The last 18 months have been an unmitigated disaster. Financial planners have seen their income melt away like global warming on steroids. The stock market has fallen to 12-year lows. Unemployment has risen to 25-year highs. Even traditionally conservative investments like municipal bonds fell roughly 15 percent in 2008. Every asset class has lost value except two: U.S. Treasury bonds and gold. “I’ve spent a lot of my time in the past six months talking clients off the ledge,” says Bob Kargenian, president and principal of TABR Capital Management in Orange, Calif.
In industry circles, one question we hear more and more: Is Modern Portfolio Theory dead? Financial planners have been preaching the sacred truth of diversification to their clients for years. Elaborate asset allocation strategies have been carefully crafted. Financial goals discovered, articulated and codified. Risk tolerance measured and incorporated. Calculations, estimates and scenarios have been run. Fancy colorful financial plans were printed, presented and kept. And in the end, it just didn’t matter. Most portfolios have lost 20 percent to 50 percent in value, and for advisors whose compensation is based on AUM, 2008 was a painful year.
“The prime imperative of wealth management is if you take care of the money, everything else will take care of itself,” Kargenian says. So riddle me this: Is Modern Portfolio Theory (MPT) a best practice or folly? Once an advisor carefully diversifies a client’s portfolio, is putting it on autopilot the right thing to do?
Not according to Harold Evensky, CFP, AIF, president of Evensky & Katz Wealth Management in Coral Gables, Fla. The classic definition of MPT boils down to diversifying investments among different types of investments, each of which have unique characteristics, hence reducing the probability of sustaining a large loss. Unfortunately, the last 18 months have challenged the theory. Disparate asset classes, with distinct risk profiles, all went down together. What went so terribly wrong? Evensky concludes: “It’s not that MPT is invalid, it’s that the application has been faulty.”
According to Evensky: “The MPT model alone will not necessarily work in bear markets, or at least not using historical averages alone as inputs without other adjustments to forecast the return, volatility and especially correlation.” Evensky advocates a “core and satellite” approach, where the core allocation of a client’s portfolio is used to capture market returns, and a satellite allocation, namely a portion that is allocated 100 percent of the risk budget, provides the alpha.
John E. Rice, CFA, CFP, notes that MPT originally started with a paper by Harry Markowitz in 1952 that basically quantified mathematically the idea that diversification across different asset classes that are not well correlated reduces risk. “I do believe that diversification is appropriate and that it should be used in portfolios,” says Rice, formerly chief investment officer at Phoenix wealth-management firm Keats, Connelly and Associates. “However, I think that advisors have had a tendency to overuse the idea of standard deviations and correlations when making decisions about portfolio diversification.”
Based on Markowitz’s groundbreaking research, financial planners have been selling MPT for years as one of the tenets of prudent investing. Are they misguided? Not so says investment advisor Richard A. Ferri, CFA, founder and CEO of Portfolio Solutions in Troy, Mich.: “I fall on the side of it does work. It just doesn’t work well all the time because in finance, models are not like those in the natural sciences, where water freezes to ice at 32 degrees Fahrenheit at sea level. No matter where you go in the world, if it’s 32 degrees Fahrenheit and you’re at sea level, water will freeze…it will happen every time. But in finance, that’s not the way it happens. Theories are approximations, good generalities. They are guides. Investing is like throwing horseshoes; you get points for being close. You don’t have to get a ringer.”
Ferri believes that over the long term, generally, MPT works, but if you’re looking at it over any short-term specific period, it may not work. He comforts investors by saying: “My belief is that investors shouldn’t abandon MPT. They should continue with it because even though it did not work among risky asset classes in the last 18 months, evidence is that it will work again in the future.”
Not So Random