Raising Modern Portfolio Theory From The Dead

by: CFA Institute Contributors

By Nathan Erickson, CFA, CAIA and Richard Stott

Investors and their advisers should accept that there is life after modern portfolio theory (MPT), C. Thomas Howard said in his discussion on behavioral finance at the 70th CFA Institute Annual Conference.

His presentation and the Active Equity Renaissance series he co-authored with Jason Voss, CFA, call for the demise of MPT and the capital asset pricing model (CAPM).

Howard and Voss maintain that "financial markets should be viewed and analyzed using a behavioral lens."

We have a different opinion.

While behavioral finance has earned its place in investing and asset management, we believe it operates best in conjunction with MPT, not apart from it. Perhaps the father of MPT, Harry Markowitz, said it best when he remarked, "The most important job of a financial advisor is to get their clients in the right place on the efficient frontier in their portfolios . . . But their No. 2 job, a very close second, is to create portfolios that their clients are comfortable with." That's where the human behavior variable comes into play.

Howard argues that diversification is unnecessary: If investors understand how behavior creates opportunity and that risk reflects human behavior, then a 100% stock portfolio is all they need. Investors can take advantage of the market mispricing caused by the bad behavior of others, while simultaneously ignoring their own emotions, to generate maximum returns.

However, he also says that the starting point for successful investment management is needs-based planning wherein a client's portfolio is allocated into liquidity, income, and growth "buckets."

The liquidity bucket contains such low- or no-volatility securities as bank accounts or money markets. The income bucket has high-yield stocks and other high-yield alternatives, such as master limited partnerships (MLPs), and the growth bucket is filled with equities. While the latter bucket may be concentrated in a single asset class, the overall portfolio is diversified.

This is essentially a two-asset portfolio - stocks and cash - that is, by its very nature, mean-variance optimized in any combination. Perhaps life after MPT is still MPT.

Howard makes a strong point that emotional comfort is important. In fact, he states that emotion is the most critical determinant of long-horizon wealth.

A client who can't maintain their composure in the face of the volatility of a 100% stock portfolio will be driven to allocate to other investments. While Howard would like to call this an emotion-return trade-off and not a risk-return trade-off, they are one and the same.

The common argument against standard deviation as a measure of risk is that real risk should be defined as a permanent loss of capital. Yet emotional investors who watch the value of their 100% stock portfolios drop to an intolerable level will make an emotional decision to sell at or near the lows, thus creating a permanent loss of capital. Volatility, or standard deviation, leads to emotional responses that cause a permanent loss of capital. Risk by any other name is still risk.

So how can MPT help advisers add value? (And to clarify, our discussion considers MPT in the context of multi-asset class portfolio construction, not in an equity model or single asset class allocation.)

First, MPT creates a framework for objective decision making. All advisers should avoid subjective analysis and emotional decisions.

Behavioral finance teaches that we are all susceptible to behavioral biases. Any effort we make to avoid these biases leads to better investor outcomes. However, MPT is not the only way to remain objective.

In the case of Howard's "bucket" strategy - reminiscent of goals-based wealth management, pioneered by Jean L.P. Brunel, CFA - advisers can stay objective by using non-economic methods to determine bucket sizes. According to Howard, the liquidity bucket can be calculated based on the specific number of months or years of cash the client requires, with the other buckets holding the remainder. This then qualifies as an objective approach.

Other advisers may use a 1/N approach in which each asset class has an equal weight. Again, this is a reasonable method of portfolio construction. Where advisers often try to add value but don't is when they allocate to an asset class "because it feels like the right time to be over- or underweight" or when they believe they can time the market. To the extent advisers feel the need to try this, they should do so at the margin. As Clifford Asness and his associates said, "If you sin, then sin only a little."

MPT helps evaluate the incremental benefits of adding additional asset classes to an existing portfolio and how best to allocate among those asset classes. Whether augmenting a stock and cash portfolio with commodities or mixing international equities in with US stocks, the question remains: How much to allocate to each asset class? Again, with objectivity the key, any number of approaches are reasonable.

Remember though, explaining your process, rationale, and the supporting academic research is extremely powerful in any client-adviser relationship. Advisers earn credibility when times are good so that clients will trust them when times are bad.

MPT provides tools for assessing a client's emotional (risk) tolerance. If we're honest, this is where advisers really earn their fees. As Markowitz said, we should build portfolios that clients are comfortable with so they stay in them through all different market environments. We can talk about losses being temporary and mean reversion, but none of that matters if the variability of a client's portfolio exceeds their emotional tolerance.

Howard and Voss repeat the claim that MPT's measure of risk - standard deviation - does not reflect true risk, that only a permanent loss of capital is true risk. But understanding the standard deviation of a portfolio can help a client endure challenging market environments and avoid permanent losses.

Whether a portfolio is constructed using an optimization or not, having metrics showing the range of potential outcomes is incredibly valuable. Of course, these metrics are imperfect. For example, forward-looking capital market assumptions around risk and return for asset classes are preferable to historical data. Capital market assumptions are readily available from many reputable organizations, such as J.P. Morgan, and are relatively consistent across the industry. But historical data is readily available from many reputable organizations and is fairly consistent. The goal is not to be exact, but to have a context for discussion. We have found these conversations are far more fruitful in assessing a client's emotional (risk) tolerance than any questionnaire.

Objectively analyzing diversifying asset classes for the value they bring to a portfolio is better than adding an asset class because the timing seems right or because everyone else is doing it. Discussing a range of possible performance outcomes with a client to determine their risk tolerance is better than investing 100% in stocks and hoping we can talk the client off the ledge when the market goes south. If we educate on the front end, far fewer counseling sessions and tissue boxes will be needed during the tough moments.

Despite harsh critiques in Enterprising Investor and elsewhere, MPT continues to be widely used by pension plans, foundations, endowments, and institutional consulting firms across the globe. If there was a better way to build a portfolio, these institutions would be the first to use it.

The adviser's mission is to give clients the investing experience they deserve. The greatest danger to future wealth is failing to stay the course and not remaining invested long enough to reap the rewards. Diversification across asset classes and markets deflects emotional risk and still generates competitive returns. MPT provides a solid foundation on which to build that successful investment experience, while behavioral finance helps us counsel our clients when their emotions overtake their reason.

We don't advocate that everyone use MPT, or even agree with it. The criticism of MPT, however, is inappropriate and off-target. No one ever promised that MPT was a way to avoid losses in all markets, nor that it was the sole methodology for portfolio construction.

MPT is a tool in an adviser's toolbox - one they can choose to use or not. Behavioral finance and MPT are not at odds with each other or mutually exclusive. In fact, they work well together.

Investment paradigms benefit from the mosaic of research and ideas that continue to advance our field.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.