Modern Portfolio Theory. A 66-year-old investment strategy that contradicts itself in both name and execution.
Harry Markowitz, a Nobel Prize-winning economist, introduced the Modern Portfolio Theory (MPT) all the way back in 1952. This particular portfolio construction technique encourages investors to minimize market risk by capturing maximum level returns for their portfolio of assets. In layman's terms - MPT believes that a diversified portfolio of random assets can reduce investor risk and result in a greater return.
Maximize return, minimize risk. It sounds harmless, right? The truth is, this stale investment approach has put countless Americans on a dangerous autopilot program that, as it turns out, is failing them.
WHY IT DOESN’T WORK
In the 1950’s - the same time MPT was introduced - remote controls were plugged into televisions. Modern Portfolio Theory is built around how different investment assets correlate to one another (i.e. some may go up, some may go down, but in the long run investors achieve smooth returns).
- Negative Correlation - One asset up, one asset down, and over time investors get average return.
- In 2009, we learned what actually happens in declining markets. When you need negative correlation the most, it disappears and sends assets down with it.
- Finally, when you need it least and the markets are going up you miss out because it doesn’t allow you to put money in assets that are doing the best.
Whether you know it or not, chances are your assets are being (or have been) managed to the tune of Markowitz’s MPT. We aren’t necessarily saying your portfolio is doomed, but as independent investment advisors we believe you have the right to challenge - not blindly accept - the status quo.
It is your money on the line after all.
So let’s look at three reasons MPT should be retired, or at least ignored, by the vast majority of truly modern-day investors.
- It builds portfolios based on forecasting models, not reality: The biggest issue we have with MPT is that it ignores the needs of the individual investors and kisses the feet of forecasting models. If that seems backwards to you - that’s because it is. In our estimation, a successful portfolio focuses on the long-term goals of the investor, not some pie-in-the-sky model that generates random numbers to fawn over. Not only are these forecasts disassociated with reality, they are unable to adapt to evolving markets - a critical component to any successful investment strategy. When advisors live and breathe the MPT, they ignore the risks they should take for their clients, right along with their actual long-term needs and goals.
- It measures risk all wrong: MPT says investment risk exists in two categories. The first, systematic risk refers to the overall market. It is unpredictable, unavoidable, and cannot be diminished through diversification. Unsystematic risk, on the other hand, is industry-specific and can be minimized through diversification. Because MPT is based on the maximize-return, minimize-risk mantra - it uses beta to measure the unsystematic risk of each asset to determine its volatility in the market. Rather than looking at the whole picture of an individual asset, beta measures risk via market prices - which have little to do with the economics of a company and whether its stock will be fruitful in the long-term.
- Its rebalancing act is backwards: One of the major tenets of MPT says investors should rebalance their portfolio periodically based on performance. At its core this makes sense. Dig a little deeper, however, and this seemingly harmless principle gets a bit murky. MPT says investors should sell portions of their highest-performing investments to purchase more of the underperforming assets - all in the spirit of returning the portfolio to its original allocation. Investment advisors who subscribe to MPT believe that by selling the best to buy the worst, they are rebalancing their client’s investments to keep allocations at a constant. But wait, it gets murkier. Changing risk in the market isn’t accounted for, and MPT has no outlined strategy for when or how a portfolio should be rebalanced. Which means that advisors are left to navigate that part on their own. A scary thought when it’s your nest egg on the line.
Modern Portfolio Theory is just a theory. A point that mainstream advisors have apparently forgotten, or have chosen to ignore, for the past 66 years. In general, it’s okay to have theories and to forecast but it’s more important to have a strategy that works in practice.
Bottom line? Your portfolio should be a direct reflection of you - your needs, goals, and long-term financial objectives. Not some random index number or a theory that an economist wrote an essay about in 1952.