Can Modern Portfolio Theory Survive in the 21st Century?

Michael Maehl CWM, CRFA, CSA
December 8, 2008 — 1,894 views  
Become a Bronze Member for monthly eNewsletter, articles, and white papers.

It appears to many that Modern Portfolio Theory, (MPT), may have met its match in today's market place.

Two of the most basic underpinnings of MPT are diversification and asset allocation.  Why then is it that so many experts - financial, academic and economic - have consistently made the case over the years for these two methods as the primary ways to be protected if (when) the markets drop?  This, in spite of the dot.coms having gone upside down and other prior examples of the process having offered little protection to the investor.

The big sale of October, 1987, was created by computer-driven program trades - the premise for which, ironically, was to protect the institutional portfolio holder.  When the program trades kicked in and created yet more program-driven trades to occur, the snake quickly began eating its own tail.  MPT did little to protect investors in that instance either. 

In his 2007 book, Nassim Nicholas Taleb coined the term, "black swan theory."  He used it to refer to "large-impact, hard-to-predict and rare events beyond the realm of normal expectations."  Let the record reflect that there is certainly a case that can be made for vested interests having had more than a little impact in the recent market events.  Nonetheless, if MPT was all it was cracked up to be, there still should have been some measure of protection offered to investor portfolios due to their having been diversified and properly asset allocated. 

However, when all the caps (small, medium and large), most of the commodities and bonds (regardless of rating), along with many of the markets of foreign countries having rather large coincidental drops, the whole theory has to be looked at with some reservation.

So, how did we get here anyway?

Harry Markowitz

When Harry was a graduate student in linear programming at the University of Chicago in the early 1950s, he was stuck for a topic for his doctoral dissertation.  One day, the story goes, while he was waiting to talk with his professor about the subject, he began a conversation with a stock broker.  This broker is supposed to have suggested that Harry apply his study of linear programming to the problems investors dealt with in the markets.  Harry and the professor agreed that this was a good topic and off he went.

The result, entitled "Portfolio Selection", was a 14 page piece that was published in the Journal of Finance in 1952.  He authored a book of the same title that came out in 1959.  That book has been the basis for almost all financial theory since it first came out and, furthermore, it earned Harry the Nobel Prize in Economics in 1990.

MPT derived from Dr. Markowitz's work in that he determined that there could be lower cost (risk) for a given level of output (return).  Therefore, portfolios could now be created with different investments that, while too risky to own on their own, could be acceptable when matched with investments that were negatively correlated.  Negatively correlated means that, usually, one segment of an asset allocated portfolio will go up while the other goes down.  Therefore, the theory holds, your return should improve while your risk is minimized.
MPT defined volatility or variance of return as the cost to be minimized.  

However, what an investor may mean by "taking as little risk as possible" may not equate with the risk-free return rate of MPT.  It may just be a simple desire to avoid risks they can afford to avoid and still be able to meet the lifestyle goals their finances allow them. 

I don't think MPT is junk by any means.  Far from it.  Both asset allocation and some diversification are essential to a successful investment result.  However, it seems to me that the real problem with a strict MPT approach is that the conclusions assume that all investors will act in a logical, rational manner.  Markets such as we've been experiencing the past year, together with the other examples cited, certainly make those conclusions highly suspect. 

The risk in defining risk

Whatever the ultimate method used, when designing a portfolio, it's essential that an individual's tolerance for risk be accurately determined.  When using MPT as the basis for that determination, standard deviation is the measurement.  Most investors can't really get their minds around that.  (How does one deviate in a standard manner after all?)  Mathematician Ronald Graham said in a NY Times article that our brain "didn't evolve for the purpose of trying to understand the space-time continuum...it was there to keep you out of the rain and help you figure out where the berries were."

Almost every fund and investment firm has a questionnaire that asks what kind of return an investor wants so as to determine the amount of risk that person or entity is willing to assume.  Responding to the questions in those things in a manner that effectively relays their feelings is where it starts to get a little confusing for most folks.  There really isn't a logical answer to the questions.  It's like asking how hungry is an investor willing to be or how badly a fire should be allowed to burn them. 

In using the MPT process, an investor is often asked to define risk with choices such as "beating the S&P 500" or "a time-weighted return of indices" or having "a Sharpe ratio showing high portfolio efficiency."  Pretty hard to relate those choices to personal goals and needs.  The process then goes on to use an analysis to get the best possible return, based on an asset allocation using the investor's risk tolerance levels.  The result is then monitored and tweaks made along the way.  

What an investor may mean by "taking as little risk as possible" may not equate with the risk-free return rate of MPT or any other mathematical model.  It may just be a simple desire to avoid risks they can afford to avoid and still be able to meet the lifestyle goals their finances allow them. 

