Modern portfolio theory (MPT), introduced more than half a century ago by Nobel-laureate Harry Markowitz, is all about diversification. It’s based on the notion that over the long term, a properly balanced group of investments will perform better than any single holding would do on its own. MPT looks at the historical returns and volatility of stocks, bonds, and other assets to create a portfolio mix that can maximize expected returns based on how much risk an investor is willing to take. The riskier a portfolio is, the higher its potential return may be.
For decades, MPT has been a bedrock principle for creating investment portfolios. Asset managers have used it for the mutual funds they run, and financial advisors have put it to work in choosing investments for their clients. But in recent years, particularly since the economic crisis and market meltdown that began in 2008, MPT has come under fire. Many people contend that it no longer works. They point to the fact that in 2008 and 2009, almost every kind of investment lost value, and that even perfectly diversified portfolios let investors down.
Loading the player ...
Yet the idea that MPT has outlived its usefulness—and that it failed during the recent financial crisis—ignores the reality that an analysis of market history confirms, says independent economist Fritz Meyer. Modern portfolio theory remains “the best mousetrap yet devised” for managing investments, Meyer says, and he analyzes 40 years of market performance data, from 1970 to 2010, to prove his point.
Meyer looked at what would have happened to a portfolio, created in 1970, that was divided evenly among seven kinds of assets: cash; large-cap U.S. stocks; small-cap U.S. stocks; non U.S. stocks; U.S. bonds; real estate; and commodities. Maintaining an equal exposure to those asset classes would have yielded an average annual return of more than 10% during the subsequent 40 years, compared with just under 10% a year for the Standard & Poor's 500. Yet the diversified portfolio would have had half the volatility of the S&P, according to Meyer.
So why are so many people convinced that MPT doesn’t work in today’s markets? Meyer suggests that in many cases, it may be because investors succumbed to the natural human tendency to stop the pain during a bear market and sold their holdings at what turned out to be the worst possible time. “Our generation has learned a very important investment truth the hard way,” says Meyer. And many of those who got out of the market in 2008 or 2009 remain on the sidelines, he says, waiting until they regain their confidence. In the meantime, of course, they have missed out on several years of strong market gains.
Another problem, Meyer says, is the tendency to confuse modern portfolio theory with “buy and hold”—the idea that simply staying the course with investment choices will produce the best results over the long haul. MPT may indeed resemble a buy-and-hold strategy, Meyer notes, because an investor who subscribes to MPT will remain fully invested. But that doesn’t mean that a portfolio will sit there unmanaged no matter what occurs in financial markets.
Even an investment portfolio run according to the principles of MPT will need periodic changes, Meyer says. Rebalancing holdings to keep them in line with their original portfolio percentages is especially important, and ought to be done either quarterly or annually, according to Meyer. Without such adjustments, assets that were performing well would soon make up an outsized proportion of overall holdings, and the portfolio’s returns could suffer when stocks, for example, then lose ground during an investment cycle. Beyond rebalancing, other kinds of shifts may also be made to MPT portfolios based on an analysis of economic or industry factors.
Meyer is skeptical of the alternatives to MPT that many advisors and investors have turned to recently. Absolute return strategies, tactical asset allocation, and attempting to time the market simply don’t work, he says, and though fleeing stocks and other comparatively risky assets during market swings may seem like a good idea, it can put investors in a hole that it will be difficult to dig themselves out of. Meyer notes that some who sold out during the worst of the recent bear market may have had to postpone retirement or permanently reduce their standard of living.
With a disciplined MPT approach, on the other hand, you’re taking advantage of a powerful tool that has long proven is ability to maximize returns and minimize risks, Meyer concludes.