How Investing Got Broken…
Today’s investors need to toss aside the conventional investment dogma that has, and will continue to bog them down and bury their future plans.
Investment myths continue to be dispensed by an army of well-meaning, but miseducated investment advisors because they have been given flawed tools with which to work.
Let me explain…
Prior to the 1980′s, most stock transactions were initiated almost exclusively by either institutions or the very wealthy. Stockbrokers simply brokered trades (as their name suggests). Transaction sizes were large and commissions were fixed by law. This made for some pretty cushy lives for well-networked stockbrokers.
During the early 80′s, the effects of the commission rate deregulation from 1975 began to impact “old” Wall Street’s bottom lines. The competition of lower commission rates meant that Wall Street firms had to market to an increasingly wider audience that was increasingly less sophisticated (Now called “retail” – a.k.a. “you”).
Stop Thinking and Start Selling…
As more and more firms hired more and more reps that catered to more and more retail clients that required more and more advice, a ”standardized” method of offering that advice was needed. Ultimately, the industry adopted a promising ”mathematical” approach to investment sales by embracing an obscure economic theory posed by Harry Markowitz as a part of his doctoral dissertation in 1952.
Investment theories such as “diversification theory“, “efficient frontier theory“, “asset allocation theory“, and “buy and hold theory” are all based upon Markowitz’s original equations and are collectively known as “Modern Portfolio Theory. (MPT)” Here is the Wikipedia definition which includes the formulae.
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Coincidentally, just as MPT started to gain traction as an investment theory, we entered into a period of unprecedented economic prosperity, triggerring generally smooth and uninterrupted stock market performance (1982 – 2000).
Since Modern Portfolio Theory uses past performance in an attempt to predict the future, we’ve now figured out that using MPT to design an investment portfolio has severely underestimated the amount of risk investors are taking, while overestimating potential future returns at all risk levels.
The Theory is Flawed…
What really screws investors up is that they have never been shown exactly why Modern Portfolio Theory outside of academia is a bad idea. So, let me try:
- All all of the industry’s planning and projection tools are based upon Markowitz’s theories.
- All of Markowitz’s theories are predicated on calculating FUTURE risk only when one knows FUTURE uncertainty.
- It is impossible to KNOW future uncertainty.
- Therefore, it is impossible to utilize our industry’s planning and projection tools with any degree of certainty that the projected future outcomes will ever resemble the ultimate reality that you will experience.
The bottom line is this… Modern Portfolio Theory doesn’t work because it confuses investment hindsight for investment foresight. It ends up being an outstanding method to analyze past investment results, but utterly useless to manage future investment expectations.
So, The Industry Guesses…
Ok, so here’s where it gets weird… or unethical… or criminal, depending on how much 
money you’ve lost. Since we can’t KNOW future uncertainty, the industry just guesses at it. That’s right, they “guess”! They have to throw some kind of a risk number in there to be able to run Markowitz’s calculations because they really, really want to sell you a mutual fund.
To grease the skids a little bit to make the sale, they throw a number in there that might represent some kind of “typical” risk to make the numbers work. This “guess” usually represents about one standard deviation of past volatility while dismissing anything outside of these boundaries. Unbelievably, this means that a full one-third of all past volatility is ignored as “not typical”.
And Then They Ignore the Outcomes…
This “fuzzy math” produces some interesting probabilities. For example, according to Modern Portfolio Theory:
- The chance of Black Monday (October 19, 1987) happening was 1 in 10 to the 50th power.
- The chance of The Asian Financial Crisis (October 27, 1997) happening was one in 50 billion.
- The chance of the three down days of The Russian Crisis of 1998 (August 4, 1998) happening individually were about one in 20 million each. The chance that all three down days (-3.5%,-4.4%,-6.8%) would happen in a single month was one in 500 billion.
- During 2008, we experienced four days that were statistically impossible. The declines were so large that they simply couldn’t happen according to Modern Portfolio Theory.
[I am always adding information to my collection of statistical supporting evidence, which also includes interesting quotes, articles, and books. The collection is located here on my page entitled, "...for further study".]
It All Seems So Benign…
Most of the time the flaws are not so obvious. As long as economic things are “humming” along in a relatively positive and predictable fashion, Modern Portfolio Theory (MPT) does a pretty respectable job of smoothing out the humps and bumps along the way (although some studies report that it does lower one’s overall returns). Basically, it works the best when it’s needed the least.
“When you need it most, asset allocation won’t work.” Jeffrey Mortimer, Chief Investment Strategist, Charles Schwab
Until Someone Gets Hurt…
Although a couple of minor assumptions in an otherwise tidy mathematical theory might not be a problem for statisticians, these same assumptions can be downright dangerous when used in the real world with real money during difficult market periods. Warren Buffett famously observed that, “You only learn who has been swimming naked when the tide goes out”. The whole idea of selling investors on MPT was to protect them from that day when “the tide goes out”. Over the last decade or so, when most individual investors look at their investment accounts, they can clearly see that MPT is “swimming naked”.
And Then They Drank Their Own Kool-Aid…
And it is not just individual investors who have felt this fatal flaw in Markowitz’s theories. Twice in the last decade have we endured very public financial meltdowns. The first of these was in the summer of 1998 involving Long Term Capital Management (LTCM) which was founded by two of Markowitz’s colleagues and fellow Nobel winners, Drs. Robert Merton & Myron Scholes. LTCM mistakenly assumed that their formulae could scientifically quantify risk. So confident were they with their theories that they left no allowance for the possibility that they could be wrong. But they were wrong and government intervention was needed to keep LTCM from bringing about a collapse of the US banking system.
“Even some rocket scientists have blown themselves up.” – Jeff Snell, JR Snell Capital Management, LLC
The second example of the danger of trying to apply scientific modeling to social problems is upon us today. The pricing of credit default swaps (CDSs), collateralized debt obligations (CDOs), special investment vehicles (SIVs), and other “financial weapons of mass destruction” (thank you again, Mr. Buffett) are primarily based upon a pricing model that has it’s roots in these same theories. (The Capital Asset Pricing Model (CAPM), for those academics amongst us.)
Pricing, trading and most importantly credit ratings are based upon an expected future default rate and other expected future uncertainties. There is no allowance for the possibility that the pricing models could be wrong, or that an unusual event could occur, which happens more frequently than previously thought. In other words, there was no Plan B. We do not yet know the end of this story, but we do know it has already cost us all a whole bunch of money.
“We seem to have a once-in-a-lifetime crisis every three or four years.” Leslie Rahl, founder of Capital Market Risk Advisors
Sadly, for every AIG and LTCM that publicly blows up, there are thousands if not hundreds of thousands of individual investors who very privately watch their net worth dissolve in a cloud of well-meaning, but misapplied financial theory. Individual investors, as well as respected investment advisors and their clients are all falling victim to the same flawed thinking that bankrupted firms like LTCM, AIG and numerous banks which were all run by some very smart people.
The Solution is The Return of Thought…
I believe that for as long as the world of finance continues to embrace MPT, we will have to continue to endure the the “boom-then-bust” nature of all markets that we have experienced of late. MPT does not only fail to appropriately quantify risk but it also understates it. Because of this, overall investment risks will continue to increase and investing will become less profitable to the practioners of MPT (most investors and advisors) and more profitable to those who are not (our firm and our clients).
You are also free to make the same mistakes as the “big boys”. The difference between you and the “big boys” is that no one is going to bail you out if you fail.
We cannot truly plan, because we do not understand the future – but this is not necessarily bad news. We could plan while bearing in mind such limitations. It just takes guts. Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable
