More on the Modern Portfolio Theory

On June 2, 2014

iSectors® CEO, Vern Sumnicht, recently commented on the May 27th article:
The Modern Portfolio Theory Flat Earth Society by Vitaliy Katsenelson for GuruFocus.

It’s easy to sound like an investment educator maligning Modern Portfolio Theory (MPT) and belittling Chartered Financial Analysts (CFA) not to mention the implied put down of those who’ve earned an MBA. This could be taken wrong by young men and women considering an education in finance.

I’ve lost money in the past (along with many others) inappropriately applying MPT. I can agree that many investors have been hurt by the way most advisors in the investment industry incorrectly apply the principles of MPT. ERISA and the Prudent Investors Act, in effect, even mandate this incorrect application of MPT’s principles. But, the problem isn’t with MPT or education.

A quick review of the basic tenets of MPT begs the question: Which of the principles derived from MPT are no longer relevant?

  • Are investors no longer risk averse?
  • Are equity markets no longer pretty efficient?
  • Isn’t the allocation of the portfolio as a whole important?
  • Shouldn’t most investors invest for the long-term?
  • Is there no longer an Efficient Frontier where every level of risk has an optimal allocation of asset classes that will maximize returns?
  • Would investors rather be concentrated in a few asset classes than be diversified among a greater number of asset classes with low correlation to each other?

Common sense instructs most investors that these basic principles, derived from MPT, remain as relevant today as they were the day they were conceived. Most of the present confusion seems to derive from mean variance optimization (MVO); this is the asset allocation formula used to determine the efficient frontier of optimal (risk adjusted) asset allocation portfolios. But MVO was not intended to be used for managing portfolios, and it should not be considered equivalent to MPT.

Understanding the weaknesses in how MPT is applied enables investors to improve the risk-adjusted returns that their portfolio achieves from asset allocation.

  • The asset allocation algorithm shouldn’t use standard deviation to measure risk.
  • Asset allocation should be applied using asset classes that have truly low correlation to one another.
  • The asset-allocation algorithm needs to be more robust than MVO. That is, more than three basic factors are required to determine optimal asset allocation. Changes in capital market and economic factors, like money supply, inflation, unemployment, dividend yields, etc., need consideration in determining optimal asset allocation.
  • The asset-allocation approach should be applied using fee-sensitive investment vehicles to mitigate management, transaction, and tax expenses as much as possible.
  • The tenets of modern portfolio theory still hold true.

What is needed is a re-thinking of how to apply the principles of MPT.

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