It’s not about you: understanding MPT
What Harry actually said…
(This could be sub-titled: “All 747s are planes, but not all planes are 747s, or, the art of manipulating research to fit your own conclusion.” Ed)
Dr Harry Markowitz received the 1990 Nobel prize in economics for developing what is known as Modern Portfolio Theory.
The paper he published was called ‘Portfolio Selection’, back in March 1952, whilst a research associate at The Rand Corp. This was further written up by him in his 1959 book, Portfolio Selection: Efficient Diversification of Investments.
The original article showed that diversification is a way to invest optimally while reducing risk. Modern Portfolio Theory is anchored in ‘buy and hold’ and has become the basic investing road map across the financial services industry.
The problem is: the theory was not designed for an individual retail investor and it can be particularly harmful when blindly applied to an investor’s portfolio.
A simple example is a conversation with a ‘wealth manager’ regarding a 60 year old’s account, where the client’s life is reliant on one overarching financial need – income.
The well intentioned client manager immediately said the client money would be allocated on a 60/40 basis (60% equity, 40% fixed income) – a proposal that ignores the client’s income need, the amount of income needed and, worst, the fact that fixed income is at the highest possible price ever seen with the corresponding lowest yield.
The problem is caused by investment managers trying to fit retail investors into institutional research. Markowitz did not produce Modern Portfolio Theory for individual investors, just like diesel was not invented for petrol engines.
This is his clarification on this mis-application of his work:
To confirm this was not for individuals, he ignored it for his own pension, saying,
“I visualised my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.”
If there’s a cash account paying 5% per year and an investor needs 5% a year income, then having 100% in cash is absolutely fine, it meets the investor objective. Only an investment company trying to fill their own funds for their own reasons would suggest otherwise.
Further analysis of Markowitz’s 1952 work, comparing it directly to his 1991 views, has been done by Jason Branning and Ray Grubbs, PhD, in their paper The Markowitz Conundrum Part ll.
