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    Dr. Marcinko is originally from Loyola University MD, Temple University in Philadelphia and the Milton S. Hershey Medical Center in PA; as well as Oglethorpe University and Emory University in Georgia, the Atlanta Hospital & Medical Center; Kellogg-Keller Graduate School of Business and Management in Chicago, and the Aachen City University Hospital, Koln-Germany. He became one of the most innovative global thought leaders in medical business entrepreneurship today by leveraging and adding value with strategies to grow revenues and EBITDA while reducing non-essential expenditures and improving dated operational in-efficiencies.

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Do Physician Investors and/or their Financial Advisors Use and Abuse Modern Portfolio Theory?

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The Cultural Clash of Passivity versus Activity

By Dr. David Edward Marcinko MBA CMP™

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[Publisher-in-Chief]

Ninety-three year old Professor Harry Markowitz PhD, coined the phrase “modern portfolio theory” [MPT] and concluded that investors are rewarded for taking certain risks but may not get rewarded for taking others. He developed the notion of an “efficient frontier” for different groups of asset classes and the idea that the higher the expected return, the higher the risk.

The Biblical Brinson, Hood, Beebower Study

In their 1986 study, Brinson, Hood, and Beebower attempted to measure three investment activities: (1) asset class selection, (2) market timing, and (3) security selection. They concluded that asset class selection had, by far, the greatest effect on the risk/return characteristics of a portfolio (some 93.6% of performance). But the most startling conclusion was that, if left alone, investment policy would have produced a higher average return than when market timing and security selection were taken into account. These latter factors actually reduced the average return over a 10-year period.

The Fama & French Study

In 1982, Fama and French found that three factors—market exposure, company size, and “value”—were systematic risks that explained the vast majority of equity market returns. “U.S. small-cap value stocks” is therefore a discreet asset class possessing all three of these systematic risks.

Most physicians and financial advisors are aware of modern portfolio theory but some fail to apply the principles to actual investor situations. Three examples: (1) using erroneous asset-class definitions, (2) using actively managed funds, and (3) relying on market timing. The abuse of modern portfolio theory can create portfolios loaded with latent risks that, on the surface, appear benign.

Not all Agree

Not everyone is in agreement with modern portfolio theory. Some detractors agree in principle, recognizing, for example, that “value” stocks have had higher returns than “growth” issues but they cite the cause as “mispricing” rather than risk.

Assessment

Institutional investors have gradually increased their commitment to passive strategies from virtually zero 20 years ago to 30% or more in the last decade [Think: Vanguard].

Individual and physician investors, on the other hand, have less than a 5% commitment.

Note: “Modern Portfolio Theory: Fact or Fiction?,” Gerard F. Stellwagen and Robin P. LaCouture, NAPFA Advisor, July 1997, pp. 1–7, National Association of Personal Financial Advisors for Fee-Only Financial Advisors.

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The Living Legacy of Dr. Harry Markowitz

Creating Diversified Portfolios of Uncorrelated Assets

By Dr. David Edward Marcinko MBA CMP™

[Publisher-in-Chief]

More than a half century ago, a paper appeared in The Journal of Finance written by a 24-year-old doctoral candidate in economics at the University of Chicago—Harry Markowitz. It was called “Portfolio Selection” and suggested that investors take into account risk in pursuit of the highest return—a concept that we take for granted today [Modern Portfolio Theory].

Markowitz drew a trade-off curve between risk and reward and called it the “efficient frontier.” A rational physician executive or other investor who knew his or her risk tolerance could choose an appropriate portfolio from a point on this curve. Markowitz led investors to diversified portfolios of uncorrelated investments.

Dissertation Follow-up

Markowitz followed up his dissertation in 1959 with a book entitled Portfolio Selection [Efficient Diversification of Investment]. His many contributions to finance earned him the Nobel Prize in Economic Science in 1990 along with William Sharpe and Merton Miller. He reasoned that diversification is about avoiding the covariance.

If risks are uncorrelated, you can reduce the risk of a portfolio to practically zero by sufficient diversification. This doesn’t work if risks are correlated. If one invests in a very large number of securities that are correlated, risk does not approach zero but rather the average covariance, which is a very substantial amount of risk.

Where It All Started

It was at the RAND Corporation that Markowitz met William [Bill] Sharpe who was working on his PhD at UCLA. Markowitz takes issue with Sharpe’s Capital Asset Pricing Model (CAPM), which claims that the expected return of a security depends only on its beta—ignoring fundamental analysis.

CAPM also implies that the market portfolio is efficient, even though investors in the market may not act rationally. It says that the market portfolio is a mean-variance efficient portfolio. Markowitz disputes this conclusion. He points to Fama and French and others who have found that expected returns are more closely related to book-to-price or size—not to beta.

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Assessment

The still living Markowitz fends off criticism of mean-variance analysis only being valid when probability distributions are normal by stating that he realizes that probability distributions are not normal in the real world.

