The Death of Modern Investment Theory

Posted: Dec 11, 2012 12:01 AM

Regarding Harry Markowitz’s Modern Portfolio Theory (MPT), at what point do we throw in the towel, give up the ghost, or even call it a day? 

Markowitz, in his quest to deliver an understandable doctorate thesis, used lines, dots, and all sorts of machinations in order to prove that investors were rational and that financial markets were efficient. 

He dealt with diversification while theorizing that a collective group of assets had inherently less risk compared to owning the very same assets individually. 

In fact, most of the asset allocation models utilized by the mutual fund industry base their heart and soul on Harry’s basic premise which examines the relationship of probable investment portfolio returns vs. asset risk, return, correlation, and diversification. 

Markowitz’s theory, lauded by every financial regulatory body, even won him the Nobel Prize in Economic Sciences which allowed him to join the prestigious list of former Nobel Prize winners that includes celebrities such as Jimmy Carter, Mikhail Gorbachev, Al Gore, Yasser Arafat, and of course, the ever-popular Barack Obama. 

For years, debates have raged over the accuracy of Harry’s “efficient frontier” theory which led to something that has emerged as the good-old standby when MPT doesn’t seem to work, namely, relative performance. 

Over the years, in order to defend the theory of portfolio construction within MPT, the financial services industry has based performance not on real return but has based performance results upon a particular benchmark, thus Wall Street can continue to tout the stock market as an investment. 

For example, if the S&P 500 declines 30% for the year and a particular mutual fund only decreases 20% for that same year, the regulators allow the advertisements to declare that the mutual fund outperformed the benchmark by 33.3%. 

Therefore, with the mutual fund company in this example still delivering a negative return to their investors, it’s quite obvious to recognize the discrepancy of the advertised end results in a bear market when relative performance is utilized in place of real performance. 

In the 1950s, Markowitz’s focus on risk and reward was of major benefit to investors everywhere, however, as technology becomes more and more dominant and with the varieties of investments becoming even more diverse these days, the theories of the past are routinely called into question. 

Needless to say, both Wall Street and financial regulators have been mired in maintaining the so-called status quo of the past, which has a nice ring to it, but is ultimately devoid of fact. 

Let’s be honest, with the current blitzkrieg of high-frequency trading  does anyone still believe that the financial markets are efficient or that investors are rational? 

Well, perhaps some people are more rational than others which would not only be real, but also, relative.