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:
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:
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.
SmartStops Comment: WisdomTree suggests its time to consider a strategy of hedging with ETFs to mitigate risk as the Fed begins to taper. That can be one approach to ensuring that a market correction will minimally affect your portfolio. But determining when to hedge especially with the costs incurred, becomes the main question. That’s where SmartStops can help – by providing an objective analysis for when risk levels are increasing in the market.
This excerpt from a white paper of WisdomTree:
Over the last nine months, the Federal Reserve (Fed) has gradually reduced the pace of its asset purchases in
conjunction with improving strength in the U.S. economy. With tapering on pace to conclude October 29, we believe that investors should now look beyond 2014 and start to focus on when, not if, the Federal Reserve will begin to tighten monetary policy. In our view, the way that investors have prepared their portfolios for tapering could be inadequate for the likely market reaction to increases in short-term rates. In the remainder of this discussion, we intend to focus on the following topics:
+ Preparing your portfolio for tightening is different than tapering
+ Traditional approaches to rising rates may not adequately insulate portfolios from losses going forward
+ Duration4-hedged and negative duration exchange traded funds (ETFs) may provide investors with
more comprehensive and intuitive tools to mitigate interest rate risk
For the entire white paper, click here.
SmartStops Comment: We couldn’t agree more with this author.
From Seeking Alpha, Contrarian Profits
The bulls are back out in force, as the hiccups from a few weeks ago seem a distant memory. Indexes have resumed breaking records on a regular basis, and all seems right with the world.
Great – trust me, few things make me happier than a happy market. I like making money as much as the next guy.
But I’m also a little more suspicious than the next guy. And right now, that suspicion is warranted.
… Today, the average price-to-earnings ratio of an S&P 500 stock is a hair below 19. The long-term average is right around 15. We’re solidly sitting in overbought territory. Stocks are expensive right now.
- Market Risk?
- Interest Rate Risk?
- Liquidity Risk?
- Volatility Risk?
- Credit Risk?
A new article by Paula Vasan titled “Talking About Risk? Advisors, Industry Must Do Better“, takes the industry to task claiming investment risks are not well understood by advisors and not being well explained to clients.
Be aware when your risk is on the rise with SmartStops.net Equity Risk Alerts.
The past year has been a dramatic time for electronics retailer Best Buy (BBY). After nearly tripling its stock price, peaking at $45 a share in November 2013, the company’s stock plummeted almost 30 percent after releasing its fourth quarter earnings report. The store had weak sales during what should have been a strong holiday season and fell far short of its goals.
Over the past decade, Best Buy and similar retailers have faced difficulties competing with websites like Amazon.com (AMZN). The theory is that consumers use brick-and-mortar stores like showrooms. After finding the products they like, customers then take their business online. Read More…
SmartStops comment: We couldn’t agree more! It is exactly why we brought this service to the marketplace.
Look at the money protected by SmartStops recently on AAPL, CMG, NFLX etc.
SmartStops Comment:: Indeed, Beta and correlation approaches are not enough to manage risk in today’s markets. However we have somewhere for you to run – to intelligent self-adjusting risk methodologies that the SmartStops optimization engine offers.
Originally published at Seeking Alpha: http://seekingalpha.com/article/815851-nowhere-to-run-the-correlation-bubble
Fundamental analysis of “buy and hold” companies is a quaint, Warren Buffetish notion that probably works in the long term. But as Keynes said, in the long term we’re all dead. The big risk in today’s über-correlated markets is systemic shock. One can practice due diligence on a company and buy at a reasonable valuation, but if global markets collapse the next day and don’t recover for years, one has paid a lot in opportunity cost. In other words, tail risk is not reflected in fundamental analysis.
Fundamental analysis is valuable so long as the basic fabric of capital markets remains intact. In an insane world (where U.S. Treasuries and German Bunds are considered “risk-free”, of infinite rehypothecation, where MF Global’s John Corzine walks off with $200M segregated assets, of the London Whale, LIBOR, Goldman’s muppets, regulatory capture of SEC and Fed, U.S. / China animosity and the dollar’s loss of world reserve status) it’s unlikely that business-as-usual will continue without a disruptive bout of creative destruction.
Precisely when and how it will occur is anyone’s guess, but, unfortunately, old school techniques like cross-asset class and regional diversification have lost their glimmer. Just as socioeconomic disparity is partitioning the globe into lords and serfs, so too has the market been divided into polarized castes of highly correlated risk-on assets and (scarce few) risk-off havens.