This article was inspired by a comment/question posed by a reader who shall go nameless, on my recent article titled: "Utilities - Today's Best Bond Alternative." Here is the question:
"Last question, I promise. Wondering what you use to lower portfolio volatility for clients that are more risk averse? What is your bond substitute for the purpose of lowering the risk/volatility in portfolios? Thanks."
I believe this question is one of the most important questions that investors need to have answered. This is especially true for retired investors whose lifestyles depend on the incomes their portfolios provide. But, in addition to income, safety, or stated differently, risk, is also a critical consideration. Moreover, on the surface this may seem like a relatively straightforward question to answer. However, there are much deeper issues that this question conjures up. Therefore, in order to answer this question most effectively the concept of risk must be defined, understood and dealt with in its totality.
Furthermore, I believe that implicit in this question is the notion that equates volatility with risk. As I will discuss in greater detail later, this notion that volatility equals risk is one that is widely held and ubiquitously promulgated in today's so-called modern world of finance. In my opinion, this overly simplified, and I contend rather shallow view of risk, does a great disservice to the very idea of risk.
In my opinion, the notion that risk and volatility are synonymous is a notion that has greatly undermined not only the importance of mitigating risk, but also the very nature of how I believe the financial services industry is currently shortchanging their clients. Furthermore, I also believe that clients (all investors for that matter, including those desirous of self directing their portfolios) deserve more and better advice and guidance than they are currently getting. The manner in which risk is currently being defined and dealt with may represent one of the most glaring examples of what I believe to be the great failure of modern finance theory.
To summarize my introduction, I intend to illustrate that volatility in and of itself is not risk. Instead, I would argue that people's reaction to risk is a much greater risk than volatility itself. But even more importantly, I intend to demonstrate and discuss that to the extent that volatility relates to risk, it represents only a very small component of a much broader spectrum known as risk. In other words, risk is a multifaceted and complex concept with volatility merely representing a small piece of a much larger puzzle. But more importantly, although I do not believe that price volatility can be avoided, I do believe that it can be intelligently ignored and therefore appropriately dealt with.
When I first became involved with the financial services industry in 1970, today's universally followed concept known as "Modern Portfolio Theory" or MPT was not the dominant financial concept it has evolved into today. Instead of this so-called Modern Portfolio Theory that is taught in almost every university, and to almost every financial advisor, portfolio strategies prior to MPT's wide adoption dealt with portfolio design and risk in a much different, and I believe better way. I have personally dubbed what I was originally taught and what I have followed and practiced my entire career as "Ancient Portfolio Reality."
The primary differences between what I was originally taught, and what is promulgated today is profoundly different. But more importantly, and in my point of view, what I was originally taught is also profoundly more relevant and intelligent as well. Therefore, the primary purpose and thesis of this article is not to denigrate Modern Portfolio Theory. Instead, my primary purpose is to return what I believe to be sound and prudent investment practices and portfolio design back to their rightfully prominent place. However, in order to accomplish that, I must also and simultaneously point out what I believe to be the many flaws and fallacies of Modern Portfolio Theory that is so widely practiced and promoted today.
Perhaps the best place to start is with a brief review of the origins of MPT (Modern Portfolio Theory), followed by a brief overview of its many primary tenets. The reader should note that the scope of this article precludes itself from presenting a thorough and comprehensive analysis of MPT. At the very least, this would require a large book, or even a volume of books. Consequently, what follows is a brief overview and introduction to the origins of MPT, and the primary academics that initially introduced it.
MPT (modern portfolio theory) was introduced by the work of the Nobel prize-winning American economist Harry Markowitz through an article he published in 1952 and followed in 1959 by his widely read book - "Portfolio Selection: Efficient Diversification of Investments." Later, Harry Markowitz's original work was supplemented and elaborated on by William Sharpe, the recipient of the 1990 Nobel Memorial Prize in Economics for the development of the Capital Asset Pricing Model (CAPM).
Other notable contributors to MPT, include Merton H. Miller who along with Harry Markowitz and William F. Sharpe shared the 1990 Nobel Prize for their work in the theory of financial economics. Eugene Fama is another noted academic that introduced the so-called Efficient Market Hypothesis (EMH) in 1970. Most importantly, the common thread between the noted academics I cited above, and other contributors, is their adherence to mathematical models and statistical formulas, over a more comprehensive fundamental analysis approach. Also, I believe it is important to add that MPT is additionally flawed in a very profound way. MPT is backward analysis, in other words, based on past results. As I will elaborate on later, when designing or building an investment portfolio, it is the analysis of what the future might bring which is the most critical consideration.
