Suppose you’re exploring a large city that you’ve never previously visited or you’re hiking a wilderness area for the first time. Would it be better to take with you an inaccurate map or no map at all. That’s the question raised by Nassim Nicholas Taleb in his book Silent Risk. We tackle the question, is modern portfolio theory creating lazy Financial Advisers, unknowingly investing their clients with additional risk.

**Many investment advisers use an inaccurate map**

Taleb contends that when it comes to financial modelling including determining an optimal asset allocation for individuals that many investment practitioners and academics prefer an inaccurate map, to no map to all. The inaccurate map that is used by many financial advisers when working with clients to determine the optimal asset mix is called modern portfolio theory or MPT. We still see the clear majority of Financial Advisers and Industry Superfunds still using this flawed map today.

**What is Modern Portfolio Theory**

Harry Markowitz first introduced modern portfolio theory in 1952 and eventually won the Nobel Prize for his efforts. The theory was developed from the early 50’s throughout the early 70’s and it remains the bedrock of modern finance.

The idea behind modern portfolio theory is that for a given level of risk there is an optimal portfolio mix which is the split between stocks, bonds and other asset classes that will maximize the expected return. With MPT, risk is defined as volatility which is the variability of returns, how high are the highs compared to how lower the lows.

To use an asset allocation model based on model portfolio theory you need a couple things. You need an expect return and an expected volatility for each asset class, such as domestic large company stocks, small company stocks, international equity, bonds and many others. Then you need an assumption for how these asset classes move in relation to each other. How closely do the asset classes returns track in the same direction or perhaps move in opposite direction over a given period. This is called correlation.

With these inputs, for a given level of expected return the model can calculate the optimal mix between stocks, bonds, real estate and other asset classes that minimises the expected volatility. A line graph of the expected returns and volatilities of different optimal portfolios is displayed. That line draft is called the efficient frontier. The goal of the exercise is to select a portfolio mix that lies on that efficient frontier, sounds complicated? Well it is because there’s a lot of inputs.

**Is there an investment alternative to MPT?**

Most financial advisers work with clients to help them select a portfolio mix using modern portfolio theory. What we’ve found is most clients don’t really need a truly optimal portfolio. They need a portfolio that fits their comfort level yes but removes the flawed over diversification model and the indiscriminate exposure to highly inflated asset classes. We believe a portfolio developed on a client’s palatable risk profile which still resides on the efficient frontier but is not heavily constrained, is key for client portfolio development. Critical during this late stage of the business cycle.

**Diversification won’t save you.**

Many Advisers, Superannuation investment options cling to this flawed investment map, perhaps because it seems better than having no map at all. Ultimately it forces clients to diversify into different asset types regardless of conditions or valuations.

**Give it away – Investment Advisers**

Our advice to all Financial Advisers would be to step away from the modern portfolio theory, give up on it. We can no longer ignore the evidence, MPT has serious flaws, these flaws are outlined by Nassim Nicholas Taleb in his book the Black Swan and by Benoît Mandelbrot and his book the Misbehaviours of Markets.

The problem with MPT is it assumes market returns congregate around the average expected return much more than they do. In other words, good times and tough times, good returns, bad return happens way more frequently than the theory predicts. MPT also assumes returns in 1 year do not effect returns in the next, that the returns are independent from year to year and that’s not the case. And finally, it assumes investors are rational agents that they are alike we know that investors are very, very different. So, the truth is accepting good and bad returns happen much more often than the theory predicts. These extreme events tend to clump together rather than to be spread out randomly, they cluster.

As we all know, investors are far from rational but suffer from bouts of extreme fear and greed. So, you don’t need to use modern portfolio theory. We don’t use it in terms of our allocation or in teaching clients about investing their money. We focus on building diversified portfolios by having different portfolio drivers. Making sure that we have reasonable return assumptions for those asset classes. In terms of risk we don’t care about volatility, we care about losing money. How much will we lose in a market drawdown and what’s a reasonable expectation for recovery. So, you don’t have to use model portfolio theory. You should be diversified by having different portfolio drivers and understand what you can earn investing.

**The fuzzy feeling won’t protect your money.**

Right now, as we write this article in July 2018, in this extremely overvalued market we know now more than ever. Investors need to step away from the fuzzy feeling that modern portfolio theory has lulled investors into. We believe that nice feeling may soon turn painful.

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