Modern Portfolio Theory

I’m not going to reiterate my disclaimer with every post other than this: You are reading what amounts to financial advice from a guy who has no credentials and no expertise–it’s just what I’m finding in reviewing my own financial situation. View it as a wake up call and nothing more.

Modern Portfolio Theory (MPT) is a lot like Political Correctness. or Progressive Policy–a marketingĀ  label that sounds like a blanket endorsement. Or in more direct parlance–bullshit. 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 MPTĀ  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: http://en.wikipedia.org/wiki/Nobel_Memorial_Prize_in_Economic_Sciences.

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 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.

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 takes away 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.

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:

It’s 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 slime mold, would be the ones that survive to reproduce, and produce exactly the line that yielded you, and yet here you are. 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.

Next time we’ll talk mechanics and toss in Robo Advisors–some easy ways to implement MPT that might work well for you. We’ll also probably get to 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.

 

 

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