So, what makes investors act as they do?

The short answer - emotions.  The challenge is, of course, is trying to quantify that impact.  An entire new discipline dedicated to providing insights into this very question has grown up.  It is referred to as, interchangeably, either behavioral finance or behavioral economics.

Here is a textbook definition for your consideration.  "Behavioral economics and behavioral finance are closely related fields which apply scientific research on human and social, cognitive and emotional factors to better understand economic decisions and how they affect market prices, returns and the allocation of resources.  The fields are primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents, (aka, people).  Behavioral models typically integrate insights from psychology with neo-classical economic theory.  Behavioral analysts are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases."

My more simplistic way of defining the field is that it's one that studies what investors might do - not what they should do and the impact on their portfolios.  It's about how real people - not theoretical ones - make their financial decisions.  Let's consider some of the findings studies in these areas have come up with.

Loss aversion

A gentleman named Dr. Daniel Kahneman won a Nobel Prize in 2002 for his prospect theory in which he, essentially, demonstrated that - in fact - investors are "predictably irrational." 

Loss aversion explains that investors will take on more risk to avoid a loss than they will for a comparable gain.  Matter of fact, psychologists tell us that the pain of a loss is 2 to 2.5 times more deeply felt than the thrill of equivalent gains.  This also helps to explain why they will hang on to stocks that are cratering - just so they can avoid making that paper loss become real.

Fear of regret

This is closely aligned with the loss aversion mentality.  People tend to feel badly after they've made a mistake.  The bad feeling in itself is a source of anguish.  As one professor noted, "when you realize a loss, you kiss that money goodbye forever and you kick yourself."

The individual and institutional herd instinct of buying and selling also can fit into this fear of regret category.  The reason is that by following the herd - even if done subconsciously - people feel some level of insulation from remorse because, after all, "everyone was doing it."  As psychologist Robert Caildini puts it, "when people are unsure...they are more likely to attend to the actions of others and to accept those actions as correct."  Or, as put another way by a leading financial author, "when people are chicken, they become sheep - going along with what they see others doing."

This herd instinct/fear of regret connection can help put into clearer perspective what may have helped bring the current credit challenges on.  Avinash Persaud stated in a prize winning essay that, "banks or investors like to buy what others are buying, sell what others are selling and own what others own."  Further, he says that these institutions have structural reasons for this behavior.  This is because, "they are often measured and rewarded by relative performance so that it literally does not pay for a risk-averse player to stray too far from the pack.  Bankers are more likely to be sacked for being wrong - and alone - than being wrong and in company."

One problem that the fear of regret can cause is at the base of why individuals often underperform the returns that their mutual funds can earn.  That has to do with selling their winners before there is a good, financial reason for doing so.  The rationale is that by doing so, they won't have to regret failing to realize their gains if the stock does fall.

Other findings

Some of the more interesting include the fact that the majority of investors truly believe that they can beat the market - despite overwhelming evidence to the contrary.  Another has investors discerning false patterns from a series of random events - good or bad. 

Further, investors tend to confuse noise with information.  Studies have shown that when new information comes in concerning the markets, economy, whatever, investors have a tendency to amend their beliefs.  They will give the new material more importance and react as if all prior information is far less important. 

The studies also revealed that investors would do well to not get caught up with short-term thinking.  Frequency of evaluation is a term that applies to how often investors tend to check their holdings.  The higher the frequency, the less successful that investor tends to be.  This simply tends to cause an overinvestment of time, attention and analysis to little, if any, real benefit. 

Summary

I believe we need to amend how we use MPT to include more specific and definite feedback from clients as to what is important to them - and why.  Fact and feelings, if you will.  Then, smaller, specific portfolios can be created based on the tenets of MPT to address each goal and make solving their problems and addressing the needs much more likely. 

In other words, the amount of risk should be based on what's important to the person and what consequences are more painful to them than the investment risk if a particular goal isn't achieved.  Moreover, how can anyone really know that there isn't a greater risk in investing in cash and bonds than in a stock portfolio?  The real answer is that it depends - on the market environment and, more importantly, on the objectives of an investor for that piece of money.
Successful investing is as much art as science.  If there truly were a one-size-fits-all formulaic method for market success, you can be sure that someone would have figured it all out by now...

Michael Maehl CWM, CRFA, CSA

Website

Following his graduation from Northern Illinois University and subsequent service as an infantry officer in the Marine Corps, Mike began his investment career in New York City in 1973. Subsequently, Mike worked as a financial advisor in Chicago and Anchorage. He was selected to be a branch manager for a member firm of the New York Stock Exchange in 1984. He relocated to Washington State in 1993, continuing to serve as a branch manager until March, 2008. At that time, Mike decided to become an independent advisor based in Spokane.