The Failure of Modern Portfolio Theory

When  my father started investing in the mid- 50s there were only a few mutual funds and most people bought individual stocks and bonds. This was a nothing fancy investing style. (Don’t get me wrong, there was plenty of misdirection and junk being peddled then as now.) The money management style that most amateur investors used back in the day was either a recommendation by someone who worked in the investment business, an understanding of a particular business or industry or searching for high yield interest or dividends. There wasn’t any discussion about risk, beta, alpha or asset allocation

Yes, there were people like John Templeton and Benjamin Graham that were carving their own niche but were pretty much unknown outside the wealthy and professional investor.

It wasn’t until about 20 years ago that asset allocation and portfolio management was openly discussed with the average retail investor.

One thing that is different today from the 1950s is there is so much more  information available to the average investor that it is overwhelming. People have a difficult time keeping up with the flood of stuff that keeps pouring out of investment houses, publications, on-line web sites and cable television. The reason for all this info is to assist investors to make as much money as possible and reduce the possibility of mistakes.

Today almost everyone has either heard of or is in some fashion a student of asset allocation. Some investors are actual fanatics believing that one cannot be allocated enough. Asset allocation is just one part of Modern Portfolio Theory. The concept of asset allocation is to buy and own different investments that act in opposite to each other. In theory bonds should do the opposite of stocks. It is part of the ‘don’t put all your eggs in one basket’ investment philosophy.

MPT was pioneered by Harry Markowitz who was awarded the Nobel Prize for devising and explaining the relevance of investing using an efficient frontier for optimizing investment portfolios. The funny thing is that some of the most successful money managers don’t believe in MPT.

Warren Buffett doesn’t believe in MPT, neither does Jack Bogle of Vanguard fame when it comes right down to it.

Harry himself doesn’t follow his own theory but owns a hodge-podge of stocks, funds and investments that he has trouble explaining. Asset allocation is a part of MPT and sometimes you hear Jimmy (Ze Mouth) Cramer bragging about his educational Trust that is perfectly allocated. 

Managed accounts are set up using asset allocation. There are fund companies that use asset allocation in their portfolio design. Asset allocation is for many the sun, the stars the Holy Grail.

The problem is that when asset allocation and MPT needed to step up to the plate in 2008 and prove itself it fell on its Nobel Prize  winning fanny. It just didn’t work. You lost as much money if you were due diligent and followed asset allocation as if you were trading dot com stocks or  throwing quarters against a wall with Knuckles Kowalski.

Jack Bogle, who practically invented the entire ETF and index business, believes all you need is to own a bond fund and a stock fund and own as much in bonds as years you have on earth. That’s not MPT nor is that much of an asset allocation.

Warren Buffett doesn’t believe in MPT. What Warren believes in is owning the best thing there is at the cheapest price. He is a value investor buying great company stocks or entire companies when they’re cheap.

When the markets collapsed Warren lost value in Berkshire Hathaway just like everyone else but Warren then went on a shopping spree adding companies that had fallen in price but which had great value. Not many investors did that as they hunkered in their bunkers waiting for the next shoe to drop.

Today some investors are looking at their total portfolios differently. Investors have been bloodied and understand that nothing they can do can save their portfolio in the event of a global economic pandemic. Understanding that  other than cashing out at whatever price one can get investors are starting to invest and think strategically. Rather than investing in a totally asset allocated plan they are looking at parts of their portfolio and breaking it into risk sections.

• Cash- money you need now.
• Bonds- high yield intermediate money
• Medium term- 5-10 years out funds, stocks and ETFs.
• Risk – the which could include real estate, precious metals, currencies.

By modeling a portfolio using different buckets for different times and needs an investor can parse the best in each risk class. Obviously this doesn’t work if you have $50,000 -$250,000 of assets. An individual should have a minimum of $500,000 to implement a risk adjusted plan. For the rest of us the plan Jack Bogle devised may work just as well as anything we’ve seen in four decades in the business.  Keep it simple, earn as much as the market gives and reduce volatility by increasing our percentage in bonds equal to our age. By doing this you can complain all you want how much you could have made when the markets soar but you’ll never lose sleep when the markets collapse. (Unless, of course, rates start rising.)

If you have questions call Paul @ 877 783 7080 or write him at pstanley@westminsterfinancial.com. Share this blog with someone who cares about their money.