“Modern Portfolio Theory is just that, a theory; it’s not Modern Portfolio Fact,” Welch stressed Thursday afternoon in Denver. “Efficient Market Hypothesis is a hypothesis; it’s not Efficient Market Statement.”
Both of these investing staples have too many simplifying assumptions to address them otherwise, he added, but it’s something many people forgot, especially between 2002 and 2007.
“But 2008 brought this home in a big, big way,” Welch, senior managing director and member of the executive committee at alternative investment firm Fortigent, said.
He then launched into his presentation. Titled “When Bad Things Happen to Good Portfolios: Rethinking Risk and Diversification,” it began with an extensive examination of the three reactions advisors and investors have had since; the behavioral response, the “quant” response and the “rethinking the problem” response, three camps each with strong arguments and respected advocates.
The behavioral response wryly notes that “modern portfolio theory ain’t so modern anymore” and must be reevaluated. This reevaluation holds that investors act irrationally and do not have uniform risk tolerances or “utility maximizing” risk and return objectives. Rather, an investor’s risk tolerance is dependent on the starting point of wealth and changes over time in an “asymmetrical way.”
“MPT measure statistical portfolio qualities that do not capture non-statistical sources of risk within portfolios,” Welch noted. “And extreme market conditions like Black Swans cause complete model failure. Also, investors do not view upside and downside risk in the same way.”
“Is there a better way?” he asked. “In other words, can we bridge the divide between Eugene Fama and Richard Thaler?”
So called “Post-Modern Portfolio Theory” might be this “ecumenical bridge.” It measures downside risk more accurately through the Sortino ratio, semi-variance efficient frontiers, lower partial moment, etc. to find how investors actually think about their money. The upside is also more accurately captured through minimum acceptable returns (MAR) and upside potential of an objectives-based investment strategy.
“The verdict to date, based on tons of analysis, is that it is a better way,” Welch said. “However, there is little practitioner acceptance of implementation, probably because there are 25 years of investor ‘education’ to undo.”
He then moved to a discussion of the quantitative responses since 2008 (or the theory that it can all be solved with math), among them market “turbulence” optimization.