An Unconventional Approach for Unconventional Times

An Unconventional Approach for Unconventional Times

In other words, everything you know about asset allocation is wrong.

Strong words indeed.

The unprecedented seems to happen all too frequently in financial markets. Is there something wrong with the way financial advisors build their clients' portfolios?

Modern Portfolio Theory (MPT) has been the very bedrock of investment management and, more specifically, portfolio construction and asset allocation, for decades. To oversimplify, one might explain MPT in this way: It is literally a mathematical proof for the idea that you shouldn't put all of your investment eggs in one basket. According to MPT, a portfolio of non-correlated assets — distributed across the risk spectrum — can lower the overall risk of a portfolio.

Of course, MPT has been picked apart by legions of critics over the years. But suddenly, in the aftermath of the recent stock market debacle — in which nothing seemed to work at all — critics of MPT are gaining currency.

The very foundation of modern asset allocation just doesn't work, they say.

Enter “Post Modern” Portfolio Theory (PMPT).

The debate between believers in the two different approaches to portfolio construction centers around how they define risk, and how that risk influences returns. MPT models risk using standard deviation above and below expected returns (also called mean variance). PMPT models risk using only standard deviation below expected returns (semivariance). In other words, MPT assumes that there is such a thing as upside “risk,” whereas PMPT proponents believe that only downside risk matters to investors.

This difference seems to give PMPT modeling greater power to predict disasters. In fact, applying MPT's concept of standard deviation to the monthly returns of the S&P 500 indicates a monthly loss greater than 12.8 percent has nearly no chance of happening. But it has occurred 12 times since 1926.

PMPT, say supporters, allows for last year's upset because it measures asymmetrical return distributions.

It’s a Post Modern World.

When the world was presented with Mean Variance Analysis [the basis of MPT] for looking at risk/return, it was the first of its kind back in 1952. No one had seen nor done anything like that before.

However, problem with the mean variance approach and what is known as the Capital Asset Pricing Model was that it assumed that every investor has the same objective. And that's just not true.

What is risk? To many, it is essentially the fact that we don't know what's going to happen, good or bad.

In short, predicting the future is impossible — though both MPT and PMPT still try to do this with modeling.

A major difference is that MPT assumes all investors have the same investment objective: to maximize the expected return for a given level of risk as measured by deviations around the mean. And so, for example, many retirement calculators suggest that 40 year olds who claim to have moderate risk tolerance plunk 40 percent of their assets in fixed income — which assumes these individuals, whether janitor or executive, will have exactly the same goals.

Subscribers to PMPT say, conversely, that investors have different and often very specific goals. The focal point should not be the maximum return possible given a certain level of risk, but rather the rate of return that must be earned in order to accomplish these specific investment goals, such as retirement or paying for college tuition, with minimum risk.

The risk, then, is defined as the possibility that the investor will be unable to accomplish the goal. As a result, returns below the target rate of return (“downside risk”) incur risk; returns above the target do not. With client portfolios suffering some of the largest losses in a generation, wouldn't everyone want a better handle on downside risk?

Don’t get me wrong. I do not have the audacity (nor the post graduate degrees) to suggest that MPT is wrong. The trouble I have is in the input variables. We've been using long-term averages for inputs. Historic averages have no predictive power at all. We’re told that by the very same people who expound on the virtues of MPT.

Indeed the concept of average expected returns, a central assumption in MPT, has taken a huge whack in the wake of the worst bear market in years, a bear so savage that it wiped out 12 years of equity returns in 16 months. Until now, who would have imagined the following could be true: Between 1969 and 2009, investing in 20-year Treasury bonds yielded better returns than investing in the S&P 500, according to research provided by Standard and Poor.

So much for the idea that over the long term, greater risk means greater reward.

Just food for thought.