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MPT Put Through the Wringer

After another market crash, advisors question whether Modern Portfolio Theory is the best way to tackle asset allocation. We asked two experts to debate its merits.

Paul D. Kaplan, 08/25/2009

On the heels of the financial crisis and market crash, advisors are asking whether Modern Portfolio Theory is a valid approach to asset allocation and portfolio management. To shed light on this issue, I asked Steven Fox, director of capital markets research at Russell Investments, and Michael Falk, vice president and chief investment officer of ProManage LLC and an adjunct professor at DePaul University in its Certified Financial Planner program, to debate this question on May 28 at the 2009 Morningstar Investment Conference. Here is an edited transcript of our discussion.

Paul Kaplan: Steven, the current market environment reminds us again that capital markets can be very risky. Less than a decade ago, we had the tech bubble burst. We had the crash of October 1987, we had the bear market of the 1970s, and we had the great crash of 1929. Nearly every time there's been a crash, years pass before the market reaches its previous peak. Yet, the way that Modern Portfolio Theory models risk implies that these sorts of events never happen. In light of capital market history, why should investors use Modern Portfolio Theory?

Steven Fox: This question reminds me of the debates we've had in the past decade or so. We had the death-of-beta debate, which was probably premature, and the debate about the equity risk premium, which we could argue still exists. The common characteristic of all these debates is that a market event caused stress on investors. We're all looking around for explanations of something that in advance of the event seemed impossible.

Today, we're calling into question one of the most powerful, intuitive, and accessible tools that advisors have for financial planning, which is Modern Portfolio Theory. Embedded in MPT is a very concise way to measure the trade-off of risk and return and the trade-off of commonality measured as correlation among assets. Those trade-offs, and the results of the theory, tell us some very powerful things about how we should put portfolios together, such as: 1) how much you hold of an asset is inversely related to your perspective on risk; 2) similar assets should have similar status within a portfolio; and 3) diversification mitigates risk.

What you call into question here, Paul, is more the relevance of capital markets' history for making our planning decisions. If we look at the historical record, the average annual return of U.S. equities since the 1920s through 2007 is something like 12% and the standard deviation about 20%. Investors have a one in four chance in any one year of earning a negative return. They have a one in six chance of seeing a return that is less than one standard deviation, or minus 8%. Conditional upon both of those events occurring, we end up with a fairly serious expectation for a negative outcome. If we're in a world where we're seeing less than zero for an equity return, the average outcome is about minus 12%, based on these numbers. If we're down below one standard deviation, we should expect something substantially less than that, around minus 18%. So there's room in the capital markets' record, even if you distill it down to summary statistics, for these once-in-a-lifetime events to occur.

Kaplan: Michael, isn't diversification good advice? Shouldn't investors hold less of an asset the more risky that they think it is?

Michael Falk: MPT has two parts, the way I define it. One is diversification. The other is the math for how you decide how you allocate the assets/asset classes you have selected to use in your diversified portfolio.

Diversification, absolutely, is a good idea. The way I talk about it with students is that when you are properly diversified you will at all times have a dog in your portfolio. Think about that for a second. You want to ensure that at no given time will your entire portfolio bark at you. That is the objective of diversification.

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