Modern Portfolio Theory: it still works

By Dr. Jason White
Director of Investments
Family Investment Center

I received a great deal of feedback on the optimism of my last column on investor capitulation. Thanks for taking the time to write and call. I love talking about this finance and economics with pros and novices alike.

On the off-chance that not too many of you subscribe to Financial Advisor magazine, I wanted to share my summary of an important article that appeared in the March 2010 issue entitled: “Markowitz: MPT Holds Up.”
MPT is the acronym for Modern Portfolio Theory, the only time-tested, scientifically-proved and academically-accepted method of managing investments for long-term success. Actually developed in the 1950s, MPT involves the search for optimal investment returns while simultaneously minimizing risk. Harry Markowitz, the creator of this strategy which I use religiously in practice with Family Investment Center, won a long overdue Nobel Prize in Economics in 1990. I recognize that the Nobel Committee is sometimes criticized for awards to candidates that baffle the public, but in this case, the award was absolutely justified.

The 82-year old Markowitz still teaches at the Rady School of Management at the University of California, San Diego. He is also an active financial consultant and is working on a new book.

Some have questioned the effectiveness of MPT during the most recent financial crisis. Yes, in times of panic, all historic correlations between assets tend toward one – meaning for short panic-stricken periods of time, there is no “safe haven” asset to avoid losses.

As the markets first stabilize, and then normalize, the old familiar patterns of risk-and-return emerge just as reliably as springtime in Northwest Missouri.

The patient and properly-advised investor rode the cycle, investing all along as stock prices took a nosedive in 2009. They did not jump ship or believe that this time it was really the end. And they were rewarded. With the Dow knocking on the door of 11,000, those who remained loyal and faithful to the modern implementation Markowitz MPT asset allocation doctrine are in fine shape. Those who chose the parachute, rather than the seatbelt, when the market turbulence hit have now missed nearly two-thirds of the recovery off of the lows from just one-year ago.

One professional I chatted with recently gloated about getting his clients out of the market before it hit the lows, but in the same breath, he lamented the fact that his timing indicators had not signaled a good re-entry point for him and his clients. This sort of story hurts my heart because I know what it means on a human level: a less secure retirement; a longer work life; a second-choice college for the kids.

Modern Portfolio Theory is the one and only one scientifically proven method for long-run investment success. The TV pitchmen, the investment commercial garbage, the book peddlers all claim it possible to “beat the market.” These claims are never proven true when the light of truth is shined on them. That is part of the reason these shows, pitches, and books have a short-shelf life. Good salesmen preying on primal motivating forces of human nature (primarily fear and greed) frame arguments in a believable way, and we bite.

Before you take your next sip of snake oil, check out Modern Portfolio Theory and the use of diversified asset allocation strategy to make these most important money decisions. I promise you over time you will be right!