But, if they are similar to a normal distribution, mean variance does a good job at approximating expected utility. He admits that when they are too dispersed, mean variance doesn’t work well.

Note: Travels along the Efficient Frontier,” an interview with Harry Markowitz by Jonathan Burton, Dow Jones Asset Management, May/June 1997, pp. 21–28, Dow Jones Financial Publishing Corp.

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Is There an “Efficient Frontier” for Medicare Payment Reform?

An Essay on Financial Health Risk Self-Selection

By Dr. David Edward Marcinko MBA CMP™

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[Publisher-in-Chief]

Health economist Austin Frakt PhD, of the Incidental Economist, alerted us to this recent publication “Achieving Cost Control, Care Coordination, and Quality Improvement through Incremental Payment System Reform”, by and from: (Averill, et al., JACM, 2010). The paper describes various Medicare payment reform methods.

The Abstract

The healthcare reform goal of increasing eligibility and coverage cannot be realized without simultaneously achieving control over healthcare costs. The reform of existing payment systems can provide the financial incentive for providers to deliver care in a more coordinated and efficient manner with minimal changes to existing payer and provider infrastructure. Pay for performance, best practice pricing, price discounting, alignment of incentives, the medical home, payment by episodes, and provider performance reports are a set of payment reforms that can result in lower costs, better coordination of care, improved quality of care, and increased consumer involvement. These reforms can produce immediate Medicare annual savings of $10 billion and create the framework for future savings by establishing financial incentives for long-term provider behavior changes that can lead to lower costs.

Patient Risk Sharing

Of course, the third dimension of risk [beyond traditional doctor/hospital provider and Medicare insurer] would be the risk borne by the patient insured (degree of cost-sharing or “consumer responsibility”). This relationship is represented diagrammatically right here:

Brief Review of MPT

Modern portfolio theory (MPT) attempts to maximize investment portfolio expected returns for a given level of risk by carefully choosing the proportions of various asset classes. As a mathematical formulation, the concept of diversification aims to select a collection of assets that collectively lowers risk [measured by standard deviation] more than any individual asset class. This pleasing point is known as the “efficient frontier.” And, it can be seen intuitively because different types of assets often change in value in opposite ways.

Is There an Insurance Efficient Frontier?

Health insurance [medical payment reform] econometric considerations may now be extended in this analogy to suggest that medical providers and CMS payers are the surrogates for two dimensions in the MPT. The third might be the risks borne by the patient insured (degree of cost-sharing or “consumer responsibility”), as above.

Assessment

Then, patients could self-select where they wish to fall on the health insurance “efficient frontier”, balancing all three dimensions as in MPT, along with lifestyle and moral hazard considerations, etc.

Conclusion

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Hospital Capital Formation, Harry Markowitz and Modern Portfolio Theory

Strategic Risk Considerations for Physician-Executives and Healthcare CXOs

[By Calvin W. Wiese; MBA, CPA, CMA]

To most all financial advisors, wealth managers and stock-brokers, the work of Harry Markowitz and Modern Portfolio Theory [MPT] is not usually discussed in terms of hospital capital formation. But, perhaps it should!

Capital Investments Create Risk

Capital investments create risk. Risk is the uncertainty of future events. When hospitals make capital investments, they commit to costs that affect future periods. Those costs are known and relatively fixed. What are unknown are the benefits to be realized by those capital investments.

Defining Risk

For capital investments, risk is the certainty of future costs coupled with the uncertainty of future benefits. In some cases, while the future benefits are uncertain, there is a high degree of certainty that the benefits will exceed the costs. In these cases, risk can be very low. Risk may be better defined as the degree to which the uncertainty of unknown benefits will exceed the known and committed costs.

Asset Burdens and Benefits

When capital assets are purchased, both the burdens and the benefits of ownership are transferred to the owner. The burdens are primarily the costs associated with acquisition and installation. The benefits are primarily the revenues generated by operating the capital assets. Risk of ownership is created to the degree that the benefits are uncertain.

Understanding Risk

Hospital managers need to be skilled at putting hospital assets at risk. Without clear knowledge and understanding of the benefits and the burdens, hospitals can quickly find themselves at unacceptably high levels of risk. Risk must be continually assessed and evaluated in order to successfully put hospital assets at risk. Hospitals require many varied capital investments; their capital investments represent a risk portfolio. An effective combination of risky assets can often create risk that is less than the sum of the risk of each asset.

Modern Portfolio Theory

Of course, financial managers have know this for years as a basic principle of Modern Portfolio Theory (MPT), first introduced by Harry Markowitz, PhD, with the paper “Portfolio Selection,” which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller, PhD, and William Sharpe, PhD, for what has become a broad theory for securities asset selection; and hospital assets may be viewed as little different.

