Modern Portfolio Theorists Are Looking for Refinements for Blind Faith
Modern Portfolio Theory, or “MPT”, has been the watchword for portfolio management professionals for nearly half a century, delivering a comprehensive methodology for assembling a diversified grouping of assets based on risk and reward expectations. There are also a number of other foundational theories that support MPT, based on years of number-crunching research, but in general, the theories work best when variables are normalized within certain statistically bounded limits.
However, when a major “rock” is thrown into the market “pool”, as happened in 2008, the correlation between theory and reality was subjected to extreme doubt, sending theorists back to the drawing board to develop necessary refinements. Markets are not always efficient. Investors are not always rational. Returns and risk are not always confined to predictable and normal distributions. The episode is reminiscent of studying scientific formulas in college, and then spending hours in a laboratory discovering that Mother Nature does not always conform to a tidy formula.
This is not new news. MPT, the Black-Shoals Option Pricing Model, Efficient Market Theory, and the Capital Asset Pricing Model have all come under fire as being imperfect by a host of critics, but without something better, no one has stepped forward to suggest a better system. The fact is that computers cannot easily model our markets, whether they be stocks, commodities, or forex currency pairs. As soon as one quantitative approach works, the personality of the market changes related to the fringe elements of a few critical assumptions. Variables take on a life of their own, refusing to behave as expected, and the results spell catastrophe in capital letters.
After Lehman Brothers failed in 2008, credit markets collapsed. Liquidity vanished while volatility soared off the charts. Asset classes that were supposed to be opposites in correlation were suddenly dropping off a cliff together as global equities plummeted. Portfolio designs that were supposed to reduce risk did not perform as expected. Excessive risk taking was excessively punished, but did Modern Portfolio Theory fail to deliver?
Wealth management professionals are now questioning their blind faith in computer formulas to substitute adequately for prudent judgment decisions. There have now been a few years to recoup, market values have returned, but the experts are once again debating risk, diversification techniques, and how best to assemble a portfolio of assets going forward. From a quantitative perspective, theorists are probing for the right adjustments to existing finance models, leaving investor behavior to psychologists. Here is a summary of present thinking:
• Market Turbulence: MPT assumes stable volatility and correlation relationships, but studies have confirmed that markets exhibit internal cycles between stable progression and outright turbulence. In order to improve diversification, the effects that occur outside two standard deviations of a normal distribution curve must be factored into the equation, the so-called “fat tail” anomaly.
• Extreme Value Considerations: More adaptation is required to include the impact of extreme market fluctuations. Events thought to be of low probability have occurred more frequently than expected due to misunderstandings in the “fat tail” portion of return distributions. Efforts involve expanding the weighting of “tail” events and determining better “what if” scenarios for planning purposes.
• Chaos Theory: Adaptations of modeling work developed for chaos theory offer another approach. These studies purport that certain dynamic systems that are sensitive to initial conditions can yield wildly diverging results based on small differences in assumptions. The randomness of data and potential results more closely mimics real market conditions, a benefit of this approach.
Portfolios are riskier than previously thought, but improvements are on the way. MPT will survive.