You probably recall Hans Christian Andersen’s delightful story “The Emperor’s New Clothes,” in which a potentate parades before his subjects while supposedly wearing a garment so refined it’s hard to see — until a child points out that the emperor’s naked.
Sometime in the spring of 2009, without fully realizing it, I took on the role of the child in a modern day rendition of the fable. As various seers and prognosticators debated “black swans” and even talked about the progeny of Modern Portfolio Theory, I announced to anyone who would listen to me: “Modern Portfolio theory is naked! Its consort, Buy and Hold, is naked. And for good measure, the third pillar of the state finance religion — don’t manage money — makes it a shivering threesome.”
Perhaps I was able to see this as clearly as I did because I am not a financial advisor. Nor have I done a formal study of MPT. But just as the child saw clearly that the emperor was naked, I saw just as clearly that not only is Modern Portfolio Theory threadbare, but that advisors now need to take back the management of their funds. Twice in this new millennium, highly manipulated markets have handed your clients a 50 percent asset reduction plan. Be prepared for the next one.
Given its influence, the bankruptcy of Modern Portfolio Theory as a comprehensive investment management tool should have been bigger news than it was. It should have been on the front page of the New York Times. About the best one could do was a February 2009 Barron’s article titled “Modern Portfolio Theory Ages Badly: The Death of Buy-and-Hold,” which noted the 2008 fourth quarter massacre saw ostensibly uncorrelated asset classes — except Treasury bills — dive into the shallow end of the pool simultaneously.
The 2010 annual research report from Dalbar, “Quantitative Analysis of Investor Behavior,” or QAIB, released mid-April, is a must-read for financial advisors who make their living on being more right than wrong. The report states: “In spite of the catastrophic losses in 2008, the belief in Modern Portfolio Theory (MPT) has inexplicably remained strong.” As the report explains, MPT presumes asset classes to be predictably uncorrelated, but investment results in 2008 “showed clearly that correlation of asset classes varied unpredictably and with no warning.”
The report goes on to suggest MPT “should be thought of as only one reference point for modeling the behavior of a potential portfolio; it is only one dimension of a more comprehensive investment management process.”
I’ll put it more bluntly: MPT, RIP.
Real vs. Theoretical
Modern finance theory seems to live in a world not connected to the real world of clients, retirement, educational funding needs, illness, joy, sorrow and ultimately death. It lives in a theoretical world, not a real world.
My first encounter with this world was at the University of Virginia where I was pursuing a Ph.D. in Economics. One of my classes was macroeconomics. The professor, a hotshot just out of Yale, would often cover the blackboard with differential equations. Once when he completed a particularly difficult proof and was dusting the chalk off his hands, I raised my hand and asked what all this had to do with anything.
“Mr. Good,” he replied smugly, “You have been doing this long enough to know that in economics we deal with the real world and the theoretical world. This was a theoretical world construct and as such, has nothing to do with anything.”
I knew that of course. But for whatever reason, on this day, in that proof, something went click and I replied, “That’s what I thought.”
Then I picked up my five-pound textbook, put it in my briefcase with several other five-pounders and walked out. While I showed up for a few other classes, I was done with my academic career and its torturous journey into the “theoretical world.”
Like my class in macroeconomics, “buy and hold” exists in the theoretical world, not the one you and I and investors inhabit. In the real world, buy and hold does not exist.