…for further study
This page is a collection of third-party quotes, articles, references to articles and links, etc. all related to the problems of Modern Portfolio Theory or some aspect of it. I offer this up as a self-help or self-discovery opportunity to investigate the facts and decide for yourself what is right.
It is the ‘science’ of risk management that effectively turned Wall Street into clueless robots. We replaced so much experience and common sense with ‘models’ that work worse than astrology, because they assume that the Black Swan does not exist. Trying to model something that escapes modelization is the heart of the problem.
Greed pushes bankers to take the maximum amount of ‘hidden risks,’ those risks that do not show on a regular basis because the models miss it, but end up causing blowups. Banking is a very treacherous business because you don’t realize it is risky until it is too late, till after a Black Swan surprises us, triggering an economic meltdown, like now, and we’re stuck cleaning up the mess.
-Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable.
Asset Allocation…
“Radical Thoughts on Asset Allocation,” Elaine Floyd, CFP – Written by an investment advisor for other advisors, this is a good introductory article to the whole issue.
“The Asset Allocation Hoax,” William Jahnke – Written in 1997, Jahnke saw early on that the statistics that investors were being barraged with from the Brinson study were flawed. Now, when a sales rep tells you that “93.6% of portfolio returns are due to asset allocation, not investment selection”, you will know that he is selling “sound bites” and not deep personal research.
“Why Diversification is Failing,” Robert Huebscher, Advisor Perspectives - We’ve all been told that by spreading our investments out between different asset classes (i.e.value stocks, growth stocks, bonds, international investments, gold, real estate, commodities, etc.) we increase our safety. Huebscher shows us this is true, but only when things are going up! Sadly, when things get truly ugly, they all get ugly together… near-perfect mathematical correlation! That’s why asset class diversification doesn’t work when you need it most.
Efficient Market Hypothesis…
“Market Meltdown Refutes Efficient Market Theory,” Kate Gibson, MarketWatch – This is more evidence that investors aren’t really rational as the economists would have us believe. The myth that all people always behave rationally is the “original myth” that must be swallowed whole to believe in any statistal forecasting method. Yes, this includes Modern Portfolio Theory. Gasp.
REP. HENRY WAXMAN (D-Calif.): And my question for you is simple: Were you wrong?
ALAN GREENSPAN: And what I’m saying to you is, yes, I found a flaw….a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.
REP. HENRY WAXMAN: In other words, you found that your view of the world, your ideology, was not right, it was not working?
ALAN GREENSPAN: That is–precisely. No, that’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.
“Morningstar Ratings Fail Over a Full Market Cycle”, Robert Huebscher, Advisor Perspectives – Morningstar is one of the biggest mutual fund rating agencies. Many planners will use their fund ratings to design a portfolio of mutual funds for you. Problem is, their rating system doesn’t work over a full market cycle (i.e. “long term”). I’ve highlighted this amazing quote from Page 4, “In his analysis, Russel Kinnel of Morningstar states, “In short, the star rating is a backward-looking measure of past performance. What it is not is a forward-looking measure of fundamentals.” We concur that the ratings are not an effective forward-looking measure, but that is not how they are used in the industry. By calling this calculation a rating, Morningstar imparts at least the implicit endorsement of higher-rated funds and an expectation that their relative performance advantage will endure.”
Modern Portfolio Theory…
“Deja Vu All Over Again,” Paul Kaplan, Morningstar Advisor – Mr. Kaplan explains how it is possible that “unusual events” occur, on average five to 10 times more often than the MPT models suggest.
Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood…these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas. -Warren Buffett
”MPT Put Through the Wringer,” Paul Kaplan, Morningstar Advisor – This article, written in a Q & A style format, presents both sides of the argument about MPT by two respected investment analysts with opposing views. It’s a solid article which sheds some additional light on what academics and working investment managers both see as the problem.
Solutions…
“A Quantitative Approach to Asset Allocation Theory,” Mebane T. Faber – Higher returns with less risk? Yes, it’s possible, reasonable and simple. Mr. Faber presents a simple, and elegant solution (those are always the best) that reduces portfolio risk… but most importantly, reduces “drawdown”… the gut-wrenching drops from highs to lows that cause most investors to bail out on a plan. I like options like the one Mr. Faber presents because we don’t have to suggest to our clients that they must follow a course of action that keeps them awake at night and urges “hoping” as one of the investment tenets. This is one possible solution to the problem. Not the one that we use, but reasonable nonetheless.
