Paul Kaplan: Hello. I'm Paul Kaplan, and I'm vice president of quantitative research at Morningstar. And here at the Morningstar Investment Conference, we had a session that was called "Can Modern Portfolio Theory Take the Heat of a Meltdown?" And one of our panelists is Steven Fox. Steven is the director of capital market research at Russell Investments.
Thank you, Steve, for coming to the conference and participating in the panel. And maybe you can just briefly describe for us what we talked about in this panel and, from your perspective, what are kind of the key takeaways.
Steven Fox: Well, we vigorously debated the merits of a model-based approach, such as MPT, to deciding how to asset-allocate a portfolio, versus something that incorporated a different view of how an investor might take risk into consideration.
Key takeaways that I would describe from our discussion and debate would be that diversification still matters. It's still a valid principle. Risk/reward trade-off is alive and well in markets. The other takeaway might be that there's room in the stable for non-model-based approaches along with model-based approaches to doing asset allocation. The world is complex, and we need to take into account as much information as we can in our decisions.Read Full Transcript
Kaplan: So, at least to some extent, there is a rationale for tactical asset allocation, then, if you have some confidence that a valuation ratio, like a P/E ratio or other valuation metrics, might actually contain information that tell you that where the market is today may be very different than where the market might be sometime over your investment horizon.
Fox: Tactical is a hard word. It really brings to mind the cash-stock-bond, wild asset allocator. I think anything we do that improves and informs our decisions is beneficial, ultimately.
On top of that, though, you have to make sure that whoever holds this portfolio is comfortable with the idea that you're deviating from a strategic asset allocation, that you're doing it in a very risk-controlled way that meets the consumer's preferences. Ultimately, it's a matter of what's right for the consumer of the portfolio.
Kaplan: Does modern portfolio theory, with its emphasis on standard deviation as the measure of risk, then, perhaps, sort of lull investors into a sense that the markets are really more secure than they really are, and that, in fact, at least in part, we have to be able to step back from MPT and say, "There is such a thing as systemic risk, and we really do need to be forewarned that there are going to be occasions where none of this is really going to work, and we're going to lose a lot of our portfolio value very quickly"?
Fox: That's the reality of any model. You know, by definition, it's an abstraction of reality. And the world is much more complicated than [laughs] an expected return and a risk metric. So, to be an effective user of a tool like MPT, you have to recognize its limitations, and you have to be willing to challenge it, to do creative destruction on the results, and be willing to take into account other pieces of information that are relevant to the decisions.
Kaplan: Thanks again, Steve, for joining us today.
Fox: My pleasure, Paul.