“. . . the real conundrum in modern markets is the continued reliance of investors and policymakers on two false mantras. The first is that markets are efficient; and the second is that investors are rational. Both assertions are so specious that one has to question both the sanity or the intelligence of those who cling to them.”

~ Michael E. Lewitt

Update: This article was included in the Carnival of Financial Planning #143. Thanks!

My goal with this week's series of posts was to simply make readers aware of some of the structural problems that our markets and economy face right now. We've looked at some of the ways today's markets are different, a few ways to manage your money in challenging times, and 5 investing challenges for the next decade. Today, I'd like to look at Modern Portfolio Theory (MPT), the basis on which many retail investors' portfolios are constructed. If you visit a financial planner or read a personal finance blog, you will probably hear a lot about the virtues of MPT.

What Is Modern Portfolio Theory?

Put simply and leaving out a lot of statistical jargon, Modern Portfolio Theory proposes that it's possible to construct a portfolio of investments that maximizes returns and minimizes risk by diversifying investments among uncorrelated assets. There are 2 key assumptions inherent in MPT:

1.  Investors Are Rational: This means that investors, collectively, will be correct in their economic and financial assumptions on average. In other words, market moves are always rational and based on the fundamental economic and corporate realities of the moment.

2  Efficient Market Hypothesis: Those who subscribe to this view believe that all information relevant to a stock is priced into it at a given point in time. In other words, the stock price is reality.

MPT Is on the Money

Those who subscribe to Modern Portfolio Theory believe that, because investors are rational and markets are efficient, it's pointless to try to beat the market by timing entries and exits. It's futile to try to buy a stock based on good news because the efficient market has already priced that information into the security. The Digerati Life had a great post this week that discussed MPT and the Efficient Market Hypothesis.

Proponents of the Efficient Market Hypothesis (EMH) argue that it's impossible to use technical indicators or stock picking to time the markets and that it's better to simply match market performance by using index funds or exchange traded funds (ETFs). Efforts to time the markets using either fundamental or technical analysis are regarded as gambling.

Pop Economics had an article on Why We Panic and How to Avoid It. Pop suggests we turn off the T.V. and ignore the stock market to avoid getting sucked into the vortex of a market panic. The key is to avoid the herd mentality and trust that markets will go higher in the long run.

Since he wasn't addressing MPT or EMH directly, I sent Pop an email and asked him to clarify his views on them. He was kind enough to send back a well thought out reply. He sort of puts himself in the middle of the debate, feeling like markets are “mostly efficient”, but subject to emotional excesses that periodically take them away from fair value – especially over the past couple of decades. Where he does agree with the MPT proponents is on the idea that it's pretty hard for the average investor to decide whether a given stock or market is over or under fair value. Over longer periods of time, like the amount of time we spend saving for retirement, Pop feels reasonably confident that stocks will generally rise.

MPT is Out to Lunch

Michael Lewitt writes the HCM Market Letter and has just released a book called The Death of Capital: How Creative Policy Can Restore Stabilityin which he outlines his ideas on how to fix the mess we're in right now. He provided a brief summary of some of his ideas in a recent edition of John Mauldin's Outside the Box. If you get a chance to read the whole thing, I highly recommend it. Today's opening quote is taken from this piece as well. Here is the continuation of Lewitt's thoughts on rational investors and efficient markets:

“Yet these two bugaboos are supported by reams of academic research and much of the investment establishment! It is my contention that these delusions are why capital continues to be terminally mismanaged by the professional investment class. With few exceptions, professional investors in all asset classes have produced at best mediocre returns for their investors.”

Ouch. I'm guessing Mr. Lewitt won't be joining the MPT fan club anytime soon.

One of the main purposes of diversification is to reduce risk by investing in asset classes that are either not correlated or are inversely correlated. Opponents of Modern Portfolio Theory would argue that these correlations aren't always the same and can vary greatly over time.

During the past couple of decades, markets have become more and more correlated, nullifying the advantages of diversification. You can read more about this in the Globe's recent excerpt of a book by John Authers called The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How To Prevent Them in the Future. Authers argues that the bubble of 2007 wasn't allowed to deflate sufficiently, and that the rally of 2009 “rested on exactly the same pathologies of herding behavior, moral hazard, and a simplistic faith in models, combined with synchronized and self-reinforcing trading, that created the super-bubble in the first place.”

My 2 Cents

Like Pop, I sort of come down in the middle of this debate. The difference is that I would land more on the “MPT is out to lunch” side of the fence. Here are a few of my thoughts:

  • Rational Investors & Efficient Markets: The markets are run by humans (and computers programmed by humans). As such, rationality and efficiency are elusive and inconsistent at best. I tend to agree with Michael Lewitt on this. As for the “reams of data” that support MPT, most of this is based on historical performance. Given my view that today's market is structurally different than in the past, that data is specious. As such, I won't be using it to manage our money.
  • Diversification: I like the idea of diversification, but I think that it's overused as a rationale for people to own a lot of equities in different sectors and assume they are diversified. A diversified portfolio invested 80% in stocks is not truly diversified. In today's markets, increasing and shifting correlations between asset classes make cash the best diversifier. Stock and bond markets have, and will continue to be, volatile until we bring the economy and the markets back into balance .
  • Market Timing: I would not advocate that the average investor should be day trading stocks. But I'm not a fan of the ostrich approach either. I have less faith that the markets will inevitably go higher than many. It's not that I don't think folks should invest in stocks at all; it's just that I think we need to really look at whether, and to what degree they fit our personal situation. If our markets are in a 20 (or more) year period of stagnation, that's significant to people who are 40 or older who are saving for retirement. When you buy does matter, and you do need some sort of exit strategy – even if you're a long term investor. Again, I would direct you to a long term chart of the Nikkei. Do your savings have a time horizon that could withstand that type of market action? If so, then go ahead and dollar cost average your investments. If not, think about strategies to control your risk a little more.
  • Technical Analysis: When I traded, I used technicals all the time. Many of the professionals and computers that run the markets are driven by technical indicators. That's part of the reason markets have become so highly correlated over the past two decades. If you ignore technicals, you're ignoring one of the key drivers of today's markets. If you are relying solely on Modern Portfolio Theory, you are investing in yesterday's market. That market no longer exists.

I hope that you've found this week's series useful, or at least thought-provoking. If you have any questions about these issues or want to suggest a topic for future discussion, send me an email and I'll do some research for you.

I welcome your comments. What are your thoughts on MPT or any of the ideas we've addressed in this week's series?