[credit provider=”Nokia’s Official Flickr”]
I take my role as an adviser to my clients very seriously.My sense of responsibility is heightened by the fact that my books and blogs are widely read. I receive thousands of inquiries from readers all over the world.
Many of them rely on my views, even though they are not personal clients.
So, you can imagine how distressed I was to read an article in Financial Advisor, reporting on a survey undertaken by Risk 3.0 Asset Management. Mitchell Eichen, the CEO of this firm, believes many investment firms are “in a state of denial”. According to him, we don’t understand how markets have changed.
Here’s the part that really hurts, because it describes precisely the advice I give to my clients and recommend in my books: “They’re still applying modern portfolio theory; they still think that diversification is the answer and is going to save them, even though diversification didn’t save anybody in 2008.”
Ouch! He could be writing about me. I still apply modern portfolio theory. I still believe in diversification. According to Eichen, my belief in these basic principles of investing is a reflection of a “failed axiom.” While short on specifics, Eichen counsels advisers like me to “adapt effectively” or risk “limited growth” or even “wither[ing] away.”
Even though I have been warned, I am sticking to my “failed investment strategy”. Here’s why:
Modern portfolio theory (MPT) earned Harry Markowitz the Nobel Prize in economics in 1990. It is estimated that around $7 trillion in institutional assets are invested in accordance with the tenets of MPT.
MPT permits an adviser to construct an optimal portfolio taking into consideration the relationship between risk and return. Once an adviser knows your particular level of risk, using MPT, he can construct a portfolio that maximizes the expected return of that portfolio for a designated level of risk.
MPT does not protect you from losses in all markets. In 2008, a portfolio diversified between stocks and high quality bonds did not “fail.” In fact, it performed exactly as predicted by MPT. In an interview with Mornignstar.com, Peng Chen, president of Ibbotson Associates, explained that MPT is designed to mitigate “undiversifiable” risk, meaning the risk of having your portfolio concentrated in one asset class, like stocks.
MPT does not claim to be able to mitigate “systematic” risk, which is risk inherent in the entire market or in a segment of the market (like stocks). Investors who held a diversified portfolio of stocks and bonds in 2008 still incurred losses, but those losses were cushioned by their holdings in high-quality bonds.
Chen concluded that, contrary to Eichen’s views: “So from that regard [mitigating risk through diversification], actually, yes there was a lot of risk in 2008, but we believe modern portfolio theory actually continued to work.”
In 2008, an investor who held a diversified portfolio consisting of 60 per cent stocks and 40 per cent bonds constructed in a manner consistent with MPT had a loss of 23.01 per cent. Compare that loss to holders of a non-diversified portfolio. In 2008, if you had 100 per cent of your assets in Vanguard’s Total Stock Market Index Fund (VTSMX), you had a loss of 37.04 per cent.
Eichen’s preoccupation with short-term returns generally, and in 2008 in particular, is troubling. It’s true that, during a financial crisis, correlations increase (meaning stocks of various asset classes tend to move down together). But the same is true in strong bull markets. Is he equally concerned about the positive returns investors reap during those periods?
The focus on short-term returns, whether positive or negative, is misleading. Investors who will need 20 per cent or more of their funds within a five-year period should have no exposure to stock market risk. The problem for many investors in 2008 was not MPT. It was the fact that they were taking more risk than was appropriate, given their time horizon.
It would be equally misleading for me to extol the virtues of MPT by noting that, in 1967, a portfolio consisting of 100 per cent stocks, constructed following the principles of MPT, had a return of 54.88 per cent or that the same portfolio is up 15.18 per cent year-to-date.
Short-term data is very unreliable. Long-term data is far more meaningful. For the 20-year and 11 month period from January 1, 1992 until November 30, 2012, a diversified portfolio consisting of 60 per cent stocks and 40 per cent bonds, constructed in a manner consistent with MPT, had an annualized return of 7.46 per cent, with an annualized standard deviation (which measures risk) of only 9.35 per cent.
MPT is validated not only by extensive long-term risk and reward data, but also by hundreds of peer-reviewed academic studies. It has served both institutional and individual investors well through all kinds of markets. It is precisely the kind of “failed investment strategy” that responsible advisers should be offering to their clients.