Modern Portfolio Theory

Critical Stuff: Is asset allocation more important than performance? Probably.

In This Chapter: Modern Portfolio Theory and Avocado colored appliances. Buy and hold vs. Armageddon. Couldn’t a robot do this? 

Hiring someone to manage MPT investments is like paying someone to be your friend

Modern Portfolio Theory (MPT) is a lot like Political Correctness or Progressive Policy–a marketing  label that sounds like a blanket endorsement. Oddly enough, Modern Portfolio Theory was developed in the 1950’s, which makes it as modern as avocado-colored refrigerators. But in recent years it’s become the accepted tool for financial managers and wealth advisors. Maybe it took that long for them to understand it. Or maybe it just fits the current market mood. Wikipedia has a very technical definition of the concept, which says in part:

Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. Although MPT is widely used in practice in the financial industry and several of its creators won a Nobel memorial prize for the theory,[1] in recent years the basic assumptions of MPT have been widely challenged by fields such as behavioral economics.

As a sidebar, the Nobel Memorial prize is NOT a Nobel Prize. Financial advisors selling MPT  go on a bit about the Nobel prize aspect. I’m not discounting the theory when I say that there’s a big difference in winning the Nobel Prize and a Nobel Memorial Prize, which is actually awarded by a Swiss bank. Here’s a Wikipedia reference on the difference:

Here’s what I think–MPT is a reasonably safe way to invest. But paying someone to do it for you is like paying someone to be your friend. It’s pretty easy to do it for yourself, but having a “wealth advisor” do it for you is a more than a bit nutty–believe me, I know, I’ve done that for the last six years. I’ve earned my financial moron status–or at least I paid well for it.

I say reasonably safe, because when everything goes to hell–which is the crisis mode mentioned in the full Wikipedia entry–it probably won’t do you a lot of good. There are some trading strategies that make more sense, but they are much harder to implement, and if you get scared and pull out of them, your investments will probably get hosed. We’ll talk about those later. The theory is really only useful for long term investment–basically retirement savings. And it works best if you keep your head down during financial swings, and apply a tool like Dollar Cost Averaging to smooth some of the volatility out. If you need money in the short term, don’t put it into the stock market, and certainly don’t put it into a buy-and-hold strategy like MPT.

Without getting into the math and a lot of examples, MPT basically says that no one really knows how to time the market, and mutual fund managers don’t outperform the market over the long term, so you’re better off owning a representative bits of the entire market and diversifying between stocks, bonds, and alternative investments purchased in index funds, or funds that approximate an index.

The proportions of the asset classes chosen are intended to balance out risk in the timeframe of the investment. So, for example, if you are eighty, you’d own a lot more bonds than if you were thirty. But you probably wouldn’t own actual bonds, you’d probably own bond funds which are broad samples of the total bond market, or samples of particular bond classes, like tax-free munis, or treasuries, or perhaps TIPS, which are inflation-adjusted treasury bonds. Because broad diversification, by owning a little of everything, is one linchpin of the strategy.

MPT is good because:

In theory, it eliminates the emotional trading that kills portfolios. People tend to buy when the market is going up–which intrinsically means they buy when stocks are expensive, and they sell when the market goes to shit–which means they sell when stocks are cheap. Do that a few times and your nest egg goes away. This isn’t just something stupid people do, the Nobel Prize aspect involves long-term research that found that most investors do exactly that. Professional mutual fund managers might seem like they’d have more discipline, but they can’t afford to. If they stay the course with an investment that’s going south their fund results will suck, and they’ll only earn six figures instead of seven. Actively managed funds typically turn over 85% of the stock in the fund every year. It’s almost inevitable that the fund manager will be exposed to volatility risk. Add in the simple fact that frequent trading means a lower percentage of the money will be in the market, the trade volume runs up transaction fees, you pay capital gains even if you don’t sell, and more of the capital gains will be short term and there’s a lot more working against the fund results than just the high cost the manager extracts.

By emphasizing careful re-balancing of asset allocations the strategy tends to buy stocks when the market has cratered and to buy bonds when the market is booming. It’s an approach that cries out to be automated, and a lot of companies are doing exactly that.

MPT sucks toads because:

Its fundamental tenet is buy and hold, no matter what. Like all strategies based on statistics, it assumes that the impossible case can’t happen. But it does. The possibility that you exist is trillions of trillions to one when you look at the statistical likelihood that all your ancestors, going back to a particular cell of slime mold, would be the ones that survive to reproduce, and produce exactly the line that yielded you, and yet here you are. A Backward-looking strategy is not predictive, it’s just history. There might be better strategies that help you remain solvent after a financial meltdown. But really, who gives a damn. It will take a lot of your personal attention to go short on the survival of the species. I’m not sure it’s worth it. MPT has the benefit of being easy, and if things don’t go to hell, it probably works.

As we continue to talk about investing strategy we’ll cover the mechanics of getting it done and managing the mechanics of balancing and maintaining this kind of portfolio. We’ll also talk about Robo Advisors–some easy ways to implement MPT that might work well for you. We’ll talk about Vanguard, a remarkable company that does what you’d like an investment company to do–they don’t steal your money. Makes them almost unique. We’ll also cover low-cost advisors who provide access to DFA funds, which are index funds like Vanguard that are a bit finer-grained with some recent academic theory that drives them, and finally, we’ll talk about how you might continue to use and leverage your traditional advisor if you’ve decided to stick with one.

Another key element of MPT is rebalancing, which means when your asset allocations change because of differences in the performance of the investment classes, you rebalance to get back to the asset allocations you established. So when the stock market goes to hell and you lose value in your market holdings, but the bond market gets stronger, you sell bonds and buy more stock to rebalance your portfolio. It’s a tough thing to do, and the Robo-advisors do it automatically, which scares the crap out of some people.  Selling the stuff that’s doing well to buy more of the stuff that’s tanking is counter-intuitive. But you have to do it if you want MPT to work for you. Naturally, it’s the most controversial aspect of MPT.

We’ll finish this chapter with a comment from one of the beta readers:

“The rationale against rebalancing is that it is a form of market timing, and timing the market is pretty widely accepted as a bad strategy.  People do a poor job of determining when the market is at the top and when it is at the bottom (except in hindsight). There is an interesting metric that tracks how investors under-perform by trying to time the market. It is called the “investor return”. Morningstar tracks several funds’ investor returns. The gain you get from trying to “buy low, sell high” will have to offset the loss you get from mis-timing the market.

There is another rub against rebalancing. It is the black-hole scenario. Equities drop, so you sell bonds to buy more equities, which drop even more, and you keep chasing equities down a black hole. Historically this has never occurred, but the bad thing is if you don’t have major testicular fortitude to go all the way down to the bottom of the hole, you will lose a lot of money – if you panic and sell under-water equities, those unrealized losses are converted to actual losses. That scares a lot of people.

At any rate, when experts disagree on things like rebalancing, I figure it is a hit/miss sort of a thing and just do what makes the most sense to me.”


The Retirement Trap Copyright © by Bill Babcock and Babcock, William. All Rights Reserved.

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