The tools most advisors use to build portfolios are based on Modern Portfolio Theory (MPT), which is the idea of creating a portfolio that balances risk and return using a computer-generated distribution of holdings designed to maximize return achieved per amount of risk taken. MPT works in theory, only because of the unrealistic assumptions made in constructing the theory.
MPT assumes that the future unfolds in a random fashion. In reality, future returns are much more likely to fall – from high valuation levels and when economic fundamentals weaken – and rise when the opposite is true. In statistical jargon, the distribution of returns are not in a normal bell-shaped curve. Returns are skewed by price levels and economic fundamentals. As a result of MPT, most investors keep the same (static) portfolio construction through good times and bad, rather than ramping up risk and return during the good times, and taking less risk when the outlook is less favorable. Taking the same amount of risk, in both good times and bad, reduces optimal return during good times and produces more painful losses in down markets. Ideally, portfolio Beta (the sensitivity to market risk) should be flexible, depending on where you are in the market and economic cycles.
MPT also assumes that probabilities don’t change and that investors don’t make mistakes. While not all investors admit their mistakes, or learn from them, all experienced investors have made them. MPT assumes that everyone has good data, can reasonably calculate the probability of future events, in a rational and error-free decision process. These assumptions pretty much rule out anyone and everyone who has experience investing in the market.
Finally, MPT is typically a backward-looking method. In theory, it should look forward. In practice, however, it uses historical returns as an input. So even in a world where long-term bonds pay only about 2.2 percent and are likely to decline in price in the future, your advisor’s computer will likely estimate a 5 percent return on bonds looking into the future. The entire investment industry, it seems, is dependent on a classic garbage-in/garbage-out process for constructing portfolios.
To do a better job, computers need accurate future return numbers as input, but crystal balls are in short supply. At the very least, “efficient frontier” simulations should be based on forward-looking estimates, but I know of no brokerage or advisory firms that are prepared to take on the liability of customizing those inputs.
May-Investments solution is to admit mistakes, adjust portfolio risk based on the current market environment and economic fundamentals, and to try to stay in the way of what’s working in the market – and get out of the way of what isn’t, allowing current market action and industry-specific economic fundamentals (rather than a computer simulation) to drive our portfolio construction process.
By proactively managing portfolio risk throughout the market cycle, we hope to be able to take the most risk only when risk-taking is being rewarded, and more effectively preserve wealth when markets turn down.
Plasma ray guns are great weapons, in theory. Hollywood used them in Star Wars, The Terminator, StarTrek and dozens of lesser known works of fiction. Like MPT, plasma guns are theoretically possible. In reality, however, plasma torches which have existed for some years can project plasma streams only about a foot. If an intruder breaks into your home, common sense says that an old-fashioned colt revolver would be a better choice.
The markets turned ugly in August. Are you still relying on Modern Portfolio Theory to protect your financial house?
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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