The risk of using modern portfolio theory – like any model – is that if poor inputs go into the model, poor results come out. Michael Kitces explains.
Industry practice for much of the past 60 years since Markowitz’s seminal paper on modern portfolio theory has been to assume that markets are at least “relatively” efficient and will follow long-term trends.
As a result, the industry has used historical averages of return (mean), volatility (standard deviation), and correlation as inputs to the determination of an appropriate asset allocation.
Yet the striking reality is that this methodology was never intended by the designer of the system itself – indeed, even in his original paper, Markowitz provided his own suggestions about how to apply his model:
“To use [modern portfolio theory] in the selection of securities we must have procedures for finding reasonable [estimates of expected return and volatility].
These procedures, I believe, should combine statistical techniques and the judgment of practical men.
My feeling is that the statistical computations should be used to arrive at a tentative set of [mean and volatility].
Judgment should then be used in increasing or decreasing some of these [mean and volatility inputs] on the basis of factors or nuances not taken into account by the formal computations …
… One suggestion as to tentative [mean and volatility] is to use the observed [mean and volatility] for some period of the past. I believe that better methods, which take into account more information, can be found.”
– Harry Markowitz, ‘Portfolio Selection’, The Journal of Finance, March 1952
Nonetheless, for most of the past six decades, we ignored Markowitz’ own advice about how to apply his model to portfolio design and the selection of investments.
While he recommended against using observed means and volatility of the past as inputs, researchers and financial advisers persisted nonetheless in using long-term historical averages as inputs and assumptions for portfolio design.
Through the rise of financial planning in the 1980s and 1990s, it didn’t much matter.
The extended 18-year period with virtually no material adverse risk event suggested that long-term returns worked just fine, and led to a stocks-for-the-long-run portfolio that succeeded unimpeded for almost two decades.
Until it didn’t.
The year 2000 marked the onset of a so-called Secular Bear Market, a one or two decade time period where equities deliver significantly below average (and often, also more volatile) returns.
Advisers have found that relying solely on long-term historical averages without applying any further judgment regarding the outlook for investments is increasingly problematic – as Markowitz himself warned 60 years ago!
The rise of dynamic asset allocation has quietly but steadily been underway, and in fact now constitutes the majority investing style for advisers in the US.
Although not all necessarily characterise themselves in this manner, a recent Financial Planning Association (FPA) USA study revealed that 61 per cent of financial advisers “did recently (within the past three months) or are currently re-evaluating the asset allocation strategy [they] typically recommend/implement” – which is essentially what it takes to be deemed “dynamic” in some manner.
Notwithstanding the magnitude of this emerging trend towards advisers managing portfolios more actively, it doesn’t necessarily mean they are becoming market-timing day traders.
According to a recent FPA US survey, the average number of asset allocation changes that financial advisers made over the prior 12 months was fewer than two adjustments, and approximately 95 per cent of all those making dynamic asset allocation changes made no more than six to seven changes over the span of an entire year, many of which may have been fairly modest trades relative to the size of the portfolio.
In other words, advisers appear to be recognising that the outlook for investments doesn’t change dramatically overnight – but it does change over time and can merit a series of ongoing changes and adjustments to recognise that reality.
At a more basic level, the trend towards dynamic asset allocation is simply an acknowledgement of the fact that it feels somewhat odd to craft portfolios using long-term historical averages that are clearly not reflective of the current environment – for example, using a long-term historical equity risk premium of 7 per cent despite the ongoing stream of research for the past decade suggesting that the equity risk premium of the future may be lower.
Consistent with the idea that advisers are recognising dynamic asset allocation as an extension of modern portfolio theory and not an alternative to it, a mere 26 per cent of financial planners in the FPA’s survey said they believe modern portfolio theory failed in 2008.
For the rest, the answer was that modern portfolio theory is still intact, or at least “I don’t know” – perhaps an acknowledgement that while modern portfolio theory may still work, many of us lack the training in new and better ways to apply it.
Nonetheless, that hasn’t stopped the majority of financial advisers adopting a process of making ongoing changes to their asset allocation based on the economic outlook and other similar factors.
Unfortunately, perhaps the greatest challenge for financial advisers is that we simply aren’t trained to do dynamic asset allocation in our standard educational process.
Some financial planning practices are responding to the challenge by investing in training, staff, and/or research to support a more tactical process.
Others are responding by outsourcing to firms that can help.
Regardless of how it is implemented, though, the trend towards dynamic asset allocation itself appears to have grown from a broad dissatisfaction amongst planners and their clients that the “lost decade” of equity returns has left many clients lagging their retirement goals.
Even if diversified portfolios have eked out a positive return, it is still far behind the projections put forth when clients made their plans in the 1990s, forcing them to adjust by saving more, spending less, or working longer, to make up for the historical returns that never manifested.
And as long as the secular bear market continues, the strategy will continue to be appealing.
Ultimately, though, the sustainability of the dynamic asset allocation trend will depend on it delivering effective results for clients.
Michael Kitces is director of research with Pinnacle Advisory Group, Washington DC and a keynote speaker at the 2012 PortfolioConstruction Forum Conference.
