W. Scott Simon
There has been a good number of articles published since the market downturn of 2008 and 2009 decrying modern portfolio theory and diversification. Such condemnations include: MPT/diversification “no longer works;” MPT/diversification “should be revisited;” MPT/diversification “didn’t work” in the most recent market downturns; or it’s no longer possible to “believe in MPT or diversification.”
All these articles conclude by saying, in effect, that if an investor had only been invested in this or that best-performing stock/bond/mutual fund/market sector/asset class, etc., then it would have avoided the ill effects of the downturn. Such articles pop up after every significant downturn in financial markets. This may lead one to surmise that their authors have a “MPT/diversification is no good” story template that changes only with the dates of a downturn and the particular best-performing investments during the downturn.
The fact that, during a market downturn, an investor didn’t hold a best-performing investment like, say, Ethiopian bonds (whose superiority could not have been known until after the fact of their superiority showing up in the form of a track record) therefore “proves” that MPT and diversification aren’t relevant to investors. This kind of “reasoning” leaves me scratching my head; to me, it’s nothing more than a form of Monday morning quarterbacking that provides investors with little more than an interesting story and no useful guidance for the future.
I Get E-mails
One reader of this column sent me an e-mail recently which I have paraphrased: “The Employee Retirement Income Security Act and the Uniform Prudent Investor Act have essentially tapped modern portfolio theory as the ‘correct’ way to invest and mange portfolios. And yet, MPT did little to predict the carnage of the last couple of years or protect investors from recent market fluctuations. So do fiduciaries need to revisit MPT; should they consider post modern portfolio theory risk with more of a focus on downside risk?”
My Response: MPT and Diversification Are All-Important
This reader’s observations and questions are excellent ones; here is my response, which advisors who are so inclined may wish to use to help educate their clients.
It was never contemplated that MPT would “predict” any given downturn in financial markets. As Nobel laureate Harry Markowitz who is the father of modern portfolio theory, notes: “Risk is risk” and “You pays your money and you takes your choice!”
What Markowitz means is that financial markets are inherently risky, so if an investor wishes to avoid such risk he shouldn’t invest in financial markets. Depositing one’s assets under a mattress, though, carries its own risks. One “prediction” made by MPT is that in (inevitable) market downturns, a well-diversified portfolio will perform relatively better than a concentrated, non-diversified portfolio.
Some concentrated portfolios, of course, will perform superbly in market downturns (and others in market upturns), whether due to the skill (or luck) of their managers. The absolutely insoluble problems with this approach to investing are that no one can (1) identify–before the fact–which such (relatively few) portfolios will be winners, (2) know whether their managers were truly skillful or merely lucky (unless they have a long enough track record that’s statistically meaningful) and (3) know whether either factor (skill or luck) will be repeatable going forward (even though they may have a long enough track record that’s statistically meaningful).
The best way to counteract the problem of the inherent uncertainties which characterize all financial markets–whether efficient or inefficient–is to diversify a portfolio–preferably deeply (within each asset class held in the portfolio) and broadly (across all the asset classes held in the portfolio), while keeping costs and taxes (for taxable investors) low. Hedging strategies in certain situations can also be effective in counteracting this problem.
There’s no harm in considering “post modern portfolio theory risk with more of a focus on downside risk.” Heck, I’m all in favor of anything that helps a fiduciary better fulfill its “central consideration” under the UPIA–to determine a portfolio’s risk/return trade- off. If “post modern portfolio theory risk with more of a focus on downside risk” helps fiduciaries carry out the duty of assessing the risk side of the risk/return equation, cool. I’m tickled pink when investors and their advisors, whether fiduciaries or not, even talk about, and therefore acknowledge, risk. A fiduciary that fails to acknowledge risk and account for it in some way is a speculator; how could such behavior be characterized in any other way when the fiduciary ignores 50% of the risk/return equation? Few would disagree that fiduciaries cannot be speculators. The talking heads, of course, all focus on return and ignore risk completely so they’re always shocked, shocked when financial markets don’t always go up in a straight line (like, say, housing prices).
Markowitz once reminded me that standard deviation is a mirror image of the good and the bad (each side encompassing both compensated and uncompensated risk) so downside risk is already contemplated by MPT. Indeed, the stock or fund or portfolio that soars in price always has the potential to fall in price just as hard because risk is always embedded in an investment, whether or not investors are aware of it (and few are). None of this is to say, however, that standard deviation is the only way to measure the risk of investing; investors have different ways of looking at risk and there are plenty of ways to measure that.
The odds are looking forward that deeply and broadly diversified portfolios low in costs and taxes will experience shallower decreases in value during market downturns than concentrated, non-diversified portfolios (except, of course, those concentrated portfolios that turned out–only in retrospect naturally–to be superior). Shallower decreases in value mean that well-diversified portfolios have less terrain to cover to get back to even than concentrated, non-diversified portfolios in the (inevitable) ensuing upturn in the market. For example, a $100 portfolio dropping to $75 in value has a 25% loss and requires a 33% recovery to get back to $100. A $100 portfolio dropping to $60 in value has a bit larger loss of 40% but requires a much larger recovery of 66% to get back to $100. As such drops in value get larger, the recovery percentages required to get back to even must increase exponentially because there are fewer and fewer dollars available to cover more and more terrain.
Section 404(a)(1)(C) of the Employee Retirement Income Security Act requires fiduciaries to mitigate the often devastating effect of this unforgiving math by diversifying–preferably broadly–to minimize the risk of “large losses.” Morningstar’s Don Phillips explained the critical importance of mitigating losses in a 2009 Wall Street Journal article: “A manager who limited losses last year (i.e. 2009) goes a huge way to helping investors accumulate wealth over time and meet their long-term goals. It’s the kind of victory that often goes unnoticed,” amid widespread market downturns.
The model portfolios that my partners and I at Prudent Investor Advisors provide to plan participants in the 401(k) plans we advise performed (relatively) better in the recent downturn. Our 60/40 model portfolio in 2008, for example, was down in value about 22%. I know that wasn’t any fun for plan participants invested in it but as they pointed out to us, it was better than their concentrated 401(k) portfolios with a similar asset allocation they had not yet rolled over from previous employers or similar portfolios that their spouses had at their own employer; those portfolios were down 35% or even 45% in value over the same time period. Such deeper decreases in value create a bigger hole and make crawling out of it that much more problematic.
By the way, we didn’t create our model portfolios by picking stocks, timing markets or track record investing. We created them by simply adhering to the (decidedly non- sexy) tenets of MPT and diversification including a conscious focus on risk and return, cost-efficiency, and maximum exposure to the asset classes that comprise the world’s financial markets. I always tell plan participants that this approach is quite simple–and yet it’s quite sophisticated given that thousands of securities from dozens of countries are invested according to the respective risk/return trade-offs of the model portfolios.
So much for the risk of the larger losses registered by concentrated, non-diversified portfolios in market downturns. But what about after a market downturn has reached its bottom? The problem there with concentrated, non-diversified portfolios is the uncertainty that such portfolios will ever recover their previous values. When an (ideally) well-diversified portfolio such as the market portfolio declines in value, it will always eventually top its previous (high) value. But the same cannot be said about, say, any given individual stock or bond, or mutual fund. An investor can never know whether or not that stock or bond, or fund will ever go back up in value to its previous high. Those are odds that no prudent investor should play. Instead, a prudent investor should play the much more favorable odds offered by MPT and broad and deep diversification.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.