Next, I will review the primary tenets of MPT, some of which I agree with in theory, yet simultaneously contend that MPT has taken the notion of a simplified portfolio construction theory to a dangerous and unproductive extreme. It is my view that overly zealous academics, enthralled with complex mathematical theorems and statistical expressions suffered from a well intended but misguided form of intellectual hubris. Later I will discuss why I believe that the financial services industry, but more importantly the clients they are dutifully sworn to serve have suffered and been shortchanged as a result.
As a general overview, there are 5 statistical risk measurements commonly utilized by Modern Portfolio Theory advocates and practitioners. All of them are based on the movements of stock prices with little regard given to sound fundamental principles such as valuation. These 5 statistical risk measurements are: alpha, beta, standard deviation, R-squared and the Sharpe ratio.
Frankly, I find it easy to see why academics have embraced and promoted the utilization of MPT and its associated mathematical formulas. However, I readily admit that I do not have a strong enough mathematical background to analyze or dissect each of the 5 statistical risk measurements listed above. On the other hand, I will simply offer a standard deviation formula to make my point as follows, while simultaneously asking the question: how many advisers or investors can say they truly understand what they are looking at?:
Therefore, I ask you: How could an academic with a strong mathematical background resist such an enticing formula? Imagine the fun they would have running the above formula, and all the others that are just as complex when authoring their research papers. But this also begs the question: how can mere mortals without their own PhD's or Nobel Prizes relate to such complexity? Moreover, can the application of our innate common sense believe that any of these formulas could adequately articulate such a multifaceted concept called risk? Speaking for myself, I find these notions to be implausible.
Now I'll move on to a brief summary of the major tenets of MPT, followed by my own commentary on each. I will first summarize the tenet, and then add my own retorts.
Investors are risk averse: "The only acceptable risk is that which is adequately compensated by potential portfolio returns."
This first tenet is one that I am in general agreement with. Rational investors should expect a higher rate of return when they take on a higher rate of risk. On the other hand, how the level of risk is calculated and measured is critical. Personally, I have found that most of the MPT expressions of risk to be ruefully lacking. Moreover, most of them are related in one form or another to volatility.
As I previously stated I don't believe that volatility is true risk. The greater risk from volatility that investors face is how they react to volatility. In other words, an example would be when panicked investors sell investments at far less than their intrinsic value, merely because the investments have temporarily fallen in price. As a result of their panic, they turned unrealized losses into realized and more permanent losses.
Markets are efficient: "Because of large numbers, markets are, for the most part, fairly priced or efficient. Consequently, no investor can obtain an information edge over any other. Thus, it is pointless to even try."
In my opinion, the very notion of an efficient market defies common sense. There's no possibility in my mind that the market prices of stocks are always being efficiently priced. The stock market is an auction where people are presenting bids and asks virtually every second of every minute of every trading day. Emotions get involved, and mistakes cannot be avoided.
Instead of an efficient market, I contend that the market is always seeking efficiency. If Eugene Fama had not conjured up the EMH (theory) the whole MPT house of cards was destined to collapse. Question: how could you run Standard Deviation, Beta, R-squared or the Sharpe ratio if there were no standard to measure them against? Statistical analysis had to hold the concept that markets are efficient or their formulas would be useless.
A theory based on a flawed underlying premise is both illogical and inaccurate. As Warren Buffett so eloquently put it:
"I'd be a bum on the street with a tin cup if the markets were always efficient."
Once again, I believe the market is always seeking efficiently (the laws of supply and demand at work). But at any point in time it is often very inefficiently valuing (pricing) a given stock or the market. When this happens, as it often does in an auction market, it will inevitably correct itself. But the exact timing is unknown.
Finally, you cannot run valid regression analysis or variance without an established standard to base the analysis on. EMH provided MPT theorists the standard they had to have. But alas it is a flawed standard based on a flawed concept as it relates to markets being efficient.
The portfolio: "Allocation of the portfolio, as a whole, is more important than individual security selection or market timing."
Personally and greatly based on my previous training and penchant for comprehensive fundamental analysis, I rejected the idea that asset allocation was the primary determinant of returns. On the other hand, I could accept this idea, if it included the qualifier that this is only true if your money is being placed in the most opportunistic asset classes available at the time. However, the asset allocation concept with its policy of automatic rebalancing based on what I considered to be artificially constructed rules solely based on historical analysis, is at best irresponsible, and at worst immoral.
At this point, the question that can and should be asked is if MPT is such a flawed concept, then why has it been so ubiquitously embraced by institutional investors and Wall Street? To me the answer is straightforward. For Wall Street, the opportunity to rebalance the portfolio every 3 months was a license to churn. Backed by Nobel Prize-winning research, portfolio turnover that was once considered borderline illegal or even immoral was now supported and endorsed by academic prize-winning research.
Here, the reader should consider the basis of the "prudent man rule" in Wall Street. Implicit in this rule is the notion, that if an advisor behaves in concert with other "prudent men" then he or she is acting prudently. Consequently, when all or at least a great majority of advisors are following in implementing MPT, then those same advisors are deemed to be acting prudently. Here is an iteration of the Prudent Man Rule courtesy of the Farlex Financial Dictionary. © 2012 Farlex, Inc. All Rights Reserved:
"A legal rule requiring investment advisers to only make investments for their clients' discretionary accounts that a "prudent person" would make. This means that investment advisers operating discretionary accounts are not allowed to make investments they believe will lose money for the client. It does not require that the investment adviser always make correct decisions; it merely requires him/her to make decisions that will be generally accepted as sound for someone of average intelligence. The rule has its origins in an 1830 court decision in Massachusetts, stating that trustees must manage the affairs of others as if they were managing "their own affairs."
As it relates to the institutional investing community, MPT provided the perfect venue and opportunity to draw fancy graphs purporting to describe the risk profile of their client portfolios. Moreover, they can use the same formulas with supporting graphics to theoretically measure the returns that their clients' portfolios were receiving from their managers, as well as the alleged level of risk they were taking to achieve them.
It brings to mind what Charlie Munger once said about MPT. "It all boils down to dementia and twaddle." But since it is backed by prize-winning academic research, it allows the institutional consultant to justify their fees. And it all seems so complex and professional, regardless of whether or not it provides real value. The great recession of 2008 shot gaping holes in the utility of MPT and its many tenets and theorems. But the industry goes on embracing it, undaunted by mounting evidence of its lack of real-world utility.
Investing should be for the long term.
No argument here, I agree that all true investing is long-term investing. In contrast, short-term trading is a speculative endeavor. Speculation is not inherently evil, but is certainly different than a prudent long-term investing strategy.
Efficient Frontier: "Every level of risk has an optimal allocation of asset classes that will maximize returns. Conversely, for every level of return, there is an optimal allocation of asset classes that can be determined to minimize risk."
Although I might agree in theory that there could exist an optimal allocation of asset classes, I vehemently disagree that it can be predetermined, especially when utilizing a backward looking theory. Finding the optimum allocation of your assets would require the ability to clearly see the future.
However, you cannot clearly see the future by looking through the rearview mirror. This could only be accomplished through forward-looking, comprehensive and what I would call good old fashion serious fundamental analysis. Even then, picking the optimum asset class could not be done with perfect precision. On the other hand, I believe it could be more accurately accomplished through comprehensive fundamental analysis tempered with good old common sense. A sound investment strategy is not a game of perfect.
Diversification: "Diversifying investments among assets with low correlation to each other reduces portfolio risk."
This concept of diversification only makes sense if you believe, as MPT would like you to believe, that volatility is risk. Although I do believe that volatility is a component of risk, I further believe that only represents a very small part of a much bigger issue. MPT likes us to believe otherwise, because their formulas are designed to measure volatility in one form or another
Markets are efficient
A few excerpts from an article written by Lawrence A. Cunningham and published in the Columbia Law School Blog on Corporations and the Capital Markets on April 13, 2013, nicely summarize my views on market efficiency. Like yours truly, Lawrence A. Cunningham is a devotee of Warren Buffett and is the author of a book, which I highly recommend titled - "The Buffett Way."
"Modern finance theory, now nearly 50 years old, was among the most revolutionary investing ideas of our time. This is an elaborate set of ideas that boil down to one simple and misleading practical implication: it is a waste of time to study individual investment opportunities in public securities.
According to this view, you will do better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense."
"One of modern finance theory's main tenets is modern portfolio theory. It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio-that is, it formalizes the folk slogan "don't put all your eggs in one basket." The risk that is left over is the only risk for which investors will be compensated, the story goes."
"Being part of a distinguished line of investors stretching back to Graham and Dodd which debunks standard dogma by logic and experience, Buffett thinks most markets are not purely efficient and that equating volatility with risk is a gross distortion. Accordingly, Buffett worried that a whole generation of MBAs and JDs, under the influence of modern finance theory, was at risk of learning the wrong lessons and missing the important ones.
