Sunday, January 8, 2012

Is modern portfolio theory dead?

Modern portfolio theory is the basis for professional investment advice that you get when you see a financial advisor regardless of whether they’re from Merrill Lynch or Charles Schwab. CFA’s (Chartered Financial Analysts) & CFP’s (Certified Financial Planners) all learn the same theory. Its so engrained in the industry that to deviate from it in any substantial way is to invite a lawsuit from an unhappy client, either not getting the return they expected or experiencing more volatility than they wanted.

Modern portfolio theory is based on the idea that you can invest in different types of asset classes that do not necessarily move in tandem. The idea is that one asset class may go up while another goes down netting in a more constant growth with less volatility. For example: In 2011 the US stock market ended virtually flat performing well compared to European markets which lost 11% and the Japanese Nikkei which lost 17%.

Correlations increase
But while diversification seems to work well when markets go up, since 1998 we’ve seen more and more that when markets decline in this ever more connected global market, they move down together. In other words, just when you need these markets to have a low correlation (not moving together) they actually increase to a nearly perfect correlation to the downside. Since that year in 1998 when Russia defaulted on their bonds, and Long Term Capital Management, a hedge fund holding bonds from all over the world and levered 30 to 1, had to be bailed out by wall St when they discovered that in a bad market trading nearly stopped as nobody wanted to buy bonds in a fearful market. Again in 2001 and 2008 we saw that when the market turned down, it turned down all over the world. There was no place to hide but in short term US Treasuries.

Risk without return
Typically in investing there is a relationship between risk and return. Since risk is measured in volatility, we can expect that highly volatile investments would correspond with higher returns. Conversely, we would expect lower returns with lower volatility. What we certainly would not expect was that in 2011 the S&P 500 would have unprecedented days of moving both up & down by 300-550 points in a single day! Some intra day swings were nearly 1,000 points! And what return did investors get for all that volatility? Zero! Over the last ten years the S&P 500 has barely returned the rate of inflation. And consider, over that same period the US dollar has declined by 33% relative to other currencies! Does that sound like a good investment?

Protecting your wealth
Certainly part of what we see today is the result of globalized trade as well as globalized information. Economies are so closely tied together that when the US experiences a recession, its effects China and all of Europe. Even US companies now often receive 40% or more of their earnings abroad, effectively making them “global” investments. But it also means that the modern portfolio theory that’s worked well for the last 50 years does not work the same or as well as it used to. Investment advisors need to do more than just show you a pie chart with an asset allocation. They need to critically evaluate the potential risk of each asset class and determine if they are suitable given the current macro environment. In some cases even long term investors should be positioned for capital preservation rather than a high, short term risk of capital gain or loss. This last year especially has showed that risk and reward are not always related and that one certainly does not guarantee the other.

No comments:

Post a Comment