Modern Portfolio Theory in Modern Times

Modern Portfolio Theory in Modern Times

In the 1950’s, Modern Portfolio Theory or MPT was developed, and its key tenant was that diversification can reduce risk in a portfolio and that diversification across uncorrelated assets can achieve higher returns with lower risk.

The theory describes an “efficient frontier” where an ideal investment portfolio occupies the ‘efficient’ parts of the risk-return spectrum. These portfolios are set to achieve the optimal maximum return with the given level of quantifiable risk.

It sounds great, and is common practice, but MPT theory has not worked out well for most investors.

Why? For starters, it assumes that markets are efficient. But markets are often irrational and mis-priced. As economist John Maynard Keynes famously said, “the market can remain irrational longer than you can remain solvent.”

Secondly, MPT and most investors see risk purely as price volatility, and are focused with the marked-to-market values that were quoted.

Imagine the common risk profiles that most institutions are using, often framed around an investor’s age or “investment horizon”:

  • Low Risk: Buy 100% Bonds
  • Medium Risk: Buy 50% Bonds 50% Equities
  • High Risk: Buy 100% Equities

Where risk is seen as price volatility over time. But there is much more to risk than just fluctuating prices.

Risk is also knowing how real and liquid the quoted price is. For example, a perceivably safe government-backed airline bond was not necessarily less risky than a Microsoft stock (that has a price drawdown of 37%) in March 2020. But due to the liquidity crunch, the airline bond became illiquid, sits its price was not “real.”

If price volatility is not truly reflective of risk, then it makes no sense to quantify it as such. Simple diversification of assets does not reduce risk, even though that is the go-to strategy for many wealth managers. Our house view is that what you diversify into is more important than how much you diversify.

We determine the risk of an investment in a company through due diligence and primary research, conducting a deep dive into financial statements, calculating the numbers and investigating the competencies of the managers. The more knowledge we have, the better we are able to assess the risk of the asset.

The key to successful investment selection should lie in the individual merits of the underlying businesses. A successful portfolio manager has to take into account the ever-changing conditions of the market and not just adopt a one-size-fits-all approach to risk.

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