Limitations of Modern Portfolio Theory

In 1952, finance professor Harry Markowitz revolutionized the world of investing with a paper that launched what we now know as Modern Portfolio Theory. Using a security’s mean, its standard deviation, and its correlation to other securities in the portfolio, Markowitz developed the Efficient Frontier, a curve that represents an optimal return by blending asset classes for each level of risk.

At the lower left end of the curve are assets that have low risk, but also low return. Assets at the upper right offer higher returns, but at a higher risk. By allocating assets along the Efficient Frontier, the goal is to achieve the greatest expected return for a given level of risk. To assure that the portfolio stays aligned with the Frontier, assets are rebalanced periodically to maintain the right balance between risk and return.

With the proliferation of computers, data and optimization software, applications of the Modern Portfolio Theory have become increasingly sophisticated and widely applied across investment asset classes. But before you accept Modern Portfolio Theory as the key to investment success, you need to understand one very basic fact. The Efficient Frontier can shift dramatically. A static asset allocation based on the Efficient Frontier at one point in time may be very inefficient in a different time frame.

Rydex Investments demonstrated this very vividly by looking at a relatively simple Efficient Frontier for the S&P 500 Index and the Ibbotson Long-Term Government Bond Index based on each decade from 1960 to 2005.

The Shifting Frontier – 1960-2005

Efficient frontier of equity and bond portfolios illustrated in 10% increments

Calculated by Rydex Investments using information and data presented in Ibbotson Investment Analysis Software. All rights reserved. Used with permission. Standard deviation (risk) is a statistical measure of the historical volatility of an investment that measures the extent to which numbers are spread around their average. Equity returns are based on the S&P 500 index, including the reinvestment of dividends and adjusted for inflation. Bond returns are based on the Ibbotson Long-term Government Bond index with dividends reinvested, adjusted for inflation. Both indexes are unmanaged and cannot be invested in directly. Past performance is no guarantee of future results.

The Efficient Frontier changes from one decade to the next from its traditional fishhook shape to a curved line to an inverted fishhook. In the process, the percent of a portfolio that should be invested in bonds for the highest return for the lowest risk shifts from 10% to 70%. As market conditions change, so does the Frontier.

One answer to the shifting Frontier is to lengthen the time horizon used to calculate the optimal portfolio mix. The problems with doing so are two fold. First, most investors have a 10 to 20-year investment horizon, not a 30 to 50-year horizon and second, there is no guarantee that the curve developed from the longer time period will fit current circumstances. Modern Portfolio Theory also has a major vulnerability in that it relies on historical data to determine mean returns, standard deviation and correlations. The disclosure found at the bottom of financial ads, Past performance is no guarantee of future results, is often so overused that it is overlooked. But it is true. While history is often the only resource we have to analyze and understand market patterns, it is not necessarily predictive.

As much as we might like for it to be true, there are no easy one-size fits all solutions when it comes to investing. Putting a portfolio on autopilot based on an Efficient Frontier calculation does not guarantee optimization.

Successful investment approaches are flexible investment approaches, strategies that look for trends in the market rather than trying to impose past trends on current market behavior.

Active Investing Offers Sources of Profits in Declining and Sideways Markets

According to advocates of buy-and-hold investing, there’s no point in attempting to actively trade the market because the market’s long-term trend has always been up. The catch is that long term means just that. Studies citing long-term market trends typically encompass 70 or more years, far longer than the average investor’s time frame. During that long term, some good, bad and frustrating moves take place in the market.

Looking at just the history of the U.S. financial markets shows us a number of lengthy time periods when the market has gone down or sideways, with market indices neither gaining nor losing over the period. The most recent was the 16 years from 1965 to 1982. The Dow Jones Industrials started 1965 in the neighborhood of 1000 only to bounce between a low of 607 and a high of 1020 for 16 years. It wasn’t until July of 1982 that the market finally started a definitive up trend.

An individual who bought and held the stocks making up the Dow Jones Industrials during that period would have achieved a cumulative return over 16 years of less than 5%.

During that 16-year period, however, there were four definitive bull cycles when the Dow gained 27% to 65%, only to retrace its gains with one- to two-year bear markets. The well-known bear market of 1973-74 set Dow Jones Industrials buy-and-hold investors back 40%, requiring a 67% gain to get back to breakeven, only to have those gains frittered away as the market turned downward from mid-1976 through early 1978.

While past performance is not indicative of future returns and only hindsight will tell us how long the current sideways market will last, investors need to do more than just sit out sideways markets if they are going to be able to retire financially secure.

In the midst of sideways markets there have always been opportunities for profit. One opportunity is to trade the up and down movements of the general market during the period. This means striving to buy in time for the bulk of the up move and sell when the market turns down. In volatile markets, this approach requires more frequent trading and a system that moves the investor quickly back into equities when the up move starts. For example, from the February 2004 high, the Dow dropped -5%, rose 4%, fell -4.5%, rose 5% and then dropped -6% through mid August. Capturing the gains and avoiding the losses would have required buying or selling at least once a month.

No investment system is perfect and it is possible to lose money as well as make money trading market trends. Whipsaws are one risk to this approach. Whipsaws occur when the market rebounds before an investor can reposition, leaving one on the wrong side of a move. Frequent trading can also result in additional costs, such as redemption fees or transaction fees, and taxes on gains are higher due to the often short-term nature of the trades.

Another approach is to look for sectors that are outperforming the market. Sector funds concentrate their stock selections within a given industry or geographic sector. In virtually any market environment, positive sectors within the broader market trend offer opportunities for gains. Among the best performing Dow Jones indices for the first three quarters of 2004 were the DJ Mining Index, followed by the DJ Consumer Electronics Index, both with year-to-date gains in excess of 30%.

The challenge to sector investing is to target the right sector early in its move and to know when to move out. The narrow focus of a sector fund increases volatility and risk compared to investing in the broader market. What is in favor can rapidly fall out of favor, making an active approach essential to sector investing.

While there are no guarantees in investing, one of the greatest risks to your financial security could be just sitting still. We have no way of knowing if the current bear market has reached its low or if there is worse to come. Nor do we know how long it will be before the broad market enters a sustained rally. Just as you try to limit risk in other areas of your life through insurance and avoiding perilous situations, you need to be prepared to limit risk in your investments while also recognizing that another risk is that of running out of money.

If you haven’t considered what a prolonged sideways market will do to your portfolio and how you can benefit from short-term trends in the overall long-term market, call me today and let’s talk.