Revisiting Modern Portfolio Theory: Was it meant to guide investors to be invested through every type of market condition?

For many years, investors and advisors have struggled with the idea of buy and hold versus market timing. There have been many research pieces claiming Modern Portfolio Theory, MPT, to be dead. Alongside that research, there have been decades of marketing messages from several asset management firms referencing diversification strategies as being what works best*. Personally, I believe that the marketing started to focus on diversification shortly after Dr. Harry Markowitz, the father of MPT,  won both the 1989 John von Neumann Theory Prize and the 1990 Nobel Memorial Prize in Economic Sciences for a thesis he wrote in 1952 called “Portfolio Selection”. Also known as Modern Portfolio Theory. 

The traditional idea of MPT is one that attempts to lower volatility by diversifying across asset classes determined by an investors risk tolerance. Dr. Markowitz was a student of linear programming and he showed mathematical proof that diversifying a portfolio would minimize the volatility of the portfolio.  His research, in conjunction with many others, helped to create the “Efficient Frontier” which graphs the expected return based on a given amount of risk by calculating historical back-tested returns. Dr. Markowitz says in his dialogue from the day he received the Nobel Prize: “I sought as good an approximation as could be implemented.” 

Further notes from the dialogue in regard to Part IV of his 1959 book, “Portfolio Selection: Efficient Diversification”, he states: “The discussion of principles of rational behavior under uncertainty in Part IV of my 1959 book starts with a variant of L. J. Savage’s axioms. From such axioms it follows that one should choose a strategy which maximizes expected utility for a many-period game. This, in turn, implies that the investor should act in each period so as to maximize the expected value of a single period utility function. This single period utility function may depend on portfolio return and perhaps other stated variables.” 

My belief based solely on my observations, is that many financial services companies changed their messaging after Dr. Markowitz was recognized for his work. They looked at this award winning theory as a scalable way to increase their assets under management. Even today you’d be surprised at how many robo-advisors still reference Dr. Markowitz, not so much by name, but by stating that their portfolios are based on a Nobel Prize winning theory. That’s great but was the intention of MPT to be permanently invested? 

Here’s an interesting interview

According to an article published in the Chicago Tribune by Gail Marksjarvis on January 31, 2010 Dr. Markowitz is quoted as saying, “I’ve never been a buy and hold guy,” and he thinks his “modern portfolio theory” has been misapplied into naively staying the course when deeper analysis is warranted.”  Article Link 

Dr. Markowitz commented that it looks like many have interpreted the “many-period game” to mean “stay invested all the time” and over time you’ll be fine, which has worked but not without massive drawdowns along the way. But he states that further analysis is warranted when staying the course isn’t providing the maximum utility. 

While I do not disagree with holding many investments to help mitigate risk, I am suggesting that there could be a different way to achieve this desired outcome while still adhering to the risk tolerance of the client. Changing the allocation depending on the trend of the markets by using a risk on/risk off process could be one way. 

Looking forward, advisors should always be using a method of analysis that helps them and their client realize the maximum utility under the current market conditions.   

On Wednesday I’ll follow up with: Actively managing passive investments might help. How do you know if you have the best ETF in your asset allocation model? 

Pete Carmasino is Managing Director at PortfolioWise, an ETF ratings system powered by Chaikin Analytics. Pete has over 25 years in the capital markets industry. He previously ran his own RIA firm for several years where he created his own ETF model strategy. In prior roles, Pete was a High Net Worth Advisor and Institutional Sales Trader.

Follow Pete on Twitter @carmasino.

*1987 Dreyfus Ad
*1993 Fidelity Ad on Diversification
*1994 Fidelity PAS Ad
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