Modern Portfolio Theory is Flawed
Recently I attended a webinar conducted by Frank Muller, Executive VP and Head of Product Distribution at Behringer Investments. Frank’s presentation echoed the direction of my thought process regarding investment portfolio design over the past few years. The presentation added tremendous perspective and value, and the main ideas will help you, the individual investor, to ensure you provide yourself the best opportunity for investment portfolio success. Frank’s presentation asked us to examine two fundamental subjects:
- Question conventional wisdom regarding how the majority of today’s financial industry allocates and manages investment portfolios, also known as Modern Portfolio Theory
- Question what we know, as human beings, about how we use past experiences and emotions to drive investment decisions, also known as Behavioural Finance.
Warning: Some of the subjects covered in this article will challenge strongly held beliefs that many investors and advisors hold dearly. For some, this will trigger a response in your mind, a reaction that says “that can’t possibly be true”. All I ask is that you keep an open mind, try and reduce or remove the emotional response, and assess the points using data and facts only.
How Asset Classes are Correlated
Mr. Muller described some of the main aspects of Modern Portfolio Theory, originally designed by Harry Markowitz, which forms the basis of how almost every financial institution I have ever been associated with manages and allocates investments. As an investor, if you have ever purchased mutual funds, or a stock and bond portfolio from a major financial institution, chances are that the foundation used was Modern Portfolio Theory. MPT uses the public equity and debt universe to diversify by what is known as the 3-Factor Model. This model diversifies your money by:
- Style (i.e. growth vs value)
- Capitalization (i.e. small vs large cap)
- Geography (i.e. Canada vs US vs Europe etc)
Using the 3-Factor Model MPT assumes that, during market downturns, these assets that are diversified across various public spectrums are going to have low enough correlation so as to protect your portfolio (side note: correlation means the degree to which investments move up and down together). This commoditization of Modern Portfolio Theory has baked into our collective consciousness, to the point where “everyone is doing it”, so it has become less effective over the past few decades. Muller cites the two main reasons behind this to be globalization and technology. If you were to turn on CNBC at any moment, you would not be surprised to see a commercial, sponsored by a mutual fund company, which posts the standard 9-box style grid.
Muller poses this provocative question: “Here’s this information, which we have broadly disseminated to the investing public for the past few decades…and we step back for a second and actually look at the data…and we realize…What If It Isn’t True???”
In fact, the data tells us that, during times when the markets go south, the correlation between assets tightens. At the same period in time when we need the protection benefits of diversification, MPT fails us, because correlation increases and the assets start to move down together. The vast majority of investors have nowhere to hide during downturns, and as a result Modern Portfolio Theory has failed investors time and time again. Uh oh! The vast majority of financial advisors out there may have some ‘splainin’ to do!
Frank explains that this is one of those “Oh My God” moments, that many investors and advisors have been suspecting for awhile, when examining investment results over previous years. They have been asking “Where exactly is the benefit, the protection, the thing that I thought I was going to get when markets went down?” Investors are noticing that, regardless of if they own value, growth, small cap, large cap, there is nowhere to hide because they all go down together! He cites the public REIT index, which an investor would assume there is protection, decades ago showing correlation to the S&P 500 of only .15 when today it is at .97 and provides almost zero diversification benefits.
This is why, going into 2008, you probably thought your balanced mutual fund, “blue chip” stock portfolio, or public REITs would protect you, and were shocked to find that it dropped a lot just like everything else, and took you way out of your comfort zone. You were not properly balanced in the first place, due to a major flaw in the foundation of Modern Portfolio Management, which has spread to almost every traditional financial firm and product out there.
Remember, It’s Only a Theory
So how did this major flaw in the foundation of almost every retail investment portfolio out there occur? Muller explains that, when MPT was being constructed, the correlation data used was not very long in the overall scheme of things. In addition, the data was incomplete, limited to only public stocks and bonds. He cites an excellent example using Dell computers. A number of years ago, Michael Dell started the company in his dorm room at the University of Texas, and it started off as private. Dell computers could not be considered for Modern Portfolio Theory because of the fact that it was private. Dell eventually grew, and became a publicly traded company, to provide liquidity. Now, under traditional MPT, Dell could be considered for a portfolio. Later, Dell took his company private again. Now, even though the company is still selling PCs (I currently own one), has paid staff, and is contributing to the economy, under MPT rules of using public companies only it cannot be included in a portfolio. Modern Portfolio Theory says that Dell no longer exists!
The argument is that, in order to truly reflect the world’s investment opportunities as they exist today, we need to change the model.
