Modern Portfolio Theory has had a rough go lately, but its apologists are still trying to find a way to make it sound plausible. There’s a lot of emotional investment in MPT because so many firms have endorsed it and so many assets are invested according to its principles. Consider, for example, the following two statements taken from the same article written by a financial advisor:
Modern portfolio theory can be a useful guide for financial advisers, but it’s just a theory. It doesn’t take into account the current economic context.
And then, a couple of paragraphs later:
MPT is only successful if it takes current economic conditions into consideration.
So, it doesn’t take current conditions into account, but it can only be successful if it takes current conditions into account? What?
That’s why I get a headache when I read this stuff.
I think I understand what he is getting at in his article-that asset allocation can’t be done mechanically through portfolio optimization. Yet, isn’t that the exact premise of Modern Portfolio Theory? Once you start actively tweaking the asset allocation based on your judgement, that’s tactical asset allocation-not a bad thing, but not MPT. When MPT advocates write articles, it seems that more often than not they backpedal into an endorsement of what everyone else calls tactical asset allocation!
Here’s one section of his article that I agree with:
…MPT assumes certain asset classes have reverse correlations — that they’re “natural hedges” for each other. But in 2008 many of those natural hedges crashed at the same time, and many investors who had put all their eggs in the MPT basket faced economic ruin.
Somehow, to me, “economic ruin” sounds slightly worse than the not-really-comforting explanation that MPT is “not that good at dealing with statistical anomalies.” Tactical asset allocation using relative strength does not make any assumptions about the correlations between asset classes and focuses entirely on current conditions, which might be a little safer bet.
