Good Advice From the Father of Modern Finance
It all started with Harry Markowitz. As an ambitious young student in the 1950s, Markowitz looked to define risk in a new way. Pre-Markowitz, investors knew that stocks were risky, as many in the business had lived through the 1929 Crash and the Great Depression. But no one had a way to quantify risk or to use their knowledge of risk to build a better, more efficient portfolio. "Diversification" meant buying a handful of hot stocks and seeing what happened.
Markowitz changed all of this by defining risk as volatility and by introducing the concept of portfolio efficiency, i.e. getting the most return for a given level of risk. Thus was Modern Portfolio Theory ("MPT") born, and 50 years later it has become the industry standard.
There are problems with MPT, as I've pointed out in the past. It makes the assumption that markets are rational and that returns are normally distributed. Of course, anyone who believed that certainly got a nasty wake-up call during the 2008 meltdown. MPT is also backward-looking, in that it builds portfolios by looking at past risk and return figures. As we all know, "past performance is no guarantee of future results." Standard asset allocation based on MPT is a recipe for large losses during secular bear markets.
Still, for all its faults, MPT has made the investment management industry better. It paved the way for products like index funds, which have lowered the frictional costs of investment to almost nothing in many cases. But perhaps most importantly, it provides a framework that can be built upon and improved by others.
At any rate, in the CFA Institute's Conference Proceedings Quarterly for December 2009, Professor Markowitz asks the question "Why Does Great Math Often Lead to Disastrous Results?"
To answer his own question, Markowitz writes,
All financial models are an attempt to describe an infinitely complex reality. As a result, to achieve any success at all, portfolio theorists must make certain simplifying assumptions. But the problem with financial models is not that most of these assumptions are incorrect. Quite the opposite. These simplifying assumptions are generally true most of the time. The problem is that they are not always true.
Markowitz would almost seem to echo the views of Nassim Nicholas Taleb, the author of Fooled By Randomness and The Black Swan. These rare -- and disastrous -- times when the assumptions do not hold are what Taleb calls "Black Swans."
Taleb is no fan of modern finance methods. He believes that such methods lead investors into a false sense of security, which in turn leads them to take greater risk than would be prudent. He's absolutely right, of course, as the 2008 meltdown proved.
Taleb recommends that the entire edifice of modern finance be scrapped and that we start over again from the beginning. Markowitz takes a softer stance, and one that I would largely agree with:
It is precisely at the point where the assumptions break down that financial models, pushed to their limits, lead to disastrous consequences, which is why I believe we should adopt what I call “best practice MPT” to protect ourselves from the exposures that represent the points at which models are most apt to break down. By this point, some of these exposures should be apparent. The first such sensitivities would be illiquidity and market impact. At times of crises, liquid securities can become illiquid very quickly. Illiquid securities may only be traded with a huge market impact, if they can be traded at all. And of course, leverage compounds these problems. The LTCM experience shows that MPT cannot protect an investor from the dangers of extreme leverage.
Markowitz essentially says, "use MPT methods but be sensible about it." Don't chase returns, and keep leverage to a minimum. To this, I would add that using non-traditional (though still liquid) asset classes can be an enhancer, as can using forward-looking assumptions. If, say, Treasury bonds are yielding practically nothing at the moment, don't make a large allocation to that sector "because MPT says you have to." Studying demographic trends can also add guidance for overweighting or underweighting various asset classes, stock market sectors, or even individual stocks.
The key here is to avoid throwing out the baby with the bathwater. Use the insights of MPT, but don't be mentally lazy about it. Do some homework. And if common sense and intuition would seem to clash with your model...trust your gut over your model. After all, according to the models, "housing in Florida always goes up in value..."
Charles Lewis Sizemore, CFA
Chief Investment Officer, Sizemore Capital Management LLC
The views expressed in this post are the personal views of Charles Sizemore and may or may not reflect the investment policies and decisions of Sizemore Capital Management.
Sizemore Capital Management LLC is a registered investment advisor specializing in money management and financial planning for individuals. Please visit us on the web for more information: www.sizemorecapital.com
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Charles Lewis Sizemore, CFA
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