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Is modern portfolio theory dead?

Advisers seem to think so, but a close examination shows the idea worked well

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July 19, 2009 6:01 am ET

“The report of my death was an exaggeration.”

— Mark Twain

In my conversations with a wide range of advisers, the death of modern portfolio theory keeps coming up. The market debacle of 2008 is said to have sounded the death knell for all of modern finance. Diversification supposedly did not work, and a new model is needed. Tactical allocations and market timing seem to be the favored choice for the new model; in other words, let my clients get the returns of 100% equity allocations, but just tell me when to get out.

I wish I could. But step back a bit: Did MPT really die in 2008?

MPT does not guarantee a re-turn. It really does not even say that correlations will hold up over any given time period.

What it does say is that on average, over time, assets perform differently, and a diversified portfolio potentially can exhibit less variation in returns than a single asset portfolio. Did this hold true?

A look at some diversified portfolios shows that it did. More-diversified portfolios declined less than the markets over 2008. And portfolios that included alternative investments, which were even more diversified, showed even lower volatility over time.

For a dead idea, MPT worked pretty well.

Yet when I point this out to advisers — noting that 20% equity/80% fixed income equity portfolios did not decline very much — the response is usually something along the lines of not having many clients in 20/80 portfolios.

WHAT ABOUT BONDS?

This is a separate question, and one that has nothing to do with MPT. Were those high-equity allocations really appropriate? Many of us did not appreciate, at a gut level, the volatility and correlation potential of equities. We bought large-cap and small-cap, domestic and foreign, emerging markets and real estate investment trusts, and said we had a diversified portfolio. Where was the fixed income? But that would lower our returns.

In the end, we found we had diversified from A to B: “What kind of music do you usually have here?” “Oh, we got both kinds. We got country and Western.” In 2008, equities acted like equities. Bonds actually did relatively well. Managed futures did very well also. Portfolios that diversified beyond equities weathered the storm much better than portfolios with a heavy equity allocation — exactly as MPT would have predicted.

Just as reports of Mark Twain's demise were mixed up with his cousin's illness, so too is news of MPT's death based on mistaken identity. Still, if you look at the markets in 2008, it is hard to escape the idea that we do in fact have a corpse on our hands.

The toe tag should read something like, “Risk-free return.” Many investors built portfolios with the majority of their assets in equities, believing that stocks always went up over the long term. They planned for the higher returns but did not really believe in the higher risk. And yet if you look at history, they were wrong. Anyone remember the Nasdaq Composite Index at 5,000? Or even further back than 2000-'01, does anyone remember the last real estate debacle?

SHORT MEMORIES

Memories are short in the financial world, and I very much doubt that five — or maybe 10 — years from now, the younger investors will really remember, or care, about the current troubles. Three years ago, I cautioned a younger colleague about how much he had invested in real estate. He was refinancing properties he owned to buy new ones.

I saw this movie, I told him, and I know how it ends. He was polite, but of course ignored me. I do not know how his investments are doing, but the last I heard, he was recovering after being hospitalized for stress. Perhaps he sold his properties and put the proceeds into the stock market.

People who focus their investments in one sector, especially a hot sector, are assuming more risk than they realize. Like everything else, the hot sector will cool, and the cold sectors will heat up. All MPT posits is that by putting money in both, you will have less variance in returns. We ignore this truth at our own peril.

So when you write the obituary, make sure you get the name right. MPT isn't dead, but we might want to create an epitaph for the idea of risk-free return.

Brad McMillan is vice president and chief investment officer at Commonwealth Financial Network in Waltham, Mass. He can be reached at bmcmillan@commonwealth.com.

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