalytic effect on the entire account. The market system that just
experienced the drawdown (and now is getting back to performing well)
will have no less funds to start with than it did when the drawdown began
(thanks to the other market system canceling out the drawdown).
Given a group of market systems and their respective optimalf’s, a
quantifiable, optimal portfolio mix does exist. Although we cannot be cer-
tain that what was the optimal portfolio mix in the past will be optimal in
the future, it is more likely to be optimal or near optimal than is the case
for the optimal system parameters of the past. Whereas optimal system