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Home > Blogs > Anthony Harrington > Modern portfolio theory - maligned but still better than active management? Part Two

Modern portfolio theory - maligned but still better than active management? Part Two

Modern portfolio theory - maligned but still better than active management? Part Two Anthony Harrington

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Taking it as read that modern portfolio theory (MPT) did not protect investors through the 2008 global financial crash, when many saw their diversified portfolios contracting by 30% to 40%, does this constitute a failure of the MPT approach? Back in 2010, Peng Chen, President of MorningStar’s Ibbotsen Associates, gave an interview in which he pointed out that MPT did not do badly in the crash and was never designed to counteract systemic risk (i.e. a shock to the entire financial system), so you can't blame it for not doing something it never set out to do. What the 2008 crash showed, Peng argues, is that basing risk control on an analysis of standard deviations alone (the heart of MPT) has severe limitations when the market moves into extreme conditions. MPT will underestimate the probability and severity of tail risk (defined as the probability of an asset moving more than three standard deviations from its price), particularly in short time frames such as monthly or quarterly periods – and when markets are crashing, they can move an awful long way in a month. His answer is to use MPT but to add in other tools such as conditional value-at-risk, semi-standard deviation, and shortfall probability (which computes the probability of the portfolio breaching its value-at-risk limit).

This sounds good but it runs slap bang into the criticism made by Mark Sidell in Part One, where he castigates active managers for getting anxious and diving in to tweak what should be a passive MPT play. It’s either MPT or its not, in his view. Many managers would say “So what? If it works, don’t knock it”. And they would trust their tactical skills. Sidell’s point is that the statistics don’t bear them out on the kind of 20 to 30 year time frame that pension savings demand.

Harry Markowitz, one of the founders of portfolio theory who won the Nobel Prize for his work in 1990, gets annoyed by what he considers to be "mistaken criticism" of how MPT played out in the crash, made by people who haven’t actually read his work properly:

"Mean-variance optimization theory worked in the crisis. In a crisis, the systematic risk factor moves downward so much it swamps the idiosyncratic factor – but do all assets go down by the same amount? No: emerging markets had beta higher than one, so fell more than the S&P 500. So I use 2008 as an example of why you should be using portfolio theory – somebody whose portfolio was high on the efficient frontier got hammered, but somebody low on the frontier didn't. Either people should have been further down or they should be aware they are taking more risk."

In other words, if you were maximizing your MPT for returns, you got hammered. If you had it properly diversified for low risk, then you wouldn’t have got hit so hard; and if you had stayed invested, you would have been made whole again. Markowitz does not like value-at risk or expected shortfall as risk measures. Variance is the best measure of risk to use in asset allocation, period, he says. His advice to all who will listen is go back and read his book – re-read it if you are one of the few who actually did read it first go round. Much will then become clearer to you, including the fact that the Basel Committee has got its Basel III banking regulations totally wrong because of its reliance on value-at-risk, the worst possible risk measure, according to Markowitz.

Finally, to end with, anyone who wants to get away from paying fees for dubious advice and model-making shenanigans could do far worse than devote a little time to Harry Browne’s Permanent Portfolio formula, immortalized in a Sunday afternoon radio broadcast that Browne did back in August 2004. The broadcast is still available and well worth a listen in its entirety. Browne points out that despite the fact that we live in an uncertain world, there is no shortage of people, particularly in the investment community, who think they know exactly what the future holds. "When someone is right once, they can dine out on it the rest of their lives," he says.

In his view there are four, and only four, possible economic states. These are:


There are phases of uncertainty when the market is transitioning from one of these states to another, but these four are all there are. So, the trick in building a permanent portfolio - which, he says, you can do with anything from £1,000 to £1 billion and over - is to spread your asset allocation across assets that do well in growth, and in inflationary times and in deflation. Recession, he says, is a problem because, in 25 years of searching, he hasn't found any asset class that likes a recessionary environment. But recessions do not last beyond six to 18 months tops, because central banks have to act and will start printing money and stimulating the economy, which will transform the recession into one of the other three states - growth, inflation or deflation.

To simplify his account, Browne has four asset classes that he wants the portfolio divided equally between. These are stocks, bonds, gold and cash. In a growth phase, stocks and bonds do well, gold does badly and cash suffers from opportunity cost (you could make more by putting it to work). During inflation, stocks do worse because inflation is disruptive to business, bonds do poorly because interest rates rise and cash loses value. Gold is the second most popular form of money in the world, so people turn to gold and its price rises during times of high inflation. In deflationary times, interest rates collapse to near zero and bonds do extremely well. Recessions will probably hurt your portfolio, but they are inherently self limiting (because of central bank action), so you ride them out. A simple balanced permanent portfolio then, is one that assigns a quarter of the portfolio to each of stocks, bonds, gold and cash. Set this up and let it run, and it will grow and protect your wealth, he says.

What of the lost opportunities that an investor in this "permanent portfolio" will suffer by being just a quarter invested in stocks and a quarter in bonds, in boom times? Shouldn't they "tweak" the portfolio to move more into these "winning" asset classes? And, likewise, shift them out of stocks when markets are failing? No, says Browne. He points out that when you analyze gains and losses, the gains made during boom periods far exceed the losses made during recessions. In a crash you might lose 40% of the portfolio holdings in stock; but, in growth times, taken over the whole cycle, you can make 200% to 300% gains. So, your gains far outweigh your losses and the whole point is to set up the portfolio so that you do not have to tweak it and start trying to time the markets, a trick that generates far more losses than gains for probably 99% of investors and investment managers. Browne is not against other kinds of speculative investments to try to generate outperformance, but that kind of speculation should only be done with money that the investor can stand to lose, he warns.

Browne's permanent portfolio would not suit the investment management community, because what would they be charging fees for once the portfolio was set up? What it will suit, he says, is anyone who wants to keep their wealth safe while giving it a very reasonable chance to increase.


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Tags: asset , asset class , Basel III , bonds , boom , cash , deflation , gold , growth , Harry Markowitz , inflation , interest rates , investing , Mark Sidell , Modern Portfolio Theory , MPT , Peng Chen , recession , standard deviation , stocks , value-at-risk
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