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November 10, 2011

Reinventing Modern Portfolio Theory for Today’s Reality

Most investors and financial advisors alike would probably agree that creating a sound, diversified asset allocation is a huge part of the foundation for anyone attempting to develop a solid, long-term financial plan. That I feel is pretty indisputable however I…

Reinventing Modern Portfolio Theory for Today’s Reality

Most investors and financial advisors alike would probably agree that creating a sound, diversified asset allocation is a huge part of the foundation for anyone attempting to develop a solid, long-term financial plan. That I feel is pretty indisputable however I feel strongly that a simple asset allocation model as most folks understand them today, does not go far enough to truly satisfy the needs of most investors in the rapidly changing environment we live in.

In fact, Modern Portfolio Theory (MPT)  – a concept developed in the 1950’s through the 1970’s which was designed to maximize expected returns while minimizing risk though diversification into “non-correlating” asset classes – has come under considerable fire in recent times because its model of the financial markets does not match the real world in many ways. MPT has been successful in reducing portfolio volatility (or risk) during periods of “normal” economic movement however it has somewhat failed during more recent and more volatile periods of market fluctuations.

The framework for MPT is based on a number of assumptions about investors as well as the markets. Unfortunately for MPT, none of these assumptions are entirely true which tends to compromise MPT to varying degrees.  Some of these assumptions include: a normal distribution to model returns (meaning large variances in returns are generally not factored in),  correlations between asset classes are fixed and held constant forever, all investors have access to the same information at the same time, and all investors are rationale and risk-averse.

If you take a closer look at each of these assumptions you’ll likely notice that they really don’t hold much water in the “real world” that we all live in. For all of you that have kept on eye on the equity markets just prior to and following the August 2nd Debt-Ceiling-Deal-Deadline, you’ll most certainly be aware of the tremendous swings that the markets have displayed day by day. Due to these wild daily fluctuations, the distribution of returns seems to be anything but normal these days.

Since the fall of 2007, the Dow has seen 154 days with swings of more than two percentage points in value. Yes, that’s a lot. To put it in perspective, we’ve endured more of these big swings in market value during 3-plus years than were seen in the 1950s, 60s, and 70s combined. Even the 1990s — which were far from calm, if not as gut-wrenching — had only 93 of such days.

As discussed earlier, diversification amongst assets who’s “normal” returns lack correlation to one another is at the heart of MPT. Unfortunately as we’ve experienced over the last 3-plus years, when the tide goes out, all boats tend to sink in unison. In 2008, investors had to watch in horror as their seemingly diversified portfolios and the supposed “non-correlating” assets inside them virtually all decreased in value in lock-step. A troubling lesson learned from the most recent recession is that asset classes that normally show little to no correlation between them during good times may be heavily correlated during times of distress – which basically defeats the whole purpose of diversifying in the first place.

I’ll wager that most of you will have very little problem unearthing the flaws in the other two MPT assumptions I listed above. You’d think that with the information age that we live in today that everyone would have access to the same information at the same time. The problem is that assumes that everyone has the same financial literacy and knows exactly where to look for the information in question – or even knows what questions to asks.

To assume that investors act rationally and with an aversion to risk all the time is nearly laughable. Just look to the over-leveraging of America. Normally “conservative” investors and even large institutions with conservative mandates got caught up in the debt-boom. If a little leverage was good, more leverage had to be even better. So I think that it is easy to prove that risk-aversion is not a quality that we can assume all investors will display at all time.

As far as the concept of a “rationale” investor – just look at the amount of money flooding into the stock market at the Dow Jones Industrial Average’s (DJIA) peak in 2007 versus the DJIA’s most recent floor in March of 2009. The old investing adage that we’ve all learned at one point or another is that you buy low and you sell high. If investors acted rationally they most certainly wouldn’t have been throwing money at the market’s peak and running for the hills just as the market hit bottom.

So where does that leave you as an investor with the MPT wool being pull away from your eyes, uncovering the flaws in traditional asset allocation models? It leaves you in a great place to rethink what portfolio diversification truly means.

I encourage you to read on to Chris’s article from the September Newsletter entitled the “Buy and Hold Lie” and also consider this: How varied are the intended durations for each of the individual assets or strategies inside your current portfolio? Do you have individual investments or investment strategies that differ in their intended hold period? If you don’t, you absolutely should.

It should be relatively easy to look back at the cautionary tale that was the last 3 years. Virtually all “risk” assets that were liquid, no matter how diversified they may have seemed, all managed to face virtually the same fate – tremendous bouts of VOLATILITY. Volatility is the Achilles’ heel of the emotional investor. When it strikes, investors tend to react by fleeing when the appropriate course of action may be to stand pat.

Unfortunately as humans we cannot help that we are emotional beings. This is why it is prudent to remove the emotion from certain portions of your portfolio by seeking assets that are intended to remain illiquid for specified periods of time, thereby removing your knee-jerk desire to make ill-advised, long-term decisions to satisfy your short-term concerns.

Once you have successfully satisfied your need for a cash safety net along with short (less than 18 months), medium (2-4 years) and long term (5+ years) liquid assets, it may be prudent to analyze investment opportunities that are intended to remain illiquid for a specified period of time.

At South Coast, when planning for the medium and long term portions of our clients’ portfolios, we actively employ direct investments in real estate (through non-traded Real Estate Investment Trusts, Limited Liability Companies and Delaware Statutory Trusts) and energy (such as oil, natural gas and coal through developmental and exploratory drilling ventures and mineral and leasehold rights), along with supplemental investments including Life Insurance, Long Term Care Insurance and Annuities.

By inserting some of these illiquid investment alternatives into a diversified portfolio, you may be reinstilling some of the core principles that Harry Markowitz originally set out to produce in his early studies of MPT in the 50’s.

Remember that whether it is a simple task during your day to day responsibilities or plotting your course toward financial prosperity, we are all human – and not a single one of us is perfect. So when it comes to creating the foundation for your financial future, be sure to take appropriate steps to remove some of that which makes us all human – our emotions – from the equation, and you’ll be far better prepared to survive and even enjoy the journey.

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