Opinion of the Day: Modern Portfolio Theory Is Junk Science

Modern Portfolio Theory

Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets.

So why am I calling it junk science?

For example, to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can in theory face lower overall risk than either individually.

While it is true that stocks and bonds often move differently over shorter time frames, stocks and long-term bonds have been moving together since the early 1980s. Rates fell. Both bond prices and stock prices went up. For long-term investors, only the long-term should matter. Anyone who thinks that stocks will do okay if the widely assumed "bond bubble" pops needs to have their head examined. Junk science.

MPT also assumes that investors are rational and markets are efficient.

Hilarious! Junk science.

The framework of MPT makes many assumptions about investors and markets.

Many assumptions? Junk science.

During times of financial crisis all assets tend to become positively correlated, because they all move (down) together. In other words, MPT breaks down precisely when investors are most in need of protection from risk.

Theory prone to failure? Junk science.

The risk, return, and correlation measures used by MPT are based on expected values, which means that they are mathematical statements about the future...

Using the distant past to predict the distant future? Junk science.

Essentially, the mathematics of MPT view the markets as a collection of dice. By examining past market data we can develop hypotheses about how the dice are weighted, but this isn't helpful if the markets are actually dependent upon a much bigger and more complicated chaotic system—the world.

Basing investment decisions on a collection of dice? Junk science.

Following MPT means portfolio managers can invest in assets without analyzing their fundamentals...

Using a gambling strategy instead of fundamentals? Junk science.

I'm saving the best reason for last. In 1966, Alan Greenspan stated:

The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

I am a believer. If you are a believer as well, then surely you must realize that modern portfolio theory offers a false sense of security. The herd cannot possibly protect itself by all doing the same thing at the same time. That's a pretty darned big target for the welfare state.