Wednesday, November 21, 2007

Modern Portfolio Theory: Is It Over Relied On?

Before I get into the discussion on a recent article that indicates Modern Portfolio Theory (MPT) might not work as many are led to believe, following is a common defintion of MPT:
Introduced by Nobel Prize winner Harry Markowitz in the 1950s, modern portfolio theory proposes that investors may minimize market risk for an expected level of return by constructing a diversified portfolio. Modern portfolio theory emphasizes portfolio diversification over the selection of individual securities. A simplified version of modern portfolio theory is "Don't put your eggs in one basket". Modern portfolio theory established the concept of the "efficient frontier." An efficient portfolio, according to modern portfolio theory, is one that has the lowest risk for a given level of expected return. An underlying concept of modern portfolio theory is that greater risk is associated with higher expected returns. To construct a portfolio consistent with modern portfolio theory, investors must evaluate the correlation between asset classes as well as the risk/return characteristics of each asset.
Many investment advisors present to their clients that MPT minimizes portfolio volatility as ones investment portfolio is allocated to assets less correlated to other assets in their account.

Now onto the discussion on MPT. Recently, SmartMoney featured an article, Modern Portfolio Theory Looks Very Outdated. The article features an interview with Niels Clemen Jensen, a former senior executive at Lehman Brothers (LEH), Goldman Sachs (GS) and Oppenheimer (OPY) who now runs Absolute Return Partners, a $400 million London fund of funds. SmartMoney notes, "Jensen is a pro well versed in the nuts and bolts of modern portfolio theory and risk management. I am here to testify that, in this case, knowledge is not bliss, more like a long leap into the unfathomable."

Following are excerpts from his October 2007 newsletter:
  • Here is the problem. Central to all the academic work referred to above is the assumption that returns are normally distributed. If they are not, you might as well bin everything to do with modern portfolio theory. Risk management tools such as volatility, covariance and value-at-risk, all so critical to how we deal with risk, become meaningless if the return pattern does not match the famous bell curve.
  • For returns to follow a normal distribution, you must have a set of independently distributed returns with no extremes. You find these mostly in static systems.
  • Now, what investors really should worry about is what we call extreme risk – 3-6 SD events which can potentially wipe out years of profits. This is often referred to as fat tail risk. It is to be found to the extreme left of the below chart (encircled in red). However, according to the text book, they do not occur very often. Take a closer look at the following table:

normal bell curve

odds of risk event table
  • Statistically, assuming you are not an ‘├╝ber human’ vastly outliving the average person on this planet, you should experience only a couple of 2 SD events in a lifetime. The problem is that recent years have been littered with 6, 7 and 8 SD events. A 7 SD event equals 1 every 3 billion years or approximately the lifetime of our planet. Since the 1998 Russian debt crisis, financial markets around the world have experienced at least 10 extreme shocks none of which were supposed to occur more than once every few billion years.
Given these higher standard deviation events AND that returns are not normally distributed, Jensen concludes, "Clearly, the theory doesn’t work in practice and it may be time that we ditch modern portfolio theory altogether. Surprisingly few academic resources have been dedicated to this subject so far."

As one considers building an investment portfolio, they must stick to an investment discipline. Warren Buffett's sage advice, "the most important quality for an investor is temperament, not intellect and "what you need is the temperament to control the urges that get other people into trouble in investing."

More often than not, this means not following the crowd.

Source:

Wagging the Fat Tail (pdf)
The Absolute Return Letter
Absolute Return Partners LLP
By: Niels Clemen Jensen
October 2007
http://www.arpllp.com/core_files/The%20Absolute%20Return%20Letter%201007.pdf

Modern Portfolio Theory Looks Very Outdated
SmartMoney
By: Igor Greenwald
November 20, 2007
http://www.smartmoney.com/invest/markets/modern-portfolio-theory-looks-very-outdated-22165/



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