Want to know what’s really scary? Even if you adhere to an asset allocation strategy with roots in Harry Markowitz’s modern portfolio theory, you could lose your shirt.
What is MPT?
For the uninitiated, modern portfolio theory was created by economists 50 years ago in an attempt to make sense of the markets. This approach enables investors to use statistical tools to gauge the potential risks and rewards of various asset classes and assemble an asset allocation plan that, theoretically at least, offers optimal returns for a certain level of risk. The “efficient frontier” plots a line on a graph that shows optimal portfolios offering the best risk/reward characteristics.
In the graph below, the X axis shows expected returns and the Y axis shows risk as measured by standard deviation. The curvy line is the “efficient frontier.” Below the efficient frontier are portfolios deemed inefficient because the risk level is higher or return is lower than it can be.
This may seem like mumbo jumbo without the math that goes along with it. But the point is that even if you did the math necessary to design a portfolio that minimizes risk and maximizes returns, it may not work.
A recent article in Investments & Wealth Monitor, called “Rethinking Modern Portfolio Theory,” unveils the flaws of MPT. You can analyze risk and examine the correlations between certain asset classes to come up with an optimal plan, but a few variables can throw the proverbial wrench into the works. These variables would be the time at which you enter and exit the market, the period of time during which you are exposed to the market, and cash flow risks, to name a few.
The authors show, for example, what happens to an investor who retires in 1976 versus one who retires in 1985, given identical portfolio strategies, asset levels and cash flow needs. Due to high inflation in the early years of the earlier investor’s retirement, he runs out of money within 10 years. The second investor has a surplus after 20 years.
Another problem is that in reality, investors generally don’t get market returns. They earn lower returns than the market because “of incomplete information and psychological inclinations.” In other words, we panic. Or we get greedy.
Yet another challenge is identifying asset classes that are not highly correlated with one another. You get true diversification if you invest in asset classes that move in different directions. This is what mitigates risk. Correlations, however, are “subject to period dependency, globalization trends and market stress.”
Diversification didn’t work during the last three months of 2008, when all hell broke loose in the financial markets. All the major asset classes fell down right along with the S&P 500. “This illustrates that generally the only thing that goes up in major market corrections is correlation,” the authors say.
So what can investors do to protect themselves? I’ll tackle this question in the next blog.
In the meantime, how do you feel about stocks? Do they scare you or do they offer promise?