(James Saft is a Reuters columnist. The opinions expressed are
By James Saft
June 7 The problem with Modern Portfolio Theory,
the basis for most diversified investment approaches, is that
the often irrational human investor in charge is a major point
In other words, nice theory but shame about the monkey who
is running it.
Modern Portfolio Theory, originated by Harry Markowitz in
1952, is the idea that portfolios, by diversifying, can maximize
returns for a given level of risk, or volatility. This allows
investors to get a higher return than they otherwise would since
the assets blended together will give a smoother ride, achieving
what is often called 'the only free lunch in investing'. Since
different assets perform differently in various circumstances -
i.e. are not perfectly correlated - mixing them together
The problem isn’t with the theory, which won Markowitz the
Nobel prize in 1960, but, according to money managers at
Newfound Investment Research, with the way it fails to take into
account the impact that behavioral flaws and biases can have on
how an investor actually does.
In MPT, volatility, how much and how quickly an asset goes
up and down in price, is used to measure risk. As shown
repeatedly in times of crisis and stress, however, different
asset classes have a nasty tendency to become more correlated,
to all go down together, at the worst possible time.
This increases the chances that an investor will lose nerve
and bail out during extreme market conditions, turning what
might be a passing downdraft into a permanent loss.
“We often say that risk cannot be destroyed, only
transformed. Beyond the 'free lunch' of traditional
diversification, most reductions in one type of risk come with
increases in other types of risk. For example, holding a higher
cash allocation will reduce volatility but will lead to more
inflation risk,” Corey Hoffstein, Justin Sibears and Nathan
Faber of Newfound write in a study. (here)
“A significant amount of effort can go into providing an
investor with an optimal portfolio under the MPT framework, only
to see it discarded before the end goal has a chance of being
realized. An investor’s behavior can be one of the biggest risks
facing a successful investing.”
Asset class returns are not evenly distributed, and
investors, who have difficulty measuring the talent of the
people they’ve hired to advise them, may face long periods when
their investments are not performing as they'd planned.
FEAR AND FOMO
Investors hate two things above all else: losing money and
missing out. The tension between the two, the fear of loss and
the fear of doing less well than one’s neighbor, drives much
behavior in financial markets.
It is psychologically painful to lose money. Psychologists
Amos Tversky and Daniel Kahneman demonstrated that losing a
dollar is about 2.25 times more painful than gaining a dollar is
pleasurable. Holding on during market falls is hard, and looking
at a supposedly evenly distributed graph of returns does little
to give the average saver comfort.
At the same time, humans are animals who naturally compare
what they have to what others get, not just to what they had
before. Go to a Wall Street trading floor the day bonuses are
announced to see how this works out in practice.
This means that investors are sensitive not simply to how
they are doing relative to their goals, but also relative to the
Smiths down the street. This fear of missing out, and its
flipside, pain at lagging, can cause investors to take on too
much or too little risk if they observe the 'stock market,'
often wrongly conflated with an index, going up faster than
their own holdings.
While volatility stands in for risk in MPT, it doesn’t fully
drive loss aversion or FOMO (fear of missing out), both of which
can drive investors to make costly mistakes.
MPT is engineered for end results but investors exult and
suffer minute by minute all along the trip.
A slavish devotion to maximizing return for risk can put an
investor into a portfolio she can’t tolerate, leading to either
selling at the wrong time or getting greedy and buying at the
In some ways, all of this simply argues for process and for
Part of the value in having a process is not that it is
perfect and always achieves best results but that it can guard
against the worst mistakes.
And while that process can certainly be run by a solitary
investor, given the right skills, another message here is that a
good deal of the value of wealth managers is serving as a guard
rail against sudden lurches one way or another.
Low-cost off-the-shelf portfolios work well in theory but
are followed less often, perhaps, than ones which also have a
hand-holding advisor involved.
(Editing by James Dalgleish)