Redefining risk: Modern Portfolio Theory and our attitude

by Edward Robertson   25 Nov 2016
[Note: this article was made the cover story for The Private Investor (formerly Exempt Edge) Issue 19, January 2017]

Fund manager Scott Vincent’s 2011 article “Is Portfolio Theory Harming Your Portfolio?” [1] is a compelling manifesto to support the position that knowledgeable investment can reliably beat the market.

His message is that Modern Portfolio Theory (MPT) dominates financial thinking, even though it is demonstrably faulty in real world application. MPT and its close association with large scale quantitative methods are deeply engrained in the financial services industry. This in turn has exerted a detrimental influence on our attitudes towards investment. It pushes us to accept very poor market returns, to over-diversify and water down our portfolios, and to confuse and cloud our view of risk.

What are the problems with the MPT model?

MPT shortcomings
Risk. Volatility is the proxy used for risk, but it is a defective notion, except perhaps for short term trading. "Any risk measure based upon standard deviation is flawed [because it measures the entire positive-negative fluctuation]. Investors worry about not meeting their goals, not about higher-than-expected returns..." [2] Later fixes (Post-modern Portfolio Theory) permitted the computation of just the downside. But curiously, "the earlier, less sophisticated MPT-derived software remains more popular among investment advisers" and so perpetuates the skewed idea of risk as volatility. [3] Further, real world portfolios have non-normal distributions of returns. Since the conventional estimate of risk assumes normal distribution, it is not very representative of reality.

Vincent explains the gap between a realistic estimate of risk and mere volatility. A sharp drop (showing high volatility) might actually be seen by active managers as a low risk, long term gain opportunity. Conversely, low volatility could coincide with the risk-laden over-valuation of a security. Evidently, volatility is not synonymous with risk, and can be a misleading substitute. A realistic estimate of risk should, moreover, examine the current context, rather than relying solely on historical data.

Asset allocation.  The adage that stocks and bonds move inversely is no longer reliable. Moreover, as various equity asset classes approach 1.000 in correlation, "we lose the value of diversification." [4]  As one client newsletter explained: "The assumption that market risk can be reduced by diversification has led to frequent catastrophic results throughout market history—most recently in 2008." [5] The classic portfolio mixes given by MPT are theoretically elegant, but assume non-correlation of asset classes and so ignore real results. [6]

Rates of return.  The MPT-inspired advice is to invest in the index, placing faith in average market returns. One critic posts a chart of ten-year returns, showing that, in fact, "the long-term 'average' returns are rarely available." [7]

Following this line of thought, I checked the Canadian Couch Potato (index investor) to see ten-year returns in recent periods. His Global portfolio annualized 10 year return ending 2011 was 4.03% [8]; model balanced portfolios ending 2014 ranged 5.24 - 6.10% [9]. Any investor with a short time frame, or low tolerance for extended periods of lost opportunity, would have endured 3-year periods with negative returns, with the worst year around -19%.

Of course, it is possible to use selection and timing of sector-specific ETFs to gain significant and efficient returns. However, as a general rule, a merely passive approach to trust the broad market index can result in minimal or negative returns, even over the long term.

Despite its defects, MPT and the financial services industry's preponderance for "super-large, super-diversified, super-profitable funds" are entrenched, because "the industry depends on quantitative finance to bring it scale and profitability.” [10]

With this much as background, we can conclude that the philosophy underpinning the financial services industry (despite selective confirming evidence in up-markets) has fundamental flaws, and ultimately serves institutional interests rather than those of the average retail investor. We can use the arguments cited so far against Modern Portfolio Theory to help explain its detrimental effects upon our investing attitude.

Inadequate notions of risk
Volatility, as discussed in Part 1, is an inadequate proxy for risk. Beyond that essential criticism, the approach to risk by MPT critics is a little vague: "Risk is a complex notion. We’ve been studying it for centuries... Risk is often in the eye of the beholder." [11]  Commentator Abodeely equates risk with "chance of loss". [12]  Yes, but I would ask: what causes the chance of loss? The investor should be able to break it down.

Behavioral finance has supposedly "developed a rich view of risk" [13], characterizing it as variable personal perception. The trouble with this view is that it places the cause of loss back in the mind of the investor, with no analysis of the structural defects of the investment. Indeed, "the supposed irrationality [of the investor] is in fact nothing more than rational behavior in the face of uncertainty". It is really time to develop a full risk profile of the investment itself  "instead of just focusing on investor behavior and cognition." [19]

When considering mutual funds or ETFs, especially when simply tracking the market, we encounter risk as an aggregate. It will be tied to broad, massive movements in the global economy. MPT's flawed measure of risk is operant, along with the disclaimer that past performance does not indicate future results. Such a broad view of risk and the market's volatility make performance track records irrelevant. For the investor dependent upon this system, risk acquires a murky character, eliciting merely a fear response.

