Editor's Letter: Fat Tails and MPT Hecklers

The central tenet of Modern Portfolio Theory is that diversification should maximize your portfolio's return at any given level of risk tolerance. Or, as David Swensen, the chief investment officer of Yale's endowment, puts it: Forget about variance asset allocation is all about choosing assets with low covariance. Peter L. Bernstein further simplifies the concept like this: In other words, you can

The central tenet of Modern Portfolio Theory is that diversification should maximize your portfolio's return at any given level of risk tolerance. Or, as David Swensen, the chief investment officer of Yale's endowment, puts it: Forget about variance — asset allocation is all about choosing assets with low covariance. Peter L. Bernstein further simplifies the concept like this: “In other words, you can hold plenty of risky assets with high expected returns as long as they fluctuate independently rather than in step with one another. This is nothing more than Markowitz's theory of diversification.” (See Capital Ideas Evolving, page 159.)

And it's pretty elementary stuff. We've all been taught this theory of diversification, which was established by Markowitz, the founder of MPT, back in 1952. MPT has always had its critics, but because the recent bear market has been so ferocious and so wide, wrecking havoc on nearly every asset class available to investors, MPT is under attack — again. And with greater intellectual force. Len Costa, the director of the Institute for Private Investors, a networking organization for wealthy investors, wrote in the Financial Times this spring that the current state of the capital markets “poses a dilemma for wealth managers, who, for a generation, have adhered to the core principles of asset allocation and earned their keep by preaching the mantras of ‘buy and hold,’ ‘invest for the long term’ and ‘stay the course.’”

Costa added, “Unfortunately, even a carefully crafted investment policy statement is not necessarily equipped to guide investors through a crisis. ‘To simply say that one has some mix of stocks, bonds, cash, and etc., and a long-term view seems insufficient,’ one IPI investor recently told his peers during an online discussion.”

Suddenly, everyone is talking about fat tails — higher-than-normal probabilities of extreme negative returns. Because MPT defines risk as volatility (both upside and downside volatility), the traditional definition of risk may be inadequate. With a financial advisor's help, clients may need to revise their thinking about risk, to chuck the traditional definition, which holds that risk equals the standard deviation of returns around some mean. Ashvin Chhabra, chief investment officer of the Institute for Advanced Study in Princeton, N.J., wrote a paper advocating that the “Markowitz Framework of diversifying market risk” should be widened to include the “concepts of personal risk and aspirational goals.”

The summary of his paper states: “The Wealth Allocation Framework enables individual investors to construct appropriate portfolios using all their assets, such as their home, mortgage, market investments and human capital. The investor may choose to accept a slightly lower ‘average rate of return’ in exchange for downside protection and upside potential. The resulting portfolios are designed to meet individual investors' needs and preferences, as well as to protect individuals from personal, market and aspirational risk factors.

“The Wealth Allocation Framework attempts to bring together MPT with aspects of Behavioral Finance through a single pragmatic framework. A major conclusion of this work is that, for the individual investor, risk allocation should precede asset allocation,” the summary concludes.

Please turn to page 32 for a discussion of MPT in the post-modern age.

We thank you for your support. Drop us a line with your comments: 249 W. 17th St., New York, N.Y. 10011-5300. Or email us: [email protected]. Publisher Rich Santos can be reached at [email protected].

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