Why Investment Advisors Will Continue To Steer You The Wrong Way

The first decade of the 21

st

century has been a trying one for investors, but what if the travails of the

2000s are partly a result of 20th century theories that professional investment managers didnt leave behind? Modern Portfolio Theory (MPT) sought to create a comprehensive model for analyzing the behavior and risk of assets. These models of risk may have seemed good in the lab, but mounting empirical evidence has continued to call into question their premises. While probability models and statistics have their uses, MPTs reliance on historical data leaves market participants consistently awestruck when assets dont perform according to the model. Instead of finding a model that fits the observational data, the data is forced to fit the existing theory, perhaps with minor alterations as new events dictate. This is not merely an academic discussion as the precepts of these theorems are the foundation for portfolio construction and in all likelihood shape the decisions of your investment advisor. These decisions have had adverse consequences on investor confidence and more importantly, investor success. The foundation of asset management is Modern Portfolio Theory. MPT asserts that investors should seek to maximize returns for a given level of risk. This is graphically displayed as the efficient frontier (see figure 1).

Figure 1*

Portfolios along this frontier are thought to be the most efficient balance of portfolio risk and reward. Risk is defined as the volatility, or standard deviation, from the historical average return of an asset. This return maximization is achieved through diversification among holdings (with different profiles of risk and return) that create a lower overall portfolio risk. For example, if your stock positions are going down, this will be offset by bond positions going up, thus lowering the overall volatility of your portfolio. In creating a portfolio, MPT utilizes both historical performance data and the concept of a normal distribution of returns. A normal distribution is graphically represented as the standard bell curve (see figure 2).

Figure 2**
The frequency of events is measured by the vertical axis, and the severity of the event is measured by the horizontal axis. For portfolio or investment returns, the curve is graphically displaying how often different returns occur and how much they vary from the average. Thus, mild events, or returns close to the average, happen quite frequently as seen in the center of the bell curve (dark blue), and high severity events or returns very different from the average, at either end of the curve happen so rarely as to be nearly impossible statistically. High severity events such as the bursting of the tech bubble, the bursting of the housing bubble, the ensuing market collapse, and the European sovereign debt crisis are 100 year flood type events. Thus, the frequency with which these events have continued to occur calls into question whether or not returns are in fact normally distributed. The 2007-2008 crisis wreaked such havoc due to its lack of precedence. This is due to MPTs reliance on historical data and a misplaced faith that events of this magnitude rarely if ever occur. Assets that historically werent supposed to decline in tandem did and on a scale never before seen. If the model that is the underpinning of investment managers decision making processes doesnt account for these market anomalies, is it any wonder that we hear the echoes of experts claiming, no one could have seen this coming?

If youre not looking for the problem, it is easy to miss it.

In addition to a reliance on historical data and a faulty belief in normally distributed risk, the next shortcoming of MPT is its view that financial markets are efficient and participants act in a rational manner to achieve the above mentioned return maximization. This is known as the Efficient Market Hypothesis (EMH). Market efficiency, as defined by EMH, is an instantaneous synthesis of relevant price data. While EMH argues that historical price performance does provide information as to the statistical

probability of returns and deviation from those returns (volatility), price movements are random and exhibit no discernible pattern. With the start of a new century that has been marked by a tech bubble, a housing bubble, and a sovereign debt bubble, the problematic nature of the Efficient Market Hypothesis should be clear.

Investors are not rational, at least in the manner defined by MPT and EMH and, in fact, are far more risk adverse.
The fear of loss is a far greater motivator than the potential for gain. This manifests itself in participants selling at market bottoms (fear of even greater losses) and buying late into market recoveries as they wait for an all clear sign. This is not the rational behavior of market actors seeking the risk adjusted return maximization that MPT and EMH suggest exists. As the example crises above illustrate, markets do not efficiently process data as it moves from one price point to another. Trends do emerge as manifested in bubbles and busts. Markets, like the constituent investors who comprise them, seem to exhibit a memory of past price movements that can influence future price movements. Modern Portfolio Theory gave rise to the ubiquitous asset allocation or risk based investment models. For those having worked with an advisor, you are familiar with the risk tolerance questionnaire that every advisor will have you fill out. It is a series of questions meant to determine the investors risk profile: conservative, moderate, aggressive, etc. From this, the appropriate allocation to stocks and bonds can be created to maximize returns given the level of risk the investor is willing to take (based on the efficient frontier above). From the analysis of MPT, we can see a number of errors in this strategy. As discussed above, investors are far more risk adverse and do not necessarily look to maximize returns but rather avoid loses. Second, investors responses can be anchored to recent experience. For example, a hypothetical client in late 2007 may have been much more willing to take on risk with equity markets hitting new all-time highs. However, that same client answering the same risk tolerance questionnaire in March 2009 at the market lows may have responded in a much more risk adverse fashion. Our construct of risk is shaped by the current market environment. With the damage caused by the 2007-2008 crisis still ingrained in investors minds, they rush for the exits at the hint of another downturn. This has been exacerbated by the trendless and volatile environment of the past two years. Markets have been held captive by the utterings of every central banker and policy maker. The net result of portfolios built on poor projections of risk is that clients are being pushed into portfolios that continue to experience higher volatility than they can truly stomach. As a result of each unexpected crisis, advisors are not able to properly manage client expectations, and oftentimes, investors will be shaken out of their positions at the worst possible time.

Confined within itself, the conclusions and formulas of Modern Portfolio Theory may be valid. However, if it does not model actual human behavior, the theory must be discarded.
The consequences are not merely academic and shoulder a great deal of the blame for the loss of investor capital and confidence. As governments and central banks attempt to work off unsustainable debt levels, the ideal scenario for policy makers would be a continuation of the past few years: low growth and high volatility or a policy of muddling through. Policy makers want to avoid losing control of the situation in one direction or the other. However, this is requiring greater and greater intervention just to maintain the lackluster status quo. Assuming that they can continue to arrest natural market forces, volatility is here to stay and in all likelihood, may only increase. Our assessment of risk and portfolio construction must adapt accordingly.

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*IBM, http://www.ibm.com/developerworks/rational/library/aug05/mckenna/mckenna_fig1.jpg **Wikipedia, http://upload.wikimedia.org/wikipedia/commons/thumb/8/8c/Standard_deviation_diagram.svg/325pxStandard_deviation_diagram.svg.png