MPT's RevengeOctober 22, 2012 Posted by: Joe Morgan, CFA
You're hot then you're cold
You're yes then you're no
You're in then you're out
You're up then you're down
- Katy Perry
This pop star's comments may well describe many investors'activities over the last several months - to their own detriment.Most agree a long-term approach is correct, but what is long-term,anyway?
Modern Portfolio Theory (MPT) is effectively the basis for everyfinance graduate program in the country and has been since itsformulation in the 1970s. An accumulation of fancy Greek symbolsand seemingly rational concepts, MPT is a tool used to create anoptimal portfolio given a market's and investor's constraints.
Because investments tend to have correlations less than 1.0, we cantheoretically build an optimal portfolio that, throughdiversification, will return a maximum amount over time for a givenlevel of risk tolerance. Even tools such as leverage can beincluded in these formulations.
An underlying theme is that investors should look to the long termfor returns, focusing little on the market's wiggles and waggles.Unfortunately, what constitutes a wiggle or waggle is left for themarket to determine. Is a three-year downturn a wiggle or is it asubstantive event demanding a change in formula inputs? How about a10-year downturn as the stock market recently reflected?
Also, note the assumption that correlations are less than 1.0.After last September's events (and even during times leading up tothem), many correlations moved very close to 1.0. This created aperfect storm of falling investment prices, which in turn led tofurther investment losses as investors panicked and sold, moving to"cash" or money market mutual funds.
For years leading up to this crisis, total investments in moneymarket funds hovered around $2 trillion. Today, we are around $3.5trillion. As these extra funds work their way back into the system,investment prices must necessarily rise. This is what we are seeingtoday.
The S&P 500 is up 55 percent since its March 9 trough withother risk markets following along. Even commodities continue theirrally with gold reaching a new...Read More