Did Modern Financial Theory Fail?

By: Frank Armstrong, CFP®, AIFA®

None of us have enjoyed the last three years. And of course, after a traumatic event people look for reasons and answers. It’s natural to question your assumptions. Actually, we must constantly test our beliefs and investment philosophy to see if it’s still valid. However, far too much of the recent commentary has been focused on the very near term and was way off base. If you are going to publish investment advice and commentary, at least get your facts straight. Otherwise, we are in danger of learning the wrong lessons from our experiences.

Modern Portfolio Theory Failed
MPT simply advocates diversification with assets that have low correlations to one another as a method of optimizing a portfolio to provide the maximum expected return per unit of risk that the investor is willing to tolerate. No one has ever argued that it eliminates risk, guarantees a profit, or prevents loss. A lower investment outcome relative to the expected return during any particular period should happen about half the time, and we can get a general feel for the range of possible outcomes that a portfolio might experience. MPT says nothing about the timing of events which are presumed to be random and unpredictable.

Diversification Failed
No matter how far you diversify an equity portfolio, market risk remains. That’s the risk that cannot be diversified away. Investors expect higher returns over time in exchange for holding risky assets, and in a properly diversified portfolio those returns are generally related to the level of risk that they assume. But the single most important decision an investor must resolve is the diversification between risky assets (stocks) and low- to zero-risk fixed income (short-term, high-quality bonds, T-Bills, certificates of deposit, money markets, and so on). There diversification worked perfectly.

Correlations Moved to One
So what? Correlations are not fixed over time. They increase and decrease in a random fashion. During a financial panic all equity assets may very well move together as frightened investors seek safe haven. That’s happened time and time again and is to be expected. But, as the crisis abates, asset class performance again diverges, and the benefits of investing in asset classes that have had historically low correlation again return.

Efficient Market Theory Failed
Because asset prices moved rapidly and widely, a number of commentators complained that markets couldn’t be right when prices were high, and right when prices plunged. They simply misunderstand. No one held that prices were right in any absolute sense. There is no conflict between markets being efficient and irrational, exuberant, or volatile.

Paul Samuelson held that while market prices fluctuated randomly they were probably the best estimate of intrinsic value. You can’t do better by looking at a firm’s accounting data or other measures.

Gene Famas Efficient Market Theory holds that prices quickly adjust to new information that arrives randomly, and that trying to outguess market prices by technical analysis, fundamental analysis or market timing is unlikely to add value over and above the cost of trying. The price isn’t necessarily right but it’s fiendishly difficult to outguess a few billion of your closest friends who are looking at the same data in real time.

Buy and Hold Failed
Buy and hold doesn’t guarantee a successful investment. And there are plenty of times when your portfolio is totally wrong. After all, holding on to your 100 shares of Enron is a losing strategy. And it doesn’t mean that you wont have ups and downs in your portfolio. That’s part of the investment process. Holding an inappropriate portfolio is always inappropriate. If you have concentrated stock positions, an otherwise inappropriate asset allocation, or have invested at the wrong level of risk, its time to rethink and optimize your portfolio to your long-term needs.

But, buying a diversified portfolio matched to your unique situation, holding it through thick and thin with occasional rebalancing to maintain the integrity of the asset-allocation plan still offers the best hope of long-term success.

We Have to Be More Tactical
After a decline in prices, you might expect market timers to emerge singing their shop-worn siren song, and they rarely miss the chance. A few folks invariably made the right call, and we can expect to hear about it for the rest of our lives. One call does not a genius make. However, if you are delusional you might begin to believe that your one lucky call was really skill.

Unfortunately, the folks that are calling for a more tactical approach to the markets cant tell us how to do it. Are we supposed to just wake up with a gut feeling? If no one has ever been able to do it consistently before, why should they be able to do it now? What fundamental research supports this harebrained approach?

It’s seductive. All of us would have just loved to have avoided the down market. But there isn’t a shred of evidence that anyone can successfully and consistently add value to a portfolio by attempting to time the market. Any claim otherwise is simply disingenuous, self-serving, voodoo finance.

Stocks Had a Lost Decade
Simply not true. The S&P 500 is not the market; its a part of the worlds market that just happened to be one of the worst possible choices for the last decade. Lots of bonds probably did better than the S&P 500, in fact anything positive did better. Many equity asset classes did very well indeed, and a properly diversified portfolio did very well. See my article, Worst Market Decade Ever–Not So!

What Has Changed?
Nothing changed! Markets go up and down. Its a fact of life. An appropriate investment strategy anticipates and accounts for market volatility. We know with certainty that bad years are going to happen, even if we dont and cant know when. Throwing out every time-tested, successful, long-term strategy and everything we have learned about how markets work would be the height of folly. If your asset allocation is appropriate for your financial situation, and is properly diversified, stay the course.

By | 2018-11-29T16:04:25+00:00 September 24th, 2012|Blog|

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