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Theory vs. Reality - again

November 27, 2010

Theory vs. Reality – Again

There was an interesting article in the New York Times business section this past weekend about a new book on investing, co-written by Gordon Murray and Daniel Goldie.  Presumptuously entitled The Investment Answer, as if there were only one solution to the investment puzzle, the book essentially presents yet another defense of modern portfolio and the efficient market theory – even after the theory failed miserably to preserve investor capital during the latest bear market.   The Investment Answer by Murray and Goldie

The book is written by an ex-institutional bond salesman from Goldman Sachs who has all but given up in his fight against terminal brain cancer, and his financial adviser.  With due respect to the authors’ good intentions – one should always question someone’s background and experience when it comes to financial advice.  The authors are not necessarily successful investors themselves – Murray concedes this himself after having witnessed many failed alternative investment strategies on Wall Street.  Yet the authors claim that they have come up with THE solution to managing other people’s money (hence the title of the book).  While the book does a good job citing historical studies and refers us to the adages of modern portfolio theory – as espoused by such brilliant minds as Markowitz, Sharpe, Fama, French – it is somewhat disconcerting that the authors have arrived at these truths simply because nothing else has worked efficiently for them in the past.  Have the authors fully researched and explored alternative strategies (including market timing)?  Do they have practical experience applying any of these strategies themselves for an extended period of time?  How did they do during the last financial meltdown? 

The authors direct the reader’s attention to the folks over at IFA.com, that admittedly have developed some impressive quantitative and objective free analytics for investors.   The risk tolerance survey and corresponding suggested allocations are based on modern portfolio theory.  It’s tough to find fault with the IFA academics (some of whom are Nobel prize laureates), but I’m writing to remind readers to bear in mind that theory has often gotten us into huge troubles over the years – especially when it comes to investing. 

Consider the tragic plight of Long Term Capital Management, the hedge fund run by John Meriwether and his team of Nobel prize laureate fund managers - that lost billions in 1998 – forcing the Fed to orchestrate a massive bailout to rescue Wall Street.  This episode is masterfully discussed by Roger Lowenstein in his book When Genius Failed, a book that I highly recommend reviewing at least once a year (especially the epilogue).    In this book, Lowenstein presents the dangers of putting too much faith in any investment model based on historical data.  While modern portfolio theory is correct in showing that there is a trade-off between reward and risk, it puts way too much emphasis on the assumption that markets are efficient.  This concept of efficient markets was proven dead wrong in the recent financial crisis.  During the meltdown, large players dumped out the baby with the bathwater, and securities in all asset classes and sectors became grossly mis-valued.  The global financial markets were grossly inefficient at valuing securities – and for a prolonged period of time.  In 2008, over $30 trillion was lost in global equity valuations. 

With this in mind, it pays to ask just how well the average investor fared during all this turmoil.  As I state on the About page of my web site, typical investors are lucky if they can capture even 35% of the average annual total return of respective benchmarks.    The bar chart below is especially revealing:

Average Investor Performance vs. Benchmark indices

What accounts for this mediocre performance?  I would suggest that the typical investor simply freaks out during volatile periods (by cashing in whatever chips they have left after bear markets have run their course), and loading the boat just prior to market peaks (especially during bubbles).   The bar chart above also helps explain why contrarians like Templeton made their fortunes beating the major indices.  But the average investor has not discovered an investment approach that can tame his emotional swings.  Neither have most financial advisers. 

My gripe about this book (and with the DFA/IFA.com) geniuses is that they wrongly assume that the average guy can stick to an optimal asset allocation through thick and thin (that is, in bull and bear markets).   The evidence clearly shows that the average investor doesn’t have the mental discipline.  I also fault these folks for recommending overly aggressive allocations (heavy allocations to stocks), when they should rather be erring on the side of conservatism.  Go ahead, try out the IFA risk tolerance survey (either the short or long version) for yourself.  You’re most likely to get a suggested allocation to stocks that is at least double what I believe investors can handle.    For example, I took the survey on IFA.com and ended up with a “50” or the “Sea Green” recommended allocation.  This allocation is comprised of 60% stocks and 40% bonds.  Without the aid of a market timing service, the most I would ever allocate to stocks for any investor is 50%.  While it’s certainly true that every investor has different financial health, goals and objectives – hence the value of taking a risk tolerance survey – it’s also true that the markets simply don’t know about Mr. Jones’ or Aunt Martha’s financial health and goals – nor do the markets care. 

Finally, it is telling that Harry Markowitz, the founder of the efficient portfolio allocation frontier and capital asset pricing model theories, employed market timing for his own investment portfolio during the recent bear market in stocks and real estate!  This according to a recent article in Financial Planning magazine. Markowitz essentially abandoned his own efficient frontier theory in favor of market timing because he knew that he could not rely on optimal diversification to preserve his own capital during extremely volatile periods.  

The theory is ideal in an ideal world.  But as we’ve seen during the last decade especially, the global financial markets are anything but ideal.

 

 

 

 

 




Disclosure: Long MDY, IWM