Baby Boomers are Thinking About Their Retirement Portfolios Incorrectly
Muller brings up some additional fascinating points. As has been well documented, baby boomers are retiring by the millions, and this trend is growing every day. The average baby boomer is taking the traditional 60/40 public equity and fixed income mentality into retirement. The tremendous challenge that a new retiree faces is to construct a portfolio, given today’s market valuations and interest rates, which:
- They can reasonably draw at least 4% per year
- Income can increase by at least 3% annually to keep up with inflation and maintain purchasing power
- Making sure this lasts for perhaps 30 years without running out
He points out that the new retiree has only one chance to get it right. If they do not get it right, the consequences can be breathtaking. Today’s investor is faced with capital moving from public to private, globalization and technology are rapidly changing the playing field, new initiatives such as crowdfunding and peer-to-peer lending are blurring the lines between public and private. And yet the majority of today’s traditional financial institutions are stuck in a time warp, using the outdated model of MPT, and placing today’s retiree at a significant disadvantage versus institutions which have evolved.
Today’s investor is stuck in a world of investment axioms and rules which appear to be obsolete. At the same time, he/ she is confronted with an industry that tells them, on one hand, to do this:
“Buy our traditional, publicly traded products, based on Modern Portfolio Theory and rebalancing”.
On the other hand, investor behaviour shows that these models are not working, because of what the average investor actually does during challenging times. Muller shows a slide which shows an investor, in the year 2000, starts with $1,000,000. They construct a traditional 60/40 portfolio using the tenets of Modern Portfolio Theory, pull out 4% per year, indexing to inflation by 3% annually, and rebalance every year. During 2002 the portfolio draws down by approx. 22%, and during 2008 approx. 30%. By the end of 10 years they are left with $821,457. Pretty decent results. Muller then asks a few important questions:
- Can you produce for me one investor who actually did this?
- What did they actually do in 2002 and 2008? A- Hit the eject button. There becomes a level of volatility that the average investor fundamentally cannot tolerate because of fear. Fear trumps greed every time.
- What is the advice and counsel provided during those challenging downturns? A- Sit down. Shut up. And just take the pain. Things will be fine.
Because the traditional 60/40 public portfolio is set up to force volatility on an investor, it is effectively designed to push them out of their comfort zone during market corrections, allowing fear to take over. Forcing someone into a behaviour in which fear takes over is the fatal flaw with today’s MPT.
Time to Redesign Portfolio Construction
If the data used to construct portfolios using MPT is flawed, then it is imperative that we re-think and re-design the foundation. Today’s boomers who are retiring need portfolios that can:
- Earn sufficient growth and income
- Stay ahead of inflation
- Prevent fear-based behaviour by protecting during market downturns which do not force an investor’s hand
The question becomes “How do you do this?”
Muller provides the answer as, instead of the traditional public securities exclusively, we think of the investing world in terms of four separate quadrants:
He uses the example of keeping the traditional 60/40 model but reducing it. The example uses 25% so-called “alternative assets”. While it is not easy to define exactly what “alternative” means, it is probably easier to define what it is not. It is any asset that does not fall into the traditional 60/40 model based on MPT. By reducing traditional equity exposure down to 37%, he notes that, using the same $1,000,000 as above, something amazing happens. Account drawdowns in 2002 and 2008 become single-digit. Instead of $821,457, the account becomes $1,079,800 over ten years, which is a $250,000 difference.
By adding alternative assets to the mix, the portfolio is now able to work for the investor, by avoiding fear-based, behavioural knee-jerk reactions, and ends up being worth significantly more.
Compare and Contrast
The addition of alternative assets to portfolios is something that the most successful pension plans and endowment funds, such as Yale Endowment, Canada Pension Plan, Ontario Teachers, and others have been increasing exposure to over the years.
Mr. Muller cites that for the 20-yr period ending December 31, 2013, the average individual investor has achieved an annual return of approximately 2.5%. After inflation, the average investor would have been better off not investing.
Compare this to Yale Endowment , which has earned more than 11% annually over the past 10 years ending June 30, 2013. A cursory look tells us that the average investor and a successful endowment have very different results because of two things:
- Alternative Investments
There is growing evidence that today’s traditional method of portfolio design, based on Modern Portfolio Theory, is flawed. It is a deep concern of mine that thousands of baby boomers are entering retirement daily, having their portfolios managed using traditional MPT, and setting themselves up for failure. The good news is that many investors and advisors are waking up to the realization that they do not have to experience the same levels of frustration as before. A well-designed portfolio can accomplish investment goals, provide solid income and growth opportunities, reduce downside risk, and avoid having to confront fear-based decisions. I am continually striving to be ahead of the curve in this thought process which, in my opinion, is an ideal place to be.
If you would like to find out how to add alternative investments to your portfolio, simple download the FREE Guide to Real Asset Investing, located to your right.