Prior to Markowitz’s work, investors focused on assessing the rewards and risks of individual securities in constructing a portfolio. Standard advice was to identify those that offered the best opportunities for gain with the least risk and then construct a portfolio from them. Following this advice, a hospital administrator might conclude that a positron emission tomography (PET) scanning machine offered good risk-reward characteristics, and pursue a strategy to compile a network of them in a given geographic area. Intuitively, this would be foolish. Markowitz formalized this intuition.

Detailing the mathematics of diversity, he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios of securities, or capital assets that each individually has attractive risk-reward characteristics. In a nutshell, just as investors should select portfolios not individual securities, so hospital administrators should select a wide spectrum of radiology services, not merely machines.

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Assessment

Savvy hospital managers will mitigate ownership risk by constructing their portfolio of risky assets in a manner that lowers overall risk

Conclusion

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Strategic Modern Portfolio Theory Considerations in Hospital Capital Formation

Understanding Risk for Doctors and Financial Advisors

By Calvin W. Wiese; MBA, CPA

www.HealthcareFinancials.com

Hospital capital investments financial create risk. Risk is the uncertainty of future events. When hospitals make capital investments, they commit to costs that affect future periods. Those costs are known and relatively fixed. What are unknown are the benefits to be realized by those capital investments. For capital investments, risk is the certainty of future costs coupled with the uncertainty of future benefits. In some cases, while the future benefits are uncertain, there is a high degree of certainty that the benefits will exceed the costs. In these cases, risk can be very low.

Risk Re-Defined

Risk may be better defined as the degree to which the uncertainty of unknown benefits will exceed the known and committed costs. For example, when capital assets are purchased, both the burdens and the benefits of ownership are transferred to the owner. The burdens are primarily the costs associated with acquisition and installation. The benefits are primarily the revenues generated by operating the capital assets. Risk of ownership is created to the degree that the benefits are uncertain.

Managing Risk

Hospital managers and physician executives need to be skilled at putting hospital assets at risk. Without clear knowledge and understanding of the benefits and the burdens, hospitals can quickly find themselves at unacceptably high levels of risk. Risk must be continually assessed and evaluated in order to successfully put hospital assets at risk. Hospitals require many varied capital investments; their capital investments represent a risk portfolio. An effective combination of risky assets can often create risk that is less than the sum of the risk of each asset.

About MPT

Of course, financial managers have know this for years as a basic principle of Modern Portfolio Theory (MPT), first introduced by Harry Markowitz, PhD, with the paper “Portfolio Selection,” which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller, PhD, and William Sharpe, PhD, for what has become a broad theory for securities asset selection; and hospital assets may be viewed as little different. Prior to Markowitz’s work, investors focused on assessing the rewards and risks of individual securities in constructing a portfolio. Standard advice was to identify those that offered the best opportunities for gain with the least risk and then construct a portfolio from them.

Following this advice, a hospital administrator might conclude that a positron emission tomography (PET) scanning machine offered good risk-reward characteristics, and pursue a strategy to compile a network of them in a given geographic area. Intuitively, this would be foolish. Markowitz formalized this intuition. Detailing the mathematics of diversity, he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios of securities, or capital assets that each individually has attractive risk-reward characteristics. In a nutshell, just as investors should select portfolios not individual securities, so hospital administrators should select a wide spectrum of radiology services, not merely machines.

Assessment

Savvy hospital managers will mitigate ownership risk by constructing their portfolio of risky assets in a manner that lowers overall risk.

Conclusion

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Are Capital Markets Efficient?

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What is the Efficient Market Hypothesis?

[By Jeffrey S. Coons; PhD, CFA]

[By Christopher J. Cummings; CFA, CFP™]fp-book1

The Efficient Market Hypothesis (EMH) states that securities are fairly priced based on information about their underlying cash flows and that physician investors should not expect to consistently outperform the market over the long-term. 

 EMH Types 

There are three distinct forms of EMH that vary by the type of information that is reflected in a security’s price:

·  Weak Form: This form holds that investors will not be able to use historical data to earn superior returns on a consistent basis.  In other words, the financial markets price securities in a manner that fully reflects all information contained in past prices.

·  Semi-Strong Form: This form asserts that security prices fully reflect all publicly available information. Therefore, investors cannot consistently earn above normal returns based solely on publicly available information, such as earnings, dividend, and sales data.

·  Strong Form: This form states that the financial markets price securities such that, all information (public and non-public) is fully reflected in the securities price; investors should not expect to earn superior returns on a consistent basis, no matter what insight or research they may bring to the table. 

While a rich literature has been established regarding to test whether EMH actually applies in any of its three forms in real world markets – probably the most difficult evidence to overcome for backers of EMH is the existence of a vibrant money management and mutual fund industry charging value-added fees for their services. 

In fact, no less than Warren Buffett has suggested that the markets are decidedly not efficient. 

Assessment

And so, while there has been a growing move towards index funds – as well as ETFs – the strength of the money management industry may reflect investor’s concern with risk management and asset allocation – as much as any view that a manager or individual can “beat the market.”   

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