Hang on! Investing in the 21st Century is a Rodeo…!
“The First rule of becoming wealthy is not to lose money. The second rule is not to forget the first rule.”
“Modern Portfolio Theory” (“MPT”)i, the 1950s’-1960s’ brain-child of University of Chicago economists and market gurus, is more or less the basis for “modern” investing – it’s the idea that investments can be measured for risk and expected return and then organized into a “portfolio” of multiple types of assets (e.g., stocks, bonds, real estate, or cash) to create diversification which can then, presumably, control investment volatility.
While MPT’s benefit is that it gets investors thinking about risk, it can also mislead us to think that risk can then be confidently managed, even controlled, by using many types of assets with less or diversified “correlationii” – correlation is the concept that different types of assets (e.g., large company stocks versus small company stocks, or U.S. stocks versus international stocks) tend to behave with different risk characteristics over time. However, looking at the chart below, since 1997 average correlations have been increasing, from the .40’s to .60 - .70’s. The takeaway is that increasing positive correlations mean increasing portfolio risk.
Sources: Goldman Sachs, Bank of America Merrill Lynch; Bloomberg, L.P.; and IMF staff; https://www.forbes.com/sites/randywarren/2015/11/04/your-portfolio-has-more-risk-than-you-think/#3d96c0e053c2
In the 2007-2009 market drawdown of -50%, every major asset class, including non-U.S. stocks and real estate (“real estate investment trustsiii, or ”REIT Index”) lost value – correlation failed to diversify risk. Assets that historically had demonstrated lower “correlation” and lower diversified risk lost value, disappointing and even disillusioning investors’ expectations that MPT could diversify risk during crisis events. Yet even today many portfolio managers, especially so-called “robotic” or robo-advisorsiv, rely on MPT
Why did MPT disappoint?
First, “liquidity” – with technology virtually all types of assets (stocks and bonds, also auto loans, mortgages, or even your health club fees) can be “securitized” (converted into investment “securities”) and traded instantaneously on markets using “exchange traded funds” or “ETFs”v. Financial markets are now incredibly liquid – transaction technologies often buy or sell ETFs (for example, the S&P 500 Indexvi) several times each trading day. So each time an S & P 500 ETF is bought or sold 500 stocks are bought or sold, instantly.
Second: “Program tradingvii” – Large institutional investorsviii now use automated-logarithmic program tradingix and are able to exploit this new level of liquidity - buy at 10 AM, sell at 10:05 AM. The vulnerabilities of MPT are increased because its methods are based on long-term assumptions and data over multiple-year market cyclesx, and may rely in part on data prior to the rise of high-volume program trading. For example, In the 1990s, post-Communist Russia was a hot emerging market, but by August 1998 its central banks were facing a cash crunch. While other factors were present (Japanese recession, devaluation of Chinese currency, U.S. President Clinton’s impeachment) conventional MPT models failed to predict severe market volatility: In August, DJIA stocks fell 3 times (first on August 4th by -3.5, then 3 weeks later by -4.4%, and finally on August 31st by -6.8%). MPT models estimated the likelihood of the August 31st drop at one in 20 million – if you traded daily for 100,000 years, you would not expect such a decline. And the odds of three drops of that magnitude in one month were a staggering one in 500 billion.xi
Third: Humans! – MPT can’t properly quantify or measure human behavior – the greed/panic factors of investing. The 2007-2009 crisis was to some degree a panic sell – small investors sold in panic as the large institutions were program selling. Greed is the flipside of fear and contributed to the 1990’s dot.com stock buying frenzy, with investors heavily weighted to technology stocks and expecting continuous annual 20%+ gains year over year – of course what followed was the 2000-2002 -50% “crash” followed by a “lost decade” from 2000-2010 when stock markets merely went sideways.
Fourth: Rising interest rates – Standard MPT moderate risk portfolios have used allocations of 40-50% in bonds or fixed income to off-set stock volatility. However, over the next several years fixed income performance is expected to underperform as governments “normalize” interest rates by raising rates from the all-time lows since 2000.
Summary: So how can portfolios be managed to reduce risk, provide income, and grow long-term to off-set inflation? Smaller investors (<$1-5 million) will need to review and adjust their methods. For example, promising hedge strategiesxii, including insurance company sponsored fixed indexed annuities, may provide alternatives to bond and fixed income instruments.
ETF and institutional trading technologies, rising rates, behavioral finance, and now 10,000 baby boomers/day moving into retirement and needing income. Hang on! It’s a rodeo out there!