“Perhaps then the risk in a portfolio is better described by taking a bottom-up view of the fundamentals of the businesses owned… rather than computing the portfolio’s historic variability with respect to the market?” [14] Yes! If so, we could then apply a systematic risk ID process, and analyze specific prospective investments. The result would be a closely defined and comprehensible risk profile.

This leads to a rather insidious aspect of the misrepresentation of risk, that is, the implication that high returns necessarily signify high risk.

If item #1 in the notice above were universally true, would it have been possible, on balance, for an entire class of accredited investors to be successful in the first place? Even relying only on personal experience and observation, I feel inclined to agree with Cora Pettipas' assertion: "Contrary to popular belief, the blow ups and losses of the public markets far outstrip the losses in the exempt market." [15] This indicates the distinct possibility, in the exempt market, of lower risk accompanied by typically higher returns.

If we agree provisionally that risk is volatility: “…the idea that assets whose prices have varied significantly warrant higher expected returns doesn’t hold up in empirical tests”. The author joins us in daring to suggest that  “it may be possible to earn higher rates of return with less risk.” [16]  If we conceive of risk properly, as potential impediments to achieving planned goals and objectives, then the more intuitive principle is correct: a low risk profile indicates maximum chances for business success and investor returns. 

Misuse of diversification
Of course, there is a place for measured and sensible diversification to offset risk. Scott Vincent makes the case, however, that the technique of diversification exploded out of control through the embrace of MPT by the financial services community; it became “the Holy Grail for financial advisors and planners who preach its virtues with an unquestioning, cult-like enthusiasm.” Here is his counter-argument:

Not only are we unlikely to find an ‘efficient frontier’ by super-diversifying an actively managed portfolio, but diversification adds a cost… Over-diversification not only decreases a manager’s ability to find inefficiencies but it may, in fact, increase risk. Warren Buffett expressed the idea more eloquently, ‘We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.’ [17]

Again, in the typical retail investing experience, the fear response to a general alarmist notion of risk plays straight into the mainstream answer of hyper-diversification in pursuit of the index. Many managers classed as "active" - and given bad report cards - are actually closet indexers. Vincent cites evidence that truly active managers in stocks need not over-diversify beause they can indeed beat the index, with persistence (i.e., the same managers can beat the market repeatedly).

Unlearning faulty assumptions, applying sound analysis
The argument for active management applies well to retail investors wishing to explore private market investments. We can first benefit from the message to unlearn misleading notions of risk. We can discard the reflexive saying “high returns equal high risk”, and question whether hyper-diversification is beneficial. Exempt Edge editor Cora Pettipas has further warned against many faulty assumptions conditioning our investment attitude, deploring that exempt market products “are classified as ‘high risk’ no matter the fundamentals of the underlying investment.” [18]

What is required is to open up the discussion, identify risks in a structured manner, and examine individual investments in their proper contexts, instead of relying solely on vast market movements and super-diversification.  A critical approach lends itself to individual private market investments, where the due diligence processes of Exempt Market Dealers can be questioned;  product issuer management teams and their track records can be assessed; and unique investment product features can be scrutinized.

The mainstream use of Modern Portfolio Theory seems to tell us to put our faith in a game on a vast scale, entirely too random, over impossibly long periods of time. Unless we are resigned to that view, it stands to reason that successful investing is better conceived as selecting intelligently and reliably designed products. It follows that chances for making the intended returns bear direct relation to the degree of risk identified and managed. Sound analysis should prevail.



[1] [10] [11] [14] [16] [17]
Vincent, Scott, "Is Portfolio theory harming your portfolio?", 29 Apr 2011

"Asset allocation optimization using downside risk analysis", Unified Trust (undated)

[3] [4] [13]
Sumnicht, Vern  Practical applications of post modern portfolio theory, 03 Mar 2008

McAuley, Brian, Client Newsletter, Sitka Pacific , Mar 2010

[6] [7] [12]
Abodeely, JJ, "Modern Portfolio Theory is harming your portfolio" 07 Jun 2011

Bortolotti, Dan "The Couch potato's 10 year report card" 18 Apr 2011

Bortolotti, Dan "Model portfolios" (2015)

[15] [18]
Pettipas, Cora "Decivious: Questioning mainstream investment assumptions", Exempt Edge, 28 March 2016

Shirvani, Hassan "A Critique of behavioral finance" Cameron School of Business, U of St Thomas, 22 Sep 2015

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