Benoit Mandelbrot, inventor of fractal geometry, is one of the most articulate critic of what is known as the Efficient Market Hypothesis.
Mandelbrot does suggest a method for portfolio construction and it closely follows what Geoff Considine developed in his Quantext Portfolio Planning (QPP) software. Mandelbrot advocates stress testing the portfolio. Quoting from his book, "It means letting a computer simulate everything that could possibly go wrong, and seeing if any of the possible outcomes seem so unbearable that you want to rethink the whole strategy. The technology is called a Monte Carlo simulation. You tell a computer how you think prices vary–specifically, what kind of random-number generator is should use. You feed it all the initial data: the particular stocks (or ETFs), their price histories, your strategy for buying them. Then you press the start button. Using the rules of randomness you gave it, the computer starts generating a series of hypothetical prices for each stock–in essence, it simulates one investor's possible experience with the portfolio. Then it does it again, and again, thousands of times, like someone flipping a coin over and over to see if the odds for getting heads really are fifty-fifty. At the end, it totes up all the scores from all the runs: That tells you which simulated outcomes happened most often, and hence, which might be most likely in real life. It also tells you which outcomes are unlikely but, if they occurred, devastating. Finally, you use your own intelligence to decide whether you like the scenario the computer paints. If not, you decide the portfolio is too risky and you start again." [Read more…]