Modern Portfolio Theory, or MPT, was the 1990 Nobel-Prize-Winning academic work of Harry Markowitz, William Sharpe and Merton Miller focusing on pricing models and asset allocation.
What is MPT? From Wikipedia:
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. That this is possible can be seen intuitively because different types of assets often change in value in opposite ways
Bottom line, the idea is that by having a diversified basket of investments, one can lower the overall risk of a portfolio vs. having all one’s money in a limited number of investments. Importantly, by risk, the Nobel prize winners were focusing on VOLATILITY, which is a statistical measure of “deviation” from the mean. In layman’s terms, Markowitz et al measured risk by how “bouncy” a portfolio was, not in terms of absolute loss. And their goal was to show that diversification provides a smoother ride (i.e. not as many 30% drops!).
MPT came to be used rather extensively through the 1990’s as mutual fund companies would put out literature extolling the virtues of this ‘intelligent’ advice extolled from the highest levels of academia. And although Markowitz stated that over 90% of the deviation of a portfolio’s return came from asset allocation, people began to say that 90% of a portfolio’s return came from asset allocation, which is wrong and not what Markowitz said. I remember being in the business and speaker after speaker at sales conferences would mention this misunderstanding and it just festered out of control! Therefore I could not blame these Nobel winners for that mistake – which many people were making. However, MPT was not the perfect answer that people seem to be always looking for in finance (which is not a science exactly).
And more interestingly, MPT has come under attack recently, with the most notable in my mind being Black Swan author Nassim Taleb’s recent charge that people should sue the Nobel prize committee because by awarding the prize for MPT, they supported an investment methodology that led to faulty assumptions and the financial disasters of recent years as investors who used this methodology underestimated the risk they faced. From Bloomberg:
“I want to make the Nobel accountable,” Taleb said today in an interview in London. “Citizens should sue if they lost their job or business owing to the breakdown in the financial system.”
Taleb said that the Nobel Prize for Economics has conferred legitimacy on risk models that caused investors’ losses and taxpayer-funded bailouts. Sweden’s central bank will announce the winner of this year’s award on Oct. 11.
Taleb singled out the Nobel award to Harry Markowitz, Merton Miller and William Sharpe in 1990 for their work on portfolio theory and asset-pricing models.
How do the authors respond? Again from Bloomberg:
“People used the theory and assigned numerical forecasts to the algebra,” said Sharpe, a professor of finance, emeritus, at the Graduate School of Business at Stanford University, in a telephone interview. “But I’m not going to take the blame for the numbers they put in.”
I’m sure that in many things in life, a good number of people make too many assumptions which certainly could have unfairly tainted MPT. Is MPT that bad? In my opinion, it is merely one way to manage a portfolio. If one understands the risks of using MPT as the methodology of managing one’s portfolio, and is ok with it, then fine. There are many styles of portfolio management: MPT, Barbell strategies, individual stock picking, to name a few. Each has pluses and minuses.
And it is true that if one is going to be fully invested, diversifying will lower volatility. The problem is that when volatility turns to market crashes, one is fully invested with MPT and it can mean that an investor will ride down with the market no matter how diversified. Also, a problem in the past decade or so is the increasing ‘correlation’ of global stock markets. Correlation means how similar do 2 or more data sources behave? In other words, if the US stock market goes up 1% and the UK stock market goes up 1% all the time, we would say these two markets are highly (if not perfectly) correlated. And this has happened – in 2007 we had almost every asset except the US dollar go up. In 2008, the US dollar (and dollar-denominated treasury debt) went up as almost everything else fell. It is much harder now to get the diversification that Markowitz aimed for.
MPT and Those At or Close to Retirement – One Big Shortcoming
MPT is merely one style of managing a portfolio. However, if you are planning income for retirement, and you don’t have excess millions of $, then using MPT is like using a firehose to hammer in a nail. It’s the wrong tool as one of my mentors, Francois Gadenne (of BU and RIIA-USA.org), would say.
Interestingly, according to Gadenne in the RMA™ body of knowledge book, originally in MPT portfolios, it was assumed that a separate pile of money was set aside for income needs, it just seems that Markowitz, Sharpe et al left out the part about the income or simply focused on the growth part of the portfolio for their work – and in that I can’t blame them.
This could simply be another case of major misunderstanding but when the whole industry adopts a certain interpretation of a financial theory that wins a Nobel Prize, then I can see Taleb’s point a bit. Bottom line, understand the animal you are dealing with, don’t fall for oversimplification of such a dyamic creature (the financial markets) and if you need income, focus on an income floor before adventuring into your growth portfolio.
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