Why Modern Portfolio Theory Isn’t Modern
A lot can change in seventy years. That’s how long it’s been since economist Harry Markowitz first presented Modern Portfolio Theory (MPT) in a Journal of Finance article. It was 1952. New homes were selling for less than $10,000, the US median salary was $3,850 a year, and gas was 20¢ per gallon. Social media didn’t exist, but neither did the home computer.
MPT wasn’t the only “modern” invention in 1952. The world also saw the first barcode, the first roll-on deodorant, and the first automotive air bag. They’ve all evolved over the years. Modern Portfolio Theory has not. Eighty years later, its original principles are still being applied to portfolio construction by countless advisory firms and third-party money managers.
The world has changed. We don’t say that to disparage the work of Mr. Markowitz. He’s a legend in the world of finance who won a Nobel Prize in Economics. His treatise on modern portfolio theory was ground-breaking in 1952. Today, it’s an old-school technique that doesn’t work in the new normal. In this article, we’ll present the reasons why.
What is Modern Portfolio Theory?
When your financial advisor speaks to you about a “balanced portfolio,” there’s a good chance he’s using modern portfolio theory. The concept revolves around risk. It assumes that certain investments are high risk and can produce high returns, with the opposite being true about low-risk investments. Balanced portfolios have a mix of the two to ensure optimal returns.
These risk assessments can be applied to individual securities or asset classes. For instance, cryptocurrency is considered high risk. Many investors earned high returns with it in 2021. Technology companies like Amazon and Apple showed minimal risk for years, suggesting the reward would be minimal but steady. Can you see the flaws yet?
Modern portfolio theory is a long-term strategy. In the 1950s, life was simpler. The workforce was composed primarily of W2 workers who stayed on the same job for decades and retired with a pension. Managers of those pension funds bought into MPT because the stock market was predictable based on historical performance. That remained the status quo for fifty years.
This “buy and hold” approach to portfolio construction is also known as “passive investing” because the investor doesn’t need to do anything but rebalance to keep the individual asset risk evenly distributed. There’s very little active trading. Financial advisors embrace this because it gives them greater capacity to scale their business.
The word “modern” has an expiration date
Henry Ford’s Model-T was the most modern machine ever created in 1908. Now it’s an antique. That’s the way it is with most things. The word “modern” has an expiration date. In 2022, that date could be six months from now. Look at the technology sector if you need proof of that. Companies rise and fall every day as the big fish eat the little fish.
The rapid development of new technology is one of several factors that have disrupted the stock market, making it impossible to use historical market trends to predict performance. That eliminates the core driver for Modern Portfolio Theory. Equity markets no longer rise and fall on a cyclical basis. They constantly shift in random patterns.
Harry Markowitz based his theory on a concept called “efficient market hypothesis.” It states that all knowledge is known and tends toward “rationality based on knowledge.” At the time, licensed professionals did all trading on Wall Street. It was safe to assume that investor knowledge would dictate rational behavior.
In 1952, Harry’s world didn’t have retail investors trading on Robinhood, meme stocks on Reddit, or the buying and selling crypto on Coinbase. Rational behavior is not a strong point in any of those locations. Retail traders are a force that has disrupted the “natural order” of the stock market that financial professionals have come to rely on.
The “pandemic effect” is the third strike for MPT
Financial advisors using Modern Portfolio Theory have been struggling to get their clients decent returns since this millennium began. In 2001, the attacks of 9/11 caused a market shutdown. In 2008, subprime adjustable-rate mortgages, which were first introduced in 1981, crashed the market. In March of 2020, the Covid-19 pandemic crashed it again.
What we just described was a twenty-year period where a long-term strategy like MPT couldn’t possibly work. Each of the three “black swan” events in the past two decades required action by financial advisors. Being passive while the market bottoms out is a sure way to lose clients. Sadly, many advisory firms went right back to their old ways when the dark days passed.
Don’t expect that to happen this time around. The “pandemic effect” on the stock market is the third strike for MPT. Supply chain disruptions, rising interest rates, and what’s looking like an endless conflict in Ukraine have permanently altered the financial landscape. Passive investing in this climate makes no sense. Change is the only constant we can rely on right now.
The transition to Tactive Investing has already begun
Tactive investing is active trading combined with tactical investment models. The idea behind it is always to be fluid enough to make changes on the fly but to do that within the parameters of an investment model that matches the investor’s risk tolerance. In other words, don’t wait for a market crash before making a move, and don’t rely on historical trends to predict the future.
Tactive investing can minimize drawdown and help the investor take advantage of uptrends as they happen. Bitcoin made a lot of people money in 2021, but it’s not an asset you want to hold onto. A long-term MPT portfolio would never incorporate BTC as a position. Tactive investing allows for a purchase in the trough and sale at the peak. That’s a positive return.
Are there risks involved with Tactive investing? Yes. There are also trading fees and occasional losses, but that’s just the nature of investing. What you don’t see are sustained downtrends that you seemingly can’t get out of. Based on Modern Portfolio Theory, those will reverse themselves at some point. You’re probably still waiting for that to happen.
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