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MODERN PORTFOLIO THEORY IS HARMING YOUR PORTFOLIO

SmartStops comment:  an excellent article that every investor should read as MPT continues to be deeply entrenched in our systems.  Its shortcomings are proven.  The article concludes with:

The advice that most investment advisors give their clients – At its core, the message is usually something similar to this: “The markets are random and unpredictable, so the best way to invest is to properly diversify and wait for the averages to play out.”

However, what most investors seem to be unaware of is that this whole theory of random movement of market prices was proven false over 50 years ago by one of the most influential mathematicians of the 20th century, Benoit Mandelbrot. The random motion of market prices was a very nice theory, but it just doesn’t match what actually happens in the real world.

Some excerpts from JJ Abodeely, CFA’s article :   Modern Portfolio Theory Is Harming Your Portfolio

              1. MPT and the quantification of investing has further (mis)informed the debate by seeking a easy way to label and quantify “risk.” In 1952, Harry Markowitz chose variance or volatility of prices or returns to define risk. He did so because it was mathematically elegant and computationally simple. However, this idea has serious limitations (most of which Markowitz has since acknowledged).

              On the individual stock level, Vincent notes

Risk is often in the eye of the beholder. While “quants” (who rely heavily on MPT) might view a stock that has fallen in value by   50 percent over a short period of time as quite risky (i.e. it has a high beta), others might view the investment as extremely safe,   offering an almost guaranteed return. Perhaps the stock trades well below the cash on its books and the company is likely to         generate cash going forward. This latter group of investors might even view volatility as a positive; not something that they need to be paid more to accept. On the other hand, a stock that has climbed slowly and steadily for years and accordingly has a       relatively low beta might sell at an astronomical multiple to revenue or earnings. A risk-averse, beta-focused investor is happy to add the stock to his diversified portfolio, while demanding relatively small expected upside, because of the stock’s consistent track record and low volatility. But a fundamentally-inclined investor might consider the stock a high risk investment, even in a diversified portfolio, due to its valuation. There’s a tradeoff between risk and return, but volatility and return shouldn’t necessarily have this same relationship.

2.  After all, if you buy and hold the market you can earn the long-term returns right? Unfortunately, the answer to that is no. The long-term “average” returns are rarely available. In fact, depending on where you are standing, the returns are either much higher, or much lower. Consider this chart from Crestmont Research which shows that even for periods as long as 10 years, average rarely occurs:

10_yr_Rolling_Stock_Market_Return

3. Consider this chart which you’ve probably seen in one form or another. It shows expected risk and return of various mixes of asset classes and the typical approach to asset allocation which Modern Portfolio Theory has spawned:

Sample_Asset_Allocation_Risk_Expected_Returns

So what’s wrong with this picture? Lots of things.

The first is the inputs– namely expected returns and volatilities of various asset classes– most investment programs are built on logic like this:

  • Bonds will return 5% on average over the long-term but be between 0-10% in any given year
  • Stocks will return 10% on average over the long-term but be between -10% and +20% in any given year
  • Some might include other nuance regarding different types of bonds like High Yield or different types of stocks like Emerging Markets
  • Some might include different types of assets like real estate, commodities, or “alternatives”

The problem of course is this is an incomplete description of investment returns:

  • The math contends that returns are randomly and unpredictably distributed around the average
  • This “normal distribution” of returns contends that larger market movements outside of the ranges above will be relatively rare
  • “Average” returns ignore the role of valuation and the importance of when you start investing (buy) and when you finish (sell) even over multi-decade time horizons

The traditional approach to asset allocation is built on false axioms. The phenomenal secular bull market in stocks and bonds from 1982-1999 created the perfect conditions for the nearly religious acceptance of MPT. In a recent post, Expensive Markets Mean Low (or Negative) Prospective Returns, I made the case that valuation matters greatly and currently portend disappointing returns for both stocks and bonds. Traditional asset allocation has no way of dealing with this in a way that successfully protects portfolios from experiencing meaningful and unnecessary drawdowns.

Read JJ Abodeely, CFA’s article :   Modern Portfolio Theory Is Harming Your Portfolio in its entirety.

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