What Now? Sixty Years of Modern Portfolio Theory
This spring, Queen Elizabeth II will lead a flotilla of 1,000 ships, boats, and barges on a seven-mile trip down the Thames River. Among the watercraft in this pageant will be the 88-foot barge Gloriana, a gilded replica specially built for the event and named in honor of the first Queen Elizabeth, whose loyal troops supposedly exclaimed “Gloriana! Gloriana!” upon hearing the news of the Spanish Armada’s defeat.(1)
This sure-to-be-impressive event is one of several celebrating the Queen’s Diamond Jubilee—sixty years since her ascension to the British throne in 1952. Modern Portfolio Theory (MPT) also turns 60 in 2012, having been born in March 1952 with the publication of Harry Markowitz’s ground-breaking article (2) establishing the mathematical framework for the concept of portfolio diversification.
The basic concepts underlying MPT are fairly straightforward:
- Investors seek to maximize portfolio returns for a given level of acceptable risk, or conversely, seek to minimize the amount of risk for a given level of desired return.
- Investment returns for different asset classes follow a bell curve-shaped distribution and tend to be less-than-perfectly correlated with one another, such that when one asset class zigs the others may zag.
- By combining uncorrelated assets into a portfolio, the risk of the overall portfolio may be lower than the weighted-average risks of its component parts. (This is the so-called “free lunch” of diversification.)
- Using mean-variance optimization3 techniques, investors can determine which asset allocation weightings will produce the most efficient portfolios in terms of expected return per unit of risk. Investors will gravitate towards these efficient portfolios, buying and selling assets as they go, thus causing market prices to adjust and making the entire market efficient in the process.
If we set aside our discomfort with the higher level mathematics, Modern Portfolio Theory appears to be quite commonsensical, perhaps even old-fashioned. One could argue, as Markowitz has, that there is very little that is modern about Modern Portfolio Theory. After all, investors have known for centuries not to “put all their eggs in one basket.” Nonetheless, MPT has fallen out of favor in recent years, not in the least because of its alleged role in creating, or at least amplifying, the Financial Crisis of 2008. Our own criticism of Modern Portfolio Theory as a framework for wealth management pre-dates the Financial Crisis. Starting with the market crash on Black Monday (1987) and extending through the Asian currency crisis (1997), the Long-Term Capital Management blowup (1998), and the bursting of the Dot-com bubble (2000), we observed the following contradictions to MPT:
- Investment returns do not always follow a bell-shaped or normal distribution. The statistical concept of standard deviation, while useful in illustrating relative risk, tends to underestimate the frequency and extent of outliers and extreme events.
- Markets are not always efficient, especially when constrained by temporary liquidity shortages.
- Investor behavior is not always rational (as defined by economists) and certainly does not always maximize personal wealth.
- Wealthy families, by definition, have excess capital versus that required to meet their basic needs & obligations, leading to different risk appetites for higher-level goals and aspirations.
- Wealthy families have a multigenerational time horizon, and depend upon their portfolios for cash flows in the interim. These circumstances skew the relationship of risk and return, making long-term compound portfolio returns far more important than single year expected returns and risk.
These observations led us to conclude that Modern Portfolio Theory, while highly useful in illustrating the relative tradeoffs between current and prospective portfolio allocations, should not be used as the primary framework for constructing portfolios for wealthy families. From the perspective of a wealthy family, MPT and mean-variance optimization are solving the wrong problem. It would be rare indeed for a family to approach us asking for a portfolio that maximizes expected return at a 12% expected standard deviation. Instead, wealthy families define and state their goals in unique and personal terms, apply dollar amounts and specific timeframes to those goals, and feel greater pain of loss for basic financial needs than for higher-level goals.
Whereas MPT seeks to maximize return per unit of risk, a goals-based investing approach would strive to maximize the probability of achieving the family’s unique goals. While MPT assumes that investment returns follow a normal distribution, the goals-based approach takes into account that markets occasionally experience negative events beyond our previous experience or even our imagination, and that investors should insulate their basic needs from those outlier events. Likewise, goals-based investing would incorporate the likelihood of periodic market liquidity crises by fencing off non-liquid or potentially non-liquid investments from that portion of the portfolio supporting near-term basic-level needs.
Perhaps most importantly, while MPT assumes that the investor’s risk appetite can be quantified in a single estimate covering the entire landscape of that investor’s goals and assets, the goals-based approach recognizes multiple levels of risk tolerance for distinct goals and goal “layers.” This nuance is a key component of goals-based investing, and is based on the “hierarchy of needs” concept introduced by psychologist Abraham Maslow (1908-70).4
Prior to the ascension of Modern Portfolio Theory in 1952, investors practiced what could be labeled “naïve” diversification. Investors intuitively knew that single-stock portfolios were riskier than a portfolio of many stocks, and that a portfolio consisting of both cash and stocks fluctuated in value less than a portfolio of stocks only.
Markowitz systematized this thinking and added a mathematical framework to support it, building that framework upon several key assumptions about investor and market behavior.
Over the years, both academics and practitioners added to the body of knowledge comprising Modern Portfolio
Theory, with perhaps the most significant complement being the Black-Scholes options pricing model (1973).5 Using MPT and the Black-Scholes model, Wall Street constructed a host of complex financial instruments designed to parse risk into separate slices or “tranches” and sell each separate piece to the investor who valued it most highly.
Whether these complex financial instruments caused the Financial Crisis or were merely symptoms of it is beyond the scope of our writing here. What is clear is this: Modern Portfolio Theory was never intended to serve as a general framework for managing multi-generational family wealth. Moreover, it may have helped lull investors into a false sense of financial security by underestimating portfolio risk and by diverting our attention from more practical issues such as liquidity and cash flow.
After sixty years of Modern Portfolio Theory, what now? Is there a Post-Modern Portfolio Theory? We think that goals based investing fills that role nicely, especially for families managing multigenerational wealth held in complex trust and partnership structures. In future quarters, we will describe in greater detail how the goals-based investment process can help wealthy families create portfolios that maximize the probability of achieving their unique goals, understand their portfolios more clearly, and cope with future crises that may occur.
Q3 2012: “Creating a Financial Hierarchy of Needs”
Q4 2012: “How Confident Can I Afford to Be?”
Q1 2013: “Asset Classes, Risk, and Return: A Post-Modern Perspective”
Q2 2013: “I-Harmony: Marrying Investment Goals and Assets”
Q3 2013: “Sticking to Your Investment Diet”
Q4 2013: “Integrative Wealth Management: Our View”
1 “Rule the Waves,” Financial Times, March 23, 2012.
2 “Portfolio Selection,” by Harry M. Markowitz. The Journal of Finance, Vol. 7, No. 1, (Mar., 1952), pp. 77-91.
3 For simplicity’s sake, we use the terms Modern Portfolio Theory (MPT) and mean-variance optimization (MVO) somewhat interchangeably in this article. In reality, MVO is one of many components in the body of beliefs, processes, and tools that make up MPT.
4 “A Theory of Wealthy Family Behavior,” by W. Jackson Parham, Jr., in Family Legacy & Leadership: Preserving True
Family Wealth in Challenging Times, by Mark Haynes Daniell and Sara Hamilton. Wiley, 2010, p.206.
5 Fischer Black and Myron Sholes created a model for valuing options based on the theory that the price of an option was equal to the cost of hedging the underlying security itself through a combination of borrowing and buying/shorting. The Black-Scholes formula is built around the factors of volatility, time-to-expiration of the option, and interest rates.