Discount mulberry outlet bristol Outlet Beware of the flaws in modern portfolio theory
Hockey legend Wayne Gretzky famously said, “I don’t skate to where the puck is. I skate to where the puck is going to be.” A friend of mine in Tennessee told me a similar story about a breed of squirrel hunting dogs called a Mountain Feist. When chasing a squirrel, most dogs run after the squirrel and seldom catch it. Supposedly, the Mountain Feist instinctively heads for the tree, knowing that is where the squirrel is going. I think my friend might be pulling my leg, but it’s a great story anyway. It’s also a great metaphor for how to invest.
In the 1950s, a brilliant young student named Harry Markowitz developed a new way to define stock market risk. Prior to that, investors knew that stocks were risky, but no one had a way to quantify risk or use their knowledge of risk to build a better, more efficient portfolio. “Diversification” meant buying a handful of stocks and hoping for the best.
Marko witz changed all of this by defining risk as volatility and by introducing the concept of portfolio efficiency. He couldn’t eliminate risk in a portfolio, but he thought he had a way to structure portfolios to get the most return for a given level of risk. He later won the Nobel Memorial Prize in Economic Sciences in 1990.
Actually what he created is known as “mean variance optimization” of portfolios, but most people can barely pronounce that, let alone explain it. His theories, along with those of a few other pioneers in the field of portfolio management, eventually became known as Modern Portfolio Theory and 50 years later it has become the industry standard.
By the 1980s, and certainly by the 1990s, Wall Street and the investment community had adopted MPT as the new magic formula. An entire generation of financial advisers and portfolio managers has since been schooled in MPT. Investment firms were thrilled. At last, someone had found the magic formula for investing and all you had to do was do the math, decide how much risk you could stand and then plug in the appropriate investments in the various asset classes. How could you lose?
Well, as with most things, nothing is quite that simple. You might say that MPT works great until it doesn’t. It has been badly misrepresented by people who don’t fully understand it. Markowitz never suggested that you could not lose money following this formula. The theory simply states that the portfolios are allocated efficiently for a given level of risk. It did not say that it eliminated risk.
There are serious problems with MPT. It makes the assumption that markets are rational and that returns are normally distributed. Of course, anyone who believed that certainly got a nasty wake up call during the 2008 meltdown. Markets are not rational,
just as people are emotional and not always rational.
MPT also is backward looking, in that it builds portfolios by looking at past risk and return figures. Moreover, the calculations used are based on 30 to 40 year averages. But how many of you invest 30 to 40 years at a time? Even though people may invest for the long term, they really think in terms of much shorter time periods. If you are 60 years old, you probably don’t care a lot about 30 year averages. In addition, if you take any 30 year period, there are 5 and 10 year periods that were really great and really awful. Just investing based on a past 30 year average is basically saying that you have no clue about the future and have just resigned yourself to whatever happens. That doesn’t sound very reassuring.
MPT leads investors into a false sense of security, which in turn leads them to take greater risk than would be prudent. The 2008 meltdown is a good example. Many people had no idea how much risk they were actually taking. Standard asset allocation based on MPT is a recipe for large losses during long term bear markets.
In my opinion, if MPT ever worked at all, it only works in long term bull markets. That is definitely not the environment we are facing today. As I have stated many times, I think we are in the early stages of a long term bear market. If you are using MPT as your investment strategy in a sideways or down market, then the only difference between a conservative, moderate or aggressive portfolio is how much money you lose. But they all lose money.
A number of years ago, when asked how he invested his own 401(k) portfolio, Markowitz said, “I visualized my grief if the stock market went way up and I wasn’t in it or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.” Ironically, the father of Modern Portfolio Theory doesn’t even use it for his own investments.
Which takes us back to Gretzky and our squirrel chasing dog. I suggest that instead of blindly following some questionable formula and relying on past averages that are largely meaningless, use the insights of MPT but don’t be mentally lazy about it. Do your homework and attempt to understand the economy, demographic trends and market trends. And if common sense and intuition would seem to clash with your model, trust your gut over your model. Then adjust your portfolio to be positioned for where things are going, not where they have been.
If someone suggests to you that MPT is the way to go and that all you have to do is decide how much risk to take and pick your model accordingly, then I suggest you take a lesson from our squirrel hunting dog and head straight for the tree. Thanks for reading.