Modern Portfolio Theory was conceived by Harry Markowitz in the 1960s, and is the theory upon which almost all contemporary investment professionals base portfolio decisions. Some tenets within MPT are quite useful in practice, and add value to the portfolio construction process. For example, there is clear evidence that diversification reduces portfolio volatility when applied wisely, though not nearly to the extent predicted by MPT. Cracks in the foundations of MPT are visible to the naked eye when we shine a light on some of its underlying assumptions:
Assumption 1. Market returns are normally distributed random variables.
A quick chart will disprove this bold assertion. In the chart below we show the distribution of monthly stock market returns going back to 1870 using Professor Shiller’s data. Only 1 month out of every 1000 months should fall outside of the green shaded area if returns are actually normally distributed. Given that there are over 1600 months in the sample, we should see maybe 2 months outside this range. Instead we see 15, with several months delivering returns that should only occur once every million years or more, and one month showing a return that should only occur once since the birth of the universe!
The ‘fat tails’ of this distribution wreak havoc on portfolios that are modeled on the basis of a true normal distribution. One need look no further than the last two years to see how this fallacy can irreparably harm investment portfolios. Many will never financially recover from decisions made on the basis of this fallacious assumption.
Source: Shiller (2009), Butler|Philbrick & Associates
Assumption 2. Correlations between assets are fixed and constant forever.
Again, a simple chart will show how all asset classes tend to move together at times of financial stress, such as during bear markets or or credit dislocations. Observe how every market around the world, with the exception of government bonds, collapsed at the same time in 2008-09.
April 4, 2010
Categories:Behavioural Finance, Retail, Volatility