I will continue to use excerpts from the same article cited above as a proxy for my views on beta. Lawrence A. Cunningham, by drawing on his vast knowledge of Warren Buffett, states it more eloquently than I could on my own.
"Buffett points out the absurdity of beta by observing that "a stock that has dropped very sharply compared to the market . . . becomes 'riskier' at the lower price than it was at the higher price"-that is how beta measures risk. Equally unhelpful, beta cannot distinguish the risk inherent in "a single-product toy company selling pet rocks or hula hoops from another toy company whose sole product is Monopoly or Barbie." But ordinary investors can make those distinctions by thinking about consumer behavior and the way consumer products companies compete, and can also figure out when a huge stock-price drop signals a buying opportunity."
"The fashion of beta, according to Buffett, suffers from inattention to "a fundamental principle: It is better to be approximately right than precisely wrong." Long-term investment success depends not on studying betas and maintaining a diversified portfolio, but on recognizing that as an investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success."
"Such "flitting from flower to flower" imposes huge transaction costs in the forms of spreads, fees and commissions, not to mention taxes. Buffett jokes that calling someone who trades actively in the market an investor "is like calling someone who repeatedly engages in one-night stands a romantic." Investment knitting turns modern finance theory's folk wisdom on its head: instead of "don't put all your eggs in one basket," we get Mark Twain's advice from Pudd'nhead Wilson: "Put all your eggs in one basket-and watch that basket."
Summary and Conclusions
After such a long discourse, the reader at this point may have forgotten the simple question I have endeavored to answer. Therefore, allow me to offer the short version. I never think in terms such as trying to find a bond substitute to reduce the volatility of my portfolios, because I do not equate volatility with risk. The only reason that I am choosing investments other than bonds today is because I do not believe that bonds offer the foreword returns that they traditionally have.
Moreover, I also believe that the risk profile of bonds in such a low interest rate environment has perhaps artificially, but nevertheless dramatically increased. Although bond prices might possess the characteristic of low volatility during normal interest rate levels, I further believe that investors must be cognizant of the reality that bond price volatility would increase dramatically in a rising rate environment.
To summarize, in lieu of trying to reduce volatility, which I believe is impossible anyway, I instead am looking for investments today that offer the best prospects for future returns at the lowest levels of true risk. Instead of artificial constructs, I believe in logically thinking my way through portfolio construction. If I believe an investment, such as bonds today, possess abnormal levels of risk while simultaneously not offering any return I summarily eschew them in favor of investments that I believe possess better risk reward profiles going forward.
Additionally, I found it fascinating that William Sharpe seems to have softened his stance regarding the strict adherence to MPT as evidenced by the following excerpt from an article published in IndexUniverse on May 15, 2008 by Heather Bell.
"IU: How should investors approach asset allocation?
Sharpe: The first thing you have to do is figure out what your objectives are. This isn't trivial: What are you trying to accomplish? What are your preferences for risk and return? What are your needs for things like liquidity?
Second, you have to figure out what your pre-existing sources of risk and return are. Do you own a house? If so, where is it and what risks are likely to impact its value? What about your job and other assets that are not in the portfolio?
One of my favorite diatribes is, "How can you possibly do your asset allocation without looking at the market values of the asset classes out there today?" That's probably the most valuable information you can get as to the future prospects of those asset classes, and what astounds me is the fact that many people-many of them very sophisticated-do asset allocation without even checking to see what the relative values of the outstanding shares in, say, European securities, U.S. securities, emerging markets, etc., are."
Finally, I would like to conclude by saying that I do not believe that practitioners of MPT are by their very nature bad or evil. It is hard to fault all the professional advisors based on what they have been taught in their colleges and universities. Moreover, as one advisor once said to me, how could so many PhD's be wrong? My answer was straightforward, how could you believe that something as complex as the stock market or the optimum design of an investor's portfolio could be relegated to simple mathematical equations and theorems? I believe that designing and building a successful investment portfolio is not only complex, but requires hard and intelligently based work and effort. This is the basis of "Ancient Portfolio Reality," building portfolios on careful and thorough forward analysis utilizing age-old sound principles of business, economics and accounting.
For those readers interested in learning more about my views on risk, and/or my suggestions for bond alternatives might find the following articles I authored of interest and value.
In Part 2, I will elaborate on the many facets of true risk, and offer time-tested strategies on how to deal with and mitigate risk.