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Modern Portfolio Theory and Diversification: Still Good

The Great Recession isn't an indictment of these valuable tools.

W. Scott Simon, 08/05/2010

Have a comment, insight, or burning opinion on this article? Make your feelings known in the comments section at the end of the article.

There has been a good number of articles published since the market downturn of 2008 and 2009 decrying modern portfolio theory and diversification. Such condemnations include: MPT/diversification "no longer works;" MPT/diversification "should be revisited;" MPT/diversification "didn't work" in the most recent market downturns; or it's no longer possible to "believe in MPT or diversification."

All these articles conclude by saying, in effect, that if an investor had only been invested in this or that best-performing stock/bond/mutual fund/market sector/asset class, etc., then it would have avoided the ill effects of the downturn. Such articles pop up after every significant downturn in financial markets. This may lead one to surmise that their authors have a "MPT/diversification is no good" story template that changes only with the dates of a downturn and the particular best-performing investments during the downturn.

The fact that, during a market downturn, an investor didn't hold a best-performing investment like, say, Ethiopian bonds (whose superiority could not have been known until after the fact of their superiority showing up in the form of a track record) therefore "proves" that MPT and diversification aren't relevant to investors. This kind of "reasoning" leaves me scratching my head; to me, it's nothing more than a form of Monday morning quarterbacking that provides investors with little more than an interesting story and no useful guidance for the future.

I Get E-mails
One reader of this column sent me an e-mail recently which I have paraphrased: "The Employee Retirement Income Security Act and the Uniform Prudent Investor Act have essentially tapped modern portfolio theory as the 'correct' way to invest and mange portfolios. And yet, MPT did little to predict the carnage of the last couple of years or protect investors from recent market fluctuations. So do fiduciaries need to revisit MPT; should they consider post modern portfolio theory risk with more of a focus on downside risk?"

My Response: MPT and Diversification Are All-Important
This reader's observations and questions are excellent ones; here is my response, which advisors who are so inclined may wish to use to help educate their clients.

It was never contemplated that MPT would "predict" any given downturn in financial markets. As Nobel laureate Harry Markowitz who is the father of modern portfolio theory, notes: "Risk is risk" and "You pays your money and you takes your choice!" What Markowitz means is that financial markets are inherently risky, so if an investor wishes to avoid such risk he shouldn't invest in financial markets. Depositing one's assets under a mattress, though, carries its own risks. One "prediction" made by MPT is that in (inevitable) market downturns, a well-diversified portfolio will perform relatively better than a concentrated, non-diversified  portfolio.

Some concentrated portfolios, of course, will perform superbly in market downturns (and others in market upturns), whether due to the skill (or luck) of their managers. The absolutely insoluble problems with this approach to investing are that no one can (1) identify--before the fact--which such (relatively few) portfolios will be winners, (2) know whether their managers were truly skillful or merely lucky (unless they have a long enough track record that's statistically meaningful) and (3) know whether either factor (skill or luck) will be repeatable going forward (even though they may have a long enough track record that's statistically meaningful).

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