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When One Is An Ugly Number

10/30/2013

For many decades now, Modern Portfolio Theory (MPT) has been the “gold standard” for investment management.  Basically, it shows that an investor can achieve above-average returns with below-average risks by spreading his risks or allocating his portfolio across many “asset classes,” i.e. large company stocks, small company stocks, international stocks, bonds, real estate, cash, etc.  This was possible because all assets are not perfectly correlated.  For example, bonds might go up in value when stocks go down in value. Or, gold may move a different direction than international stocks.  If an asset class moved exactly like the S&P 500, it had a correlation of 1.0.  If it moved up half as much as the S&P 500, it had a correlation of 0.5.  If it moved down one-quarter as much as the S&P 500 moved up, it had a negative correlation of (0.25).

Critics of MPT have always known there were some unrealistic assumptions supporting the whole theory. For example, one assumption was that all investors are rational and making decisions in their own best interest, based upon complete information.  Do you believe that?  And, there were some other unrealistic assumptions as well.

During the financial collapse of 2008, all correlations went to 1.0, which happens only when there is a complete collapse and all asset classes are losing value.  MPT made no provision for this happening, because rational investors would scoop up the bargains.  MPT made no provision for investors being terrified and wanting only cash.

In 2009, I was invited to serve on a certification committee, to re-write a certification exam for financial advisors.  At first, I was excited for the opportunity to update financial advisors on what we had learned about MPT during the global financial crisis, as well as other techniques for investment management. However, it was like finding yourself in an old-fashioned religious revival with everybody competing in their enthusiasm to agree with the preacher.  They were continuing to preach the “old-time religion.”  Disappointed in the intellectual dishonesty, I resigned from the committee and have had nothing to do with them since then.

Currently, I’m in Dallas attending an advanced but similar course and relieved to find that we are finally being honest about the limitations of MPT, as well as other techniques.  But, why did it take four years?

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