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Wax On, Wax Off

11/08/2011

The gold standard for investment management has been Modern Portfolio Theory (MPT) for most of my career.  It was mathematically proven to maximize return while minimizing risk over the long term, because it required money to be invested in multiple different asset classes, i.e., long, short, and medium term bonds:  big, small, and medium company stocks:  foreign stocks;  commodities, currencies, etc.  The reason MPT worked so well was because each asset class had its own investment dynamics, which means all asset classes would not move the same direction at the same time.  In our language, the asset classes were not closely correlated.

In 2008, the asset classes became correlated.  With only two exceptions, all asset classes lost value.  Since then, many investment advisors have abandoned MPT and adopted a Risk-on, Risk-off approach to investing.  When uncertainty is high, you increase cash.  When uncertainty is low, you decrease cash.  I’ve used this approach for years and am quite confident with it . . . but only as part of an overall blended approach.

However, there are few absolutes in life and certainly no silver bullets.  Abandoning MPT completely to practice Risk-on, Risk-off makes no sense to me.  Both have great wisdom and can be used simultaneously, along with value investing and the other popular approaches.  Don’t trust anybody who says they have seen the light and practice the one tried & true approach. 

Remember the kid in the movie “Karate Kid,” who applied wax to a car in a mindless fashion.  Exclusively applying Risk-on, Risk-off to a portfolio is equally mindless.

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