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February 25, 2014

Modern Portfolio Theory - Part I

By Anthony Harrington via QFinance

There are many ways to take a fresh look at modern portfolio theory (MPT), the brainchild of Harry Markowitz, but perhaps the most obvious is to tackle the criticism that MPT fell on its face in the 2008 crash, when its balanced portfolio approach conspicuously failed to save investors from taking a caning. First, though, in Part One we will take a brief detour through a little investment history. The way in which MPT has been picked up and implemented by shoals of financial advisers is via the traditional-as-fish-and-chips 60/40 balanced portfolio, where 60% of the portfolio is allocated to (hopefully) non correlated stocks, and 40% is allocated to bonds. The basic idea is that the bond part of the allocation protects you when the market dives for a six to 18 month period, since central banks respond to falling business confidence by trying to stimulate markets with low rates, and bonds do well in low interest rate environments.

It's a nice idea - but, as Louis Basenese, co-founder and Chief Investment Strategist at Wall Street Daily points out, the big flaw in the argument is that when academics analyzed how the 60/40 balanced portfolio approach actually played out over the last 25 years, they found that the correlation between a balanced portfolio of this nature, and a portfolio invested 100% in equities, was pretty near 100%. I quote Basenese on his take on this:

"Shocked? You should be. Because this isn't some market anomaly caused by the severity of the Great Recession and compounded by unprecedented low yields on bonds. Nope. It's been going on for the last 15 years, according to the number crunchers at Black Rock [...] Bottom line: The classic asset allocation - 60% equities and 40% bonds - is virtually no better than a 100% allocation to stocks. So know the risks and be wary [...]"

Basenese is not against the idea of a balanced portfolio. What he is against is the idea that this traditional 60/40 split is even vaguely balanced. Instead, he recommends a DIY portfolio consisting of 20% stocks, 30% long-term Treasury bonds, 30% TIPs and 20% commodities, constructed via low cost Exchange Traded Funds (ETFs) - an allocation put forward by Alex Shadi in 2012. Basenese is also somewhat annoyed at the "Wall Street whopper" which proclaims that a 60/40 "balanced" portfolio reduces risk and is suitable for a conservative investor or a retiree - since in practice it is as "risk free" as, and indistinguishable from, a 100% equity portfolio.

Mark Sidell, a regular contributor to Seeking Alpha is even more annoyed at what he considers to be the "hackneyed means" by which MPT has been applied by the financial industry:

"Investment managers love to dazzle unsophisticated investors with MPT models and statistical references that create an aura of "science", intended to supplant the thought that these investment guys/gals are simply winging it."

The problem, Sidell says, is that MPT is a passive investment strategy that is supposed to be able to see the investor safely through all economic cycles, from growth to recession, from inflation to deflation and back again. An MPT portfolio is a set-and-forget strategy, apart from a little re-balancing if values get out of whack (i.e. a particular stock grows so much in value that it skews the portfolio). It is not supposed to be actively managed, i.e. tweaked by hand by the manager when he/she gets anxious about the way things are going and thinks that a little active touch or two will correct the ship. What these active touches do, Sidell suggests, is to muddy the waters and make matters worse. An active manager deploying an MPT portfolio for an investor and charging active management fees is basically a charlatan in his view. The correlations in MPT that make it work are developed over long periods of time:

"I submit that if you truly compose a balanced portfolio of broadly diversified, non-correlated investment components it will require very little management and perform as well as the market itself with considerably less volatility."

The problem for the investment management community is that it would be difficult to crank regular fees out of investors on a proper application of MPT, because the investment manager would basically be being paid to do nothing once the portfolio is set (apart from a little re-balancing to keep the percentage proportions among the components on track - said re-balancing being a fairly minor and fairly mechanical exercise). So instead, in Sidell's view, we have active managers, diving in to the left and right, tweaking MPTs every time their ulcers twitch, and basically messing it up. Then MPT gets a very unfair kicking.

In Part Two we look at Harry Markowitz's response to the criticisms of his theory after the 2008 global financial crash, and at Harry Browne's marvelously simple recipe for a permanent portfolio.

Courtesy Anthony Harrington for QFINANCE (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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