In February 2015, iSectors Post-MPT Growth Allocation hit a milestone: 10 years of live return data (read more here). In 2009, iSectors CEO Vern Sumnicht wrote an article focused on the Post-MPT models and Modern Portfolio Theory in general with a look at Modern Portfolio Theory back in the 1950’s. While MPT is over 50 years old and might not be considered as being “modern” anymore, to some, the principles it was built on remain as important today as ever before.
In 1959, Harry Markowitz published Portfolio Selection (i), which provided the foundation of Modern Portfolio Theory (MPT). This work eventually won Markowitz (along with Merton Miller and William Sharpe) a share of the 1990 Nobel Prize for research on theories of “Financial Economics.”(ii)
To prove the principle of an “efficient frontier,” one of the principles of MPT, Markowitz used an algorithm whose computation required three variables: expected return, standard deviation and correlation. That algorithm came to be known as the Mean-Variance Optimization model (MVO).
Perhaps because Markowitz received the Nobel Prize, the Mean-Variance Optimization model became the industry standard for portfolio construction, despite the unresolved problems and the significant advancement in computer technology over the last 50 years.
What is not well-known is that the authors of MPT understood the limitations of their academic work for real life investment management. For example, Markowitz himself said that “downside semi-variance” would build better portfolios than standard deviation. But as one of his colleagues, William Sharpe Ph.D., notes, “In light of the formidable computational problems (powerful desktop or even mainframe computers were unavailable at that time) … he based his analysis on the variance and standard deviation.” (iii)
While many advisors have come to equate the MVO model with MPT, they are now beginning to understand, especially from practical experience during this recession, that MVO is a flawed algorithm for determining a client’s optimal portfolio allocation. This may be what leads them to the erroneous opinion that MPT itself is obsolete. Regardless of what it is that leads to this opinion, discounting the value of MPT’s principles because of the way investors are applying these principles, would be akin to the proverbial phrase “throwing the baby out with the bathwater.” Let me explain.
Some of the principles of portfolio management derived from the research of Miller, Markowitz, Sharpe and their colleagues include:
All of these principles of MPT continue to be as valid today as the day they were first published. However, investors do need to learn practical approaches for applying MPT’s principles in a more effective manner.
Post-MPT and Behavioral Finance Catapult Principles of MPT to a New Level of Effectiveness
It is interesting to note how principles of MPT continue to inspire academic research today. For example: Post-Modern Portfolio Theory and research in Behavioral Finance have pointed the way toward more effective applications of MPT’s principles. If these applications can be implemented in a practical fashion, they can improve investment results and catapult MPT’s principles to a new level of effectiveness.
Investors and their advisors can understand these applications of MPT’s principles and learn practical approaches to implementing them. For example, now we understand that:
i Harry M. Markowitz, Portfolio Selection, (New Haven, CT: Yale University Press, 1959)
ii For details of the 1990 Nobel Prize in economics and its three winners, go to www.nobelprize.org
iii Harry M. Markowitz, Portfolio Selection, (New Haven, CT: Yale University